Interest Rate Futures

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Information about Interest Rate Futures

Published on August 12, 2008

Author: sukumarnandi


INTEREST RATE FUTURESSukumar NandiIndian Institute of Management Lucknow : Indian Institute of Management Lucknow Interest rate Futures 1 INTEREST RATE FUTURESSukumar NandiIndian Institute of Management Lucknow Interest Rate Futures : Indian Institute of Management Lucknow Interest rate Futures 2 Interest Rate Futures Interest rate futures are forward contracts for short-term investments, money market and capital market instruments with fixed maturities and standard contract sizes traded on an exchange. This means that interest rate futures can be used to fix interest rate in advance. At the present time, contracts for about 10 money and capital market instruments are traded, the main ones being based on 3-month Eurodollar deposits, US Treasury bonds, US Treasury bills and 3-month Sterling deposits. Interest rate futures contracts have fixed units of trading, such as US$ 1 million in the case of contracts for short tier deposits (3-month Eurodollar deposits) and US$ 100,000 in the case of contracts for long-term, fixed-interest securities (US$ Treasury bonds). The trading months are limited to March, June, September and December. Slide 3: Indian Institute of Management Lucknow Interest rate Futures 3 The interest rates derived from the prices of interest futures contracts are not equal to the current interest rates for the related instruments. Rather, they represent expected interest rates for future periods. Normally, contracts are not held until delivery; instead, they are closed out before maturity through counter trades. Purchases and sales of interest rate futures are settled via the clearing houses as in the case of currency futures. The initial as well as the variation margins again play an important role in covering the liabilities assumed by any purchases and sales. The direct costs consist of a commission payable for the execution of an order which goes to the Exchange. The commission becomes payable at each opening or closing out of a position and comes to about US$ 12.50 per contract. Slide 4: Indian Institute of Management Lucknow Interest rate Futures 4 The use and funcationing of interest rate futures is illustrated by means of two common situations faced by a company. For simplicity’s sake we shall not include the commission as well as the initial and variation margins in the calculation of the yield. The Treasurer of a firm expects payment inflows of US$ 10 million in September. He intends to invest this sum in a 3-month US dollar time deposit. He expects a decline in interest rates and therefore less interest income from the placement to be made in September. He therefore, buys 10 September contracts 3-month Eurodollar deposit (US$ 1 million each) which are quoted at 93.50. This price is arrived at by deducting the expected rate from 100, i.e. 100-6.5% p.a. = 93.50. He thus fixes the interest rate on his future deposit at 6.50% p.a. Slide 5: Indian Institute of Management Lucknow Interest rate Futures 5 After the expected amounts have been received in September, the position is closed out by selling the contracts and placing the funds. As expected, the interest level has eased to 6% p.a. (contract price 94.00) and therefore the increase in the contract price offsets the interest reduction on the placement. Purchase: 10 September Eurodollar contracts 93.50 (interest rate 6.50% p.a.) Sale: 10 September Eurodollar contracts 94.00 (interest rate 6.00% p.a.) Gain 0.50 Gains or losses arising from closing out positions in futures contracts are expressed in basis points, in our case 50 basis points. Slide 6: Indian Institute of Management Lucknow Interest rate Futures 6 The value of a basis point is calculated with the following formula: Value of the Contract x 1 Basis Point x number of days 360 x 100or US$1,000,000 x 0.01 x 90 = US$ 25 360 x 100 The Treasurer achieves the desired result in the form of a 6½% yield per annum. The decline of the interest rate level to 6% p.a., is offset by the hedging profit. Hedging profit from the futures transaction: US$ 25 x 50 basis points x 10 contracts = US$ 12,500 – interest loss on the placement:US$10,000,000 x 0.5 x 90 = US$ 12,500 360 x 100 Result = US$ 0 Slide 7: Indian Institute of Management Lucknow Interest rate Futures 7 In a different situation a company must raise a short-term bridging loan in early December for 3 months for US$ 2 million in connection with a major investment project. Already in march the Treasurer wants to establish a firm basis for his calculations. As he expects interest rates to move up slightly in the coming months, he decides on the following action: He takes a short position by selling 2 December contracts 3-month. Eurodollar deposit (US$ 1 million each) which were quoted in mid-March at 94.00 (100–94.00 = 6.00% p.a.). By doing this he assures himself of a 6% p.a. interest rate for the credit he plans to take up. Contrary to his expectations interest rates go down and he can obtain the bridging loan at 5¼% p.a. in December. He liquidates his futures position at the same time he draws the loan. The loss on the futures position is offset by the reduction in the interest rate he has to pay on his bridging loan, thus providing him with an interest rate of 6% p.a. as intended. Slide 8: Indian Institute of Management Lucknow Interest rate Futures 8 Sale: 2 December Eurodollar contracts 94.00 (interest rate 6.00% p.a.) Purchase: 2 December Eurodollar contracts 94.75 (interest rate 5.25% p.a,) Loss 0.75 Loss from the interest rate futures transaction: US$ 25 x 75 basis points x 2 contracts = US$ 3,750 + reduced interest costs for the credit:US$2,000,000 x 0.75 x 90 = US$ 3,750 360 x 100 Result = US$ 0 Slide 9: Indian Institute of Management Lucknow Interest rate Futures 9 These examples show that a position with existing or future interest rate risks (underlying position) is hedged by building up a long or short position in the futures market which, in regard to its nature and scope, corresponds as closely as possible to the underlying position. By this procedure it is possible to fix in advance the future interest rate and makes it immune to market fluctuations. Gains or losses on the underlying position are then largely compensated by an increase or decrease in the value of the futures contract. An exact compensation will hardly ever occur since the amounts and the maturities of the underlying position usually differ form those of the contracts (4 delivery dates per year!) and the spot and forward market developments do not always match exactly. Slide 10: Indian Institute of Management Lucknow Interest rate Futures 10 The underlying position to be hedged is the crucial factor for the selection of the contract. Should this position be based on a money market placement, it would be advisable to choose a contract with a short-term underlying instrument, for example a 3-month Eurodollar deposit. On the other hand, if the objective is to hedge a capital market operation, a contract with a longer-term underlying security would undoubtedly be selected, such as a US Treasury bond. In general it is important to know that a borrower can protect himself against rising interest rates by selling interest rate futures. Coversely, an investor can hedge against falling interes rates by buying interest rate futures.

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