Short Term Interest Rate Futures

Description of contracts and hedging strategies

Short Term Interest Rate Futures

• Defined as:

• A futures contract on the interest rate applicable to an interbank transaction that begins life on the delivery day of the future.

• Thus the interest rate must be a forward rate of interest.

Short Term Interest Rate Futures

• Form of Price Quotation.

• Futures price quotation is – 100 minus the annualised forward rate– Thus if the forward rate is 10%pa– the futures quote will be – 100-10 = 90– So as rates go up, the futures price goes down– and as rates go down, the futures price goes up

Short Term Interest Rate Futures

• Typical Contract Specifications:• Three Month Eurodollar Contract on IMM

Chicago– Underlying Deposit: $1,000,000

• Delivery: March, June September and December, plus first three months.

• Tick size: one half of one basis point (one quarter for near month contract)

• Tick Value $12.50 (6.25)

Short Term Interest Rate Futures• Calculation of forward rates

• Assume: 225 day LIBOR =10.25% pa. And the 135 day LIBID - 10% pa.

• The 90 day forward rate 135 day out in a 360 day market is

24.1090

360*1

360135

*1.0(1

360225

*1025.01

225/135

FR

Short Term Interest Rate Futures• Hedging with futures.

• Remember as rates rise, STIR futures prices fall.

• So to hedge against rate falling – buy futures

• To hedge against rates rising – sell futures.

Short Term Interest Rate Futures• To hedge the interest rate on a future cash

flow we need to know:– The scale of the cash position to be hedged and

the nominal value of the deposit underlying the future

– The duration or money equivalence of the cash position and the future.

Short Term Interest Rate Futures• The nominal value of the deposit

underlying the future is given by the futures contract specifications eg $1,000,000 for the three month contract in Chicago, £500,000 for the contract in London.

Short Term Interest Rate Futures• The moneyness of the futures contract is the

Price Value of a Basis Point (PV01). This is not always equal to the Tick Value. In the case of the LIBOR contract on CME it is twice the tick size (four times for the near month)

• The moneyness of the cash-flow to be hedged reflects how the cash-flow will change as the interest rate changes by one basis point. We will call this the Nominal Value of a Basis Point (NV01).

Short Term Interest Rate Futures• Number of futures to trade to establish

hedge:

• Where:– FVCP = Face value of cash position– NVFT = Notional amount underlying the future

F

H

PV

NV

NVFT

FVCPn

01

01*

Short Term Interest Rate Futures• Hedging Case:

• Assume a $25,000,000 paying three month LIBOR.

• You wish to hedge the roll-over in three months time, using three month Eurodollar future on the IMM

Short Term Interest Rate Futures• Calculating the number (n) of the futures to

trade.

• NV01 of $1,000,000 three month deposit is $25.

• PV01 of future is $25 (0.25*1,000,000*0.0001)

25,000,000 25* 25

1,000,000 25n

Short Term Interest Rate Futures• Calculating the effectiveness of the futures

hedge.• Assume futures price is 90.65 when the hedge

is established• Assume three month LIBOR at the reset date is

8.75% pa., that implies a futures price of 91.25.• Thus the futures position will pay

60*$25*25=$37,500 in variation margin.

Short Term Interest Rate Futures• Calculating the effectiveness of the futures hedge

cont.• The roll-over is 0.6% pa lower than the forward

rate implied when the hedge was established.• The fall in interest revenue on the $25,000,000 90

day deposit is 0.25*0.006*$25,000,000 = $37,500 • NB Eurodollar markets assume a 360 day year!

Short Term Interest Rate Futures• Calculating the number (n) of the futures to

trade to hedge a six month deposit.

• NV01 of $1,000,000 six month deposit is $50.

• PV01 of future is $25

1225

50*

000,000,1

000,000,6n