A Note On Interest Rate Futures
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SHORT TERM HEDGING (HEDGING THE RISK OF A RISE IN INTEREST RATES FOR
OBTAINING A PREDICTABLE COST OF FUNDS)The risk of
an increase in interest rates can be hedged by selling interest rate
futures.
Example:
On January 6, 2003, a firm comes to know about a funds requirement of $10
million on March 15, 2003, for a 3-month period. A bank is ready to provide
the loan of $10 million for a 3-month LIBOR rate prevailing on March 15,
2003. Since the firm is concerned about an increase in the LIBOR rate, it
decides to go short on March Eurodollar futures contract to protect itself
from any increase in the interest rate between January 6 and March 15.
The firm will have to enter into ten contracts because the size of one
Eurodollar futures contract is $1 million. Assume that on January 6, the
March Eurodollar futures price is 92.86 and the implied three-month
Eurodollar rate is 7.14% (See Exhibit III Treasury Bill Futures and
Eurodollar Futures) while the 3-month LIBOR in January is 7.24%. Since LIBOR
rates are always quoted for one year, 7.14% implies 7.14% per annum. Assume
that the tick size is 25.
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The firm can lock a 3-month Eurodollar future rate of
7.14% and thus limit its borrowing cost to:
= $100,00,000 X (7.14/100) X 3/12
= $178,500
To limit the borrowing cost, the firm will have to sell 10 March
Eurodollar futures contract on January 6, because if the interest rates
rise, the price of the contract will go down and the firm can settle the
contract by purchasing it at a lower price and thereby gaining in the
futures market. |
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Case I
The 3-month LIBOR rises to 8.5% by March 15 (thus the March futures will be
priced at 91.5, since the Eurodollar futures price is quoted as 100 – LIBOR)
Interest Expense = (Principal) X (Annual Rate) X 3/12
= $100,00,000 X 8.5% X 3/12
= $212,500
Less: Futures Gain = (Price Change) X ($25/BP) X 10
= (92.86 – 91.5) X 100 X 25 X 10
= $34000
Net borrowing cost = $(212,500 – 34,000)
= $178,500
Case II
The 3-month LIBOR falls to 6.5% by March 15
Interest Expense = (Principal) X (Annual Rate) X 3/12
= $100,00,000 X 6.5% X 3/12
= $162,500
Less: Futures Loss = (Price Change) X ($25/BP) X 10
= (92.86 – 93.5) X 100 X 25 X 10
= $16,000
Net borrowing cost = $(162,500 + 16,000)
= $178,500
In both the above cases, the firm has locked its cost of borrowing at $178,500.
In the first case, a rise in interest expenses is compensated by a gain on the
short futures position. In the second case, loss on the futures position is
compensated by a reduction in the borrowing cost.
LONG-TERM HEDGING (HEDGING THE RISK OF A FALL IN INTEREST RATES FOR
AN INVESTMENT)
ARBITRAGE WITH T-BILL FUTURES
SPREADING WITH INTEREST RATE FUTURES
TABLE II TRANSACTIONS INVOLVING BUYING THE TED SPREAD
TREASURY BONDS FUTURES
PRICING OF T-BOND FUTURES CONTRACTS
QUOTED FUTURES PRICE
TABLE III STEPS TO CALCULATE QUOTED FUTURES PRICE
CONCLUSION
EXHIBIT I LIST OF ACTIVELY TRADED SHORT TERM INTEREST RATE FUTURES
EXHIBIT II LIST OF ACTIVELY TRADED LONG TERM INTEREST RATE FUTURES
EXHIBIT III T-BILL FUTURES AND EURODOLLAR FUTURES
EXHIBIT IV NO ARBITRAGE FUTURES PRICE
EXHIBIT V CHARACTERISTICS OF T-NOTE AND T-BONDS
EXHIBIT VI CHEAPEST TO DELIVER BOND
ADDITIONAL READINGS & REFERENCES
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