1. Interest Rate Futures Mark Fielding-Pritchard of mefielding.com ACCA p4, also CFA, ICAS, ICAEW mefielding.com1

2. The question is based on ACCA P4, Phobos from 12/08  Please download the question, it is on our website  Key information  Now is 1 January, loan will be taken out 1 March, the loan is for £30m for a period of 4 months  Assumption: when the loan is taken out it is fixed rate mefielding.com2

3. 3 Questions  1 ) Do I buy (calls) or sell (futures)?  The theoretical value of a future is 100 – LIBOR  Therefore if interest rates are 5%, value is 95  If interest rates rise to 6%, value falls to 94  If we are hedging rising interest rates we sell.  Sell at 95  Buy at 94  Gain 1 mefielding.com3

4. What does gain or loss mean?  A contract has a standard value of £500,000 for 3 months  A gain of 1 = 1%x 500000 x 3/12 = £1250  In the question they give you tick value, 1 tick = 0.01% = 12.50. 100 ticks = 1% = £1250 mefielding.com4

5. 3 Questions  Question 1, do we buy or sell. We sell because the company has a rsik of rising interest rates  Question 2, how many?  1 contract will hedge £500000 for 3 months.  If your loan will be 1 million for 3 months you need 2 contracts because your interest is twice as much  Similarly if your loan is £500000 for 6 months you will need 2 contracts because your interest will be twice as much. Remember the loan is fixed interest when taken out so don’t think about changing rates or anything, just simple maths. mefielding.com5

6. Question 2- How many contracts mefielding.com6

7. Question 3 Which Month  Assume in these questions that securities close at the end of the month  Futures price will not = 100- LIBOR  The difference is called basis risk. This arises for a lot of reasons, expectations, volatility, changes in interest rates etc. The longer the futures ha to go until closure the greater will be that basis risk  Therefore we choose the future that closes first after our risk ends, our risk ends when we take out a fixed rate loan (1 March) therefore we chose March futures  If we look at our March future he price is 93.88 which implies a Libor of 6.12%. Libor is actually 6% so basis risk is 0.12% or 12 ticks and the market is expecting a rise in interest rates mefielding.com7

8. Our Hedging Strategy  Therefore bring together the elements of the 3 questions.  On 1 January we will sell 80 March futures  On 1 March we will close our position by buying 80 March futures mefielding.com8

9. Illustration of effect  The examiner wants you to show what happens if interest rates rise and fall  So lets take 5 & 7% (Currently 6%)  Interest on the loan  30m x 4/12 x 7%= 700000  30m x 4/12 x 5%= 500000  Benchmark  30m x 4/12 x 6%= 600000 mefielding.com9

10. Effect of the future 1  7%5%  Sold 93.8893.88  Buy92.9694.96  Difference0.92(1.08)  Where does 92.96 come from?  Basis risk on 1 January was 94-93.88= 12 basis points  Basis risk declines evenly so on 1 March 2/3 will have disappeared, therefore 1/3 or 4 basis points remains. And it is above LIBOR so LIBOR of 7% gives an implicit rate in the future of 7.04% mefielding.com10

11. Effect of the future 2  So at 7% interest rate we had again of 0.92 % or 92 ticks  0.92%x 500000x 3/12x 80 = 92000, or  92x 12.5x 80 = 92000  So at 7% our additional interest was 100000 minus our future gain of 92000 gives us a loss of 8000 and hedge efficiency of 92%  If rates fall to 5%  We save 100000 on interest but we lose 108000 (108x12.5x80)  Net loss is 8000 as before, hedge efficiency is 100/108 (92.6%)  Loss has arisen because of 8 ticks of basis risk (8x12.5x80) disappearing mefielding.com11

12. Problems with futures  Cost  Deposits  Margin calls  Market sentiment  Open positions mefielding.com12