Interest Rate Futures How to use interest rate

Interest Rate Futures How to use interest rate futures to hedge interest rate movements Mark Fielding-Pritchard mefielding. com 1

Interest Rate Futures The basic principle is that we will take out a loan in x months. When the loan is taken out it will be fixed rate. We are hedging therefore against interest rate increase from today until the loan is taken out We therefore make a bet that interest rates will rise. If rates actually rise the sum of money we win on the bet = the additional interest payable mefielding. com 2

Now is 1/1. On 1/4 we will take out a loan of £ 5 m until 30/9 Our current borrowing rate is Libor + 30 which gives us 6%, now. But if LIBOR rises before 1/4 our rate will rise The loan is for 6 months, our bet therefore must win 6 month’s interest Loan Profile 7 6 Interest Rate 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 Time mefielding. com Our risk period is 1/1 to 1/4. Once the loan is taken out the risk ends. We hedge therefore from 1/1 to 1/4. 3

How do Futures Work? The value of a future is 100 - the interest rate Therefore as rates rise the value of a future falls In the period from today to closure of the future you must both buy and sell, it doesn’t matter which comes first, profit is the margin. If we are hedging rising rates we sell, falling rates we buy Interest rates are expected to rise from 6% to 7% soon. In 3 months we will take out a loan. Today is 1/1 Value of future today 94 Sell Value of future after rise 93 Buy 1 Gain Interest rates are expected to fall from 6% to 5% soon. In 3 months we will put cash on deposit. Today is 1/1 Value of future today 94 Buy Value of future after rise 95 Sell 1 Gain mefielding. com 4

How do Futures Work? The problem is that in slide 4 we had a gain but it doesn’t mean anything, 1 what? Therefore futures are denominated in notional loans at £ 500000 for 3 months Therefore a profit of 1= 1% x 500000 x 3/12= £ 1250 Therefore 1 future will provide enough winnings to cover extra interest on a loan of £ 500000 for 3 months If you have a loan of £ 1 m for 3 months or £ 500000 for 6 months you need 2 futures £ 1. 5 m for 3 months, £ 500000 for 9 months, £ 750000 for 6 months; you need 3 mefielding. com 5

Interest Rate Futures Buaben Ltd. wants to borrow £ 10 m for 2 months on 20 April with the current interest rate being 5%. It is currently January 31 st. They decide to hedge their risk by using 3 month interest rate futures which are currently quoted at: March Price = 94. 50 June Price = 94. 85 The contract size is £ 500, 000. At 20 April the futures price has moved to 94. 25 and the base rate of interest has risen to 5. 5% mefielding. com 6

Interest Rate Futures Setting up the hedge 3 questions 1) Do I buy or sell? We are hedging rising interest rates so we sell We will buy back on 20/4 mefielding. com 7

Interest Rate Futures 2) Which month? At any point in time we would expect to see various futures traded. In this question there are only 2 futures quoted. March is no use to us as it closes on 31 March (here) which would leave us unhedged from 31/3 to 20/4. We need June therefore, we sell today and buy back on 20 April. If September were quoted as well we would still take June. The reason is that futures prices are not 100 - LIBOR but that price with an adjustment for future risk (basis risk). The longer the time to closure a future has the greater is likely to be the basis risk. mefielding. com 8

Interest Rate Futures x mefielding. com 9

On 20 April We close our position by buying 13 June’s On 1/1 Sold 94. 85 On 20/4 Buy 94. 25 Gain 0. 6% x 500000 x 3/12 x 13= £ 9750 Additional Interest 0. 5% x 2/12/10 m= 8333 Hedge Efficiency 9750/8333= 117% 1% = 100 ticks. 1 tick = 0. 01% x 500000 x 3/12= £ 12. 50 0. 6% = 60 ticks = £ 750 mefielding. com 10

Interest Rate Futures Hedge efficiency therefore is 9750/ 8333 = 117% Why is it not 100%? 1) Rounding of contracts- loan here is 2 months not 3 2) Difference in price movement. Interest rates moved 0. 5% but the future price moved 0. 65% Other factors Fees, Agent fees Deposits Margin calls Maintenance requirements mefielding. com 11