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Home » Finance Case Studies » A Note On Interest Rate Futures

A Note On Interest Rate Futures Finance Case Studies

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INTRODUCTION

An interest rate futures contract is "an agreement to buy or sell a package of debt instruments at a specified future date at a price that is fixed today." The underlying assets of an interest rate futures contract are different interest bearing instruments like T-Notes, T-Bills, T-Bonds, deposits and so on.

Interest rate futures contracts were first traded on October 20, 1975, in the Chicago Board of Trade. Such contracts can have short-term (less than one year) and long-term (more than one year) interest bearing instruments as the underlying asset. In the US, short-term interest rate futures like 90-day T-Bill and 3 month Eurodollar time deposits are more popular (See Exhibit I for actively traded short-term interest rate futures). Long-term interest rate futures include the 10-year treasury note futures contract, the treasury bond futures contract and more (See Exhibit II for actively traded long-term interest rate futures).

DEFINING THE TERMS

To study and understand interest rate futures contracts, one must be familiar with a number of terms. Let us review some of the more commonly used terms. Treasury bill futures are futures contracts on 90-day treasury bills. Eurodollar refers to any dollar-denominated account outside the US. The Eurodollar futures contract is a contract on the 3-month LIBOR (London Inter-Bank Offer Rate). LIBOR is the rate of interest at which banks borrow funds from other banks in the London interbank market. The risk less return realized from buying the underlying asset and simultaneously selling a futures contract against the asset is known as the implied repo rate. Accrued interest refers to the interest that has been earned since the last interest payment date.

In a treasury bond or treasury note futures contract, the underlying financial instrument that is most beneficial to the seller to deliver is called cheapest to deliver bond. Add-on-yield is equal to the ratio of the discount to the price, multiplied by the ratio of 360 to the number of days to maturity.

HEDGING INTEREST RATES RISK WITH INTEREST RATE FUTURES

In futures hedging, an investor enters into a transaction in the futures market today, which he will transact in the cash market in future (Refer Table I). Assume an investor expects a cash inflow after six months and wishes to invest the same in long-term bonds when the cash becomes available. He is worried that interest rates may fall and hence would like to hedge the interest rate risk. He can hedge by buying bonds in the futures market today.

Interest rate futures can be used to protect against an increase in interest rates as well as a decline in interest rates. By selling interest rate futures, also known as short hedging, an investor can protect himself against an increase in interest rates; and by buying interest rate futures, also known as long hedging, an investor can protect himself against a decline in interest rates.

TABLE I

TRANSACTIONS INVOLVING HEDGING

 

EXPECTED TRANSACTION IN CASH MARKET

IN FUTURES MARKET (NOW)

Borrow short-terms funds

 Sell/Short LIBOR Futures

Lend short-terms funds

 Buy/Long LIBOR Futures

 

 

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