1. Interest Rate Futures How to use interest rate futures to hedge interest rate movements Mark Fielding-Pritchard mefielding.com1

2. 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.com2

3. 3 Now is 1/1. On 1/4 we will take out a loan of £5m 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 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. The loan is for 6 months, our bet therefore must win 6 month’s interest

4. 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 mefielding.com4 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 today94Sell Value of future after rise93Buy 1Gain 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 today94Buy Value of future after rise95Sell 1Gain

5. 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 £1m for 3 months or £500000 for 6 months you need 2 futures  £1.5m for 3 months, £500000 for 9 months, £750000 for 6 months; you need 3 mefielding.com5

6. Interest Rate Futures  Buaben Ltd. wants to borrow £10m for 2 months on 20 April with the current interest rate being 5%. It is currently January 31st.  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.com6

7. 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.com7

8. 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.com8

9. Interest Rate Futures mefielding.com9 x

10. On 20 April  We close our position by buying 13 June’s mefielding.com10 On 1/1 Sold94.85 On 20/4 Buy94.25 Gain0.6% x 500000 x 3/12x 13= £9750 Additional Interest0.5% x 2/12/10m= 8333 Hedge Efficiency9750/8333= 117% 1% = 100 ticks. 1 tick = 0.01% = 0.01% x 500000 x 3/12= £12.50 0.6% = 60 ticks = £750

11. 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.com11