FINA2322ABC Tutorial 3

THE UNIVERSITY OF HONG KONG

HKU BUSINESS SCHOOL
FINA2322EFG – DERIVATIVES
FIRST SEMESTER, 2023-2024
Tutorial 6 –Forward Rate Agreements and Interest Rate Futures

✓ Summary of different forms of interest rates

Relationship:
1 1
𝑃0 (0, 𝑇) = 𝑇 = 𝑟𝑇
= 𝑒 −𝑟𝑇
(1 + 𝑟0 (0, 𝑇)) 𝑒

[1 + 𝑟0 (0, 𝑇)]𝑇 𝑃0 (0, 𝑡)

1 + 𝑟0 (𝑡, 𝑇) = =
[1 + 𝑟0 (0, 𝑡)]𝑡 𝑃0 (0, 𝑇)

𝐵0 (0, 𝑇, 𝑐, 𝑛) = ∑ 𝑐𝑃0 (0, 𝑡𝑖 ) + 𝑃0 (0, 𝑇)

𝑖=1

1 − 𝑃0 (0, 𝑇)
𝑐=
∑𝑛𝑖=1 𝑃0 (0, 𝑡𝑖 ) why c like this?
 FINA2322ABC Tutorial 3

✓ Forward rate agreement (FRA)

• A guaranteed rate for lending/borrowing
• For long positions:
Settlement in arrears (at maturity): (spot rate – FRA rate) * notional principal

Settlement at initiation: (spot rate – FRA rate) * notional principal / (1+ spot rate)

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Tutorial Exercise
Question 1 (Forward Rate Agreement)

Suppose that in order to hedge interest rate risk on your borrowing, you enter into an FRA
that will guarantee a 6% effective annual interest rate for 1 year on $500,000. On the date
you borrow the $500,000, the actual interest rate is 5%. Determine the dollar settlement of
the FRA assuming

(a) Settlement occurs on the date the loan is repaid.

(b) Settlement occurs on the date the loan is initiated.

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Question 2

Given the Zero-coupon bond prices as follow:

Days to Bond Prices

Maturity
90 0.99009
180 0.97943
270 0.96525
360 0.95238

Suppose you are studying an FRA which fix the lending/borrowing rate on $10m for a 90-
day loan commencing on day 270.

Suppose the market FRA is 1.2% at time 0, suggest how you can capture an arbitrage
profit from FRA.

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✓ Eurodollar Futures Contract

• Eurodollar are deposits denominated in USD at banks outside US.
• The Eurodollar futures contract refers to the futures contract based upon these
deposits, traded at the Chicago Mercantile Exchange (CME)
• It is derivatives on the interest rates (e.g. 3 month LIBOR)

• Price of Eurodollar futures give you the interest rate

→ Price = 100 – annualized 3-mth LIBOR

• A long position on a Eurodollar futures maturing in 1 year, has a price of 94,

means that you can lend 1 year later, for 3 months, with a rate of 6% p.a. (i.e.
effective rate in 3 months is 1.5%).

• Long position in the contract means that you gain when interest rate falls, lose
when interest rate are high → Used by lender
Short position in the contract means that you lose when interest rate falls, gain
when interest rate are high → Used by borrower

• Gain / losses are marked to market

• Payoff (Long position)

= (Locked-in 3-month LIBOR – spot 3-month LIBOR(p.a.)) / 4 * Size
= (Spot Eurodollar futures price – Locked-in Eurodollar futures price)% / 4 * Size