Short Term Interest Rate Futures

Fixed Income
MSc.Finance
2020-2021
 Short Term Interest Rate Futures – Table of contents

1 Contract description

2 Speculation

3 Hedging

4 Reinvestment risk
 Short Term Interest Rate Futures – Table of contents

1 Contract description

2 Speculation

3 Hedging

4 Reinvestment risk
 4

1 Contract description

Contract specifications: EURIBOR 3 MONTHS

• Exchange traded contract.
• Underlying: 3 months interest rate (EURIBOR, LIBOR, TIBOR, SHORT STERLING, etc.)
• Contract bets over the 3 month interest rate at expiration of the contract.
• Nominal amount: 1,000,000 EUR
• At expiration, cash settlement (not delivery).
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1 Contract description

Contract specifications: EURIBOR 3 MONTHS

The futures price quoted has an implicit interest rate:

100 – Price = Implied Rate

There is an inverse relationship between price and rate:

 Higher interest rates means lower future price

 Lower interest rates means higher future price
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1 Contract description

Uses of Short term Interest rate Futures

Speculation
Taking a position in the futures market based on expectations about
the future trend of the underlying asset.

Hedging
Using derivatives to reduce market risk associated with a given
position (the potential loss to unfavorable price movements).

Arbitrage
Looking for risk-free returns without directional risk, taking
advantage of differences in price (theoretical versus market price).
 Short Term Interest Rate Futures – Table of contents

1 Contract description

2 Speculation

3 Hedging

4 Reinvestment risk
 8

2 Speculation

Speculation
Example 1 – LONG POSITION (Expectations: Lower Rates > Higher Prices)

Expecting lower interest rates, we took a 5 lots long position of EURIBOR 3M FUTURES at the
price of 95.50%. Later in the month, the future is trading at 97.25%.

Which is the result of the trade? (1 tick = 0.005% = 12.5 Euros).

Example 2 – SHORT POSITION (Expectations: High Rates > Lower Prices)

A speculator forecasting higher interest rates in the Eurozone, took a 2 lots short position on
EURIBOR 3M FUTURES contract. The trade was opened at 96.25%. Later, when the futures
contract was trading at 95.50%, the speculator decided to close the short position.

Which is the result of the trade? (1 tick = 0.005% = 12.5 Euros).

 Short Term Interest Rate Futures – Table of contents

1 Contract description

2 Speculation

3 Hedging

4 Reinvestment risk
 10

3 Hedging

EXAMPLE 1: Fixing an investment rate

On April 22, the treasurer of a company receives the news that next June 18 will
have an income of 100 million Euros. His concern is about a possible decrease in
interest rates before that date. The treasurer decides to “hedge" his position.

 Price futures contract expiring June = 96.70

 Implied interest rate in futures contract expiring June = 3.30%

Nominal Value Duration position

Hedge Ratio = x x Correlation between durations
Futures contract value Duration futures contract

Strategy: Go long 100 lots 3M EURIBOR FUTURES @ 96.70

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3 Hedging

Fixing an investment rate

SCENARIO 1: EURIBOR drops to 3% from 3.30%

Deposit interests:
0.03 x 90/360 x 100 Million Euros = 750,000 Euros

Future price at expiration:

100 - 3.00 = 97.00

Future profit/loss:
(97.00 - 96.70)/0.005 x EUR 12.5€ / tick x 100 lots = 75,000 Euros

Total income:
750,000 + 75,000 = 825,000 Euros
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3 Hedging

Fixing an investment rate

SCENARIO 2: EURIBOR raises to 4% from 3.30%

Deposit interests:
0.04 x 90/360 x 100 Million Euros = 1,000,000 Euros

Future price at expiration:

100 - 4.00 = 96.00

Future profit/loss:
(96.00 - 96.70)/0.005 x EUR 12.5€ / tick x 100 lots = - 175,000 Euros

Total income:
1,000,000 – 175,000 = 825,000 Euros
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3 Hedging

EXAMPLE 2: Locking a reinvestment rate

On April 22, a company has a liability of 100,000,000 EUR due on 15th December
and is currently cash-rich. In order to be certain how much cash to set aside to fund
the liability, it decides to lock in reinvestment rates using futures.

Market information:

 Notional amount 3M EURIBOR CONTRACT: 1,000,000 EUR

 2.5 months spot EURIBOR RATE: 3.34%
 3M EURIBOR CONTRACT June@ 96.74%
 3M EURIBOR CONTRACT September@ 96.66%
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3 Hedging

EXAMPLE 2: Locking a reinvestment rate

100

2nd Apr 75 days 16th Jun 91 days 15th Sep 91 days 15th Dec

3.34% 100 – 96.74 = 3.26% 100 – 96.66 = 3.34%

Step 1 99,162,790€
Hedge Ratio = = 99 September Contracts
1,000,000€

Step 2 98,352,213€
Hedge Ratio = = 98 June Contracts
1,000,000€

Step 3
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3 Hedging

EXAMPLE 2: Locking a reinvestment rate

100

2nd Apr 75 days 16th Jun 91 days 15th Sep 91 days 15th Dec

3.34% 100 – 96.74 = 3.26% 100 – 96.66 = 3.34%

Strategy
• To invest for 75 days 97,672,574€
• Go long 98 futures June contracts
• Go long 99 futures September contracts

Which is the reinvestment rate locked?

100,000,000€
97,672,574€ = RATE = 3.34%
(91 + 91 + 75)
1 + RATE 𝑥 360
 Short Term Interest Rate Futures – Table of contents

1 Contract description

2 Speculation

3 Hedging

4 Reinvestment risk
 17

4 Reinvestment risk

• Reinvestment risk refers to the probability that an investor will not be able to reinvest cash
flows, such as coupon payments, at a rate equal to their current return.
• Zero-coupon bonds are the only fixed-income security that has no investment risk as no
coupon payments are made

EXAMPLE: 106%
3 yr Bond
Annual Coupon: 6%
Redemption Value: 100%
6% 6%
YTM: 3%
PRICE: 108.48%
CF1 CF2 CF3
108.48%

Scenario 1 > reinvestment rate = 3% (equal to YTM)

𝟐
( . . )
𝟏 - 1 = 3%
.

YTM = Effective Yield … but will reinvestment rate be stable at 3% during 3 years?
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4 Reinvestment risk

EXAMPLE:
3 yr Bond 106%
Annual Coupon: 6%
Redemption Value: 100% 6% 6%
YTM: 3%
PRICE: 108.48%

CF1 CF2 CF3

108.48%

Scenario 2 > reinvestment rate = 8% (>YTM)

Scenario 3 > reinvestment rate = 1% (<YTM)

Scenario 4 > reinvestment rate = 0% (<YTM)

Thank You !