Interest Rate Futures

Interest rate futures are a tool for hedging interest rate risk.

Characteristics

Types of IRFs

There are two broad types of interest rate futures:

• Short-term interest rate futures (STIRs). These are standardised exchange-traded forward contracts on a notional deposit (usually a three-month deposit) of a standard amount of principal, starting on the contract's final settlement date.
• Bond futures. These are contracts on a standard quantity of notional government bonds. If they reach final settlement date, and a buyer or seller does not close his position before then, the contracts must be settled by physical delivery.

Short-term interest rate futures are traded on a number of futures exchanges. For example:

• STIRs for sterling (three-month LIBOR) and the euro (three-month euribor) are traded on Euronext.liffe (formerly LIFFE), the London futures exchange.
• A STIR contract for the US dollar (eurodollar) is traded on the Chicago Mercantile Exchange (CME).

Here are just a few STIR contract specifications.

Underlying assets

To understand whether you need to buy or sell contracts, interest rate futures are best understood as involving the sale or purchase of bonds.

• borrowing money equates to issuing (selling) bonds, so sell futures to set up the hedge.
• depositing funds equates to buying bonds, so buy futures to set up the hedge

Ticks and tick values

For STIRs, the minimum price movement is usually 0.01% or one basis point.

The value of a tick is calculated as follows:

• Tick value = unit of trading (i.e amount of principal) × one basis point × fraction of year.
• For three-month sterling ("short sterling") futures, the underlying deposit for one contract is £500,000, so the value of one tick is £500,000 × 0.0001 × 3/12 = £12.50.

Futures prices

Interest rate futures prices are stated as (100 - the expected market reference rate), so a price of 95.5 would imply an interest rate of 4.5%.

Open and settlement prices - in an exam question, when setting up the hedge, you may be quoted "Open" and "Settlement" futures prices. When setting up the hedge, the "Settlement" price should be used - the "Open" price is not relevant in our calculations.

Calculating the number of contracts needed

Futures hedging calculations

Step 1: Set up the hedge by addressing 3 key questions:

• Do we initially buy or sell futures?
• How many contracts?
• Which expiry date should be chosen?

Step 2: Contact the exchange. Pay the initial margin. Then wait until the transaction / settlement date.

Step 3: Calculate profit or loss in the futures market by closing out the futures contracts, and calculate the value of the transaction using the market rate of interest rate on the transaction date.

Imperfect hedges

The futures hedge is imperfect due to:

• If you are not dealing in whole contracts and have to round to whole contracts.
• Basis risk - the future rate (as defined by the future prices) moves approximately but not precisely in line with the cash market rate. An understanding of basis risk can help to predict the closing futures price if you are not given the necessary information in a scenario.

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