You are on page 1of 35

Forward Rate Agreements (FRAs) Forward Rate Agreements (FRAs)

Interest Rate Futures (IRF)


Forward forward Forward-forward
A cash borrowing or deposit which starts on
one forward date and ends on another forward.
The term, amount and interest rate are all fixed
in advance in advance.
2
Constructing forward forward Constructing forward-forward
$1.03241
13%
$1
91 days 91 days
$1 $1
183 days
13.1%
$1.06568
183 days
?%
$1.03241
$1 06568
92 days
?%
3
$1.06568
Forward forward rate Forward-forward rate
days 91 after rate forward - forward
% 79 . 12
92
365
1
1.03241
1.06568
=
|
.
|

\
|
=
L
L
year
year
d
i 1
| |
(
(
(

|
|
.
|

\
|
+
S L
S
S
d d
year
1
year
d
i 1
year
rate forward - forward
|
|
.
|

\
|

(
(
(

|
|
.
|

\
|
+
|
.

\
=
ly respective period shorter and longer for stand S and L
year

|
.

\
4
Forward Rate Agreements (FRAs) Forward Rate Agreements (FRAs)
Off balance sheet instrument Off-balance sheet instrument
Agreement to fix a future interest rate
On the agreed date (fixing date) receives or pays the On the agreed date (fixing date), receives or pays the
difference between the reference rate and the FRA
rate on the agreed notional principal amount g p p
Principal is not exchanged
No obligation for either party to borrow or lend capital g p y p
Settles at the beginning of the period
5
Use of FRA Use of FRA
by market participants who wish to hedge against by market participants who wish to hedge against
future interest rate risks by setting the future interest
rate today (at trading date) y ( g )
by market participants who want to make profits
based on their expectations of the future development
f i of interest rates
by market participants who try to take advantage of
the different prices of FRAs and other financial the different prices of FRAs and other financial
instruments, e.g. futures, by means of arbitrage.
6
FRA Events FRA Events
7
FRA Example FRA Example
A large company wishes t o fix t he int erest rat e for a loan of USD 20 Mio for
3 mont hs, beginning in 2 mont hs. The company might buy an FRA from a
bank t hat is t rading such inst ruments. The bank quot es an FRA rat e. This
FRA rat e is applied t o t he principal (USD 20 Mio), but not t o t he 3-mont h
l it lf Th b t h FRA t t h fi d t t h loan it self. Thereby, t he FRA rat e serves as t he fixed rat e t he company
want ed t o secure for t he 3-mont h t erm of int erest (from t he end of t he 2nd
unt il t he end of t he 5t h mont h). This fixed rat e is known t o bot h of t he
count erpart ies on t rading day but t hey do not know t he fut ure level of t he count erpart ies on t rading day, but t hey do not know t he fut ure level of t he
reference rat e.
Usually t wo days before t he set t lement dat e t he FRA rat e is compared t o t he Usually t wo days before t he set t lement dat e, t he FRA rat e is compared t o t he
agreed reference rat e (LI BOR).
8
FRA Example (Contd) FRA Example (Cont d)
I f t he reference rat e is higher t han t he defined FRA rat e, t he amount due is g ,
paid t o t he cust omer. This is a compensat ion for t he higher int erest
payment s for his (more expensive) re-financing.
I f t he reference rat e happens t o be lower t han t he FRA rat e, t he cust omer
must set t le t he balance. This effect in t urn is balanced by lower int erest
expenses.
I n t his process, t here is no exchange of principal; only t he int erest rat e
gaps are balanced. Wit h t he set t lement payment , t he int erest rat e for t he
f t fi i h b fi d t t h FRA t fut ure re-financing has been fixed at t he FRA-rat e.
9
FRA Quotation FRA Quotation
Establish the theoretical FRA price. How?
Dealer would put a spread, say 6 bp, around Dealer would put a spread, say 6 bp, around
the theoretical FRA price, giving for example
12 82% / 12 88% 12.82% / 12.88%
Buying FRA would deal at ?
Selling FRA would deal at ?
10
Settlement Amount Settlement Amount
For FRA period not more t han 1 year
( )
=
year
days
LIBOR - rate FRA
notional paid Buyer
|
|
.
|

\
|
+
=
year
days
LIBOR 1
notional paid Buyer
For FRA period longer t han 1 year, LI BOR rat e
i h d f h ll assumes int erest payment at t he end of each as well
as at mat urit y. What is t he set t lement amount ?
11
Constructing a strip Constructing a strip
Suppose now is January and we have the following rates:
3-month LIBOR 8.5% (92 days)
3 v 6 FRA 8.6% (91 days)
6 v 9 FRA 8.7% (91 days)
Construct a fixed-rate borrowing for 9 months?
Assume that
1) FRA settlement at the end of the period and not discount
2) the 3-month LIBOR in April and July is 9% and 9.5% respectively
12
C t ti g t i Constructing a strip
|
.
|

\
|
+
365
91
1 L
( )
(
(
(
(

+
|
.
|

\
|
|
.
|

\
|
+

|
.
|

\
|
+
365
91
1
365
91
086 . 0
365
92
085 . 0 1 1 $
365
92
085 . 0 1 1 $
L
L
$1
92 days 91 days

|
|

|
92 |
|

|
+ |
|

|
+
91
086 0 1
92
085 0 1 1 $
8.5%
L%
|
.
|

\
|
+
365
92
085 . 0 1 1 $
|
.

\
+ |
.

\
+
365
086 . 0 1
365
085 . 0 1 1 $
13
Futures Futures
A t t i hi h th dit b i g A contract in which the commodity being
bought or sold is considered as being delivered
( t h i ll ) t f t d t (may not physically occur) at some future date
Exchange traded (vs OTC in forward) g
Contract standardized by exchange
Pricing depends on underlying commodity Pricing depends on underlying commodity
14
Users Users
Hedgers, who use futures to cover their risk on
positions in the underlying assets
Speculators, who use futures to create highly
leveraged positions in a market leveraged positions in a market
15
CME
Eurodollar Futures Spec
16
CME
Last Trading & New Listing
17
CME Product Codes CME Product Codes
18
CME
Listing Eurodollar Futures
19
HIBOR Future Contract Spec HIBOR Future Contract Spec
HIBOR Future Contract Spec
20
Quotation Quotation
Price of contract is quoted not as a rate of
interest but as 100 minus the rate of
interest interest
21
Dealing Dealing
Open outcry
buyer and seller deal face to face in public in
the exchanges trading pit
Screen trading Screen trading
designed to simulate the transparency of open
t outcry
22
Clearing Clearing
Following the confirmation of a transaction, the
clearing house substitutes itself as a
counterparty to each user and becomes
the seller to every buyer and the seller to every buyer and
the buyer to every seller
23
Margin Requirements Margin Requirements
Initial Margin
Collateral for each deal transacted
Protect clearing house for the short period until
position can be revalued position can be revalued
Variation (Maintenance) Margin
Marking to market
Paid daily based on adverse price movements
24
Marking to Market Marking to Market
Cont ract Specificat ions
Three Mont h Hong Kong I nt erbank Offered Rat e Three-Mont h Hong Kong I nt erbank Offered Rat e
(HI BOR) Fut ures Cont ract
Minimum one (1) basis point (0.01 of a percent )
Fluct uat ion
The value of a Minimum Fluct uat ion is
HK$125.00 calculat ed as t he Cont ract Size
mult iplied by a basis point mult iplied by one mult iplied by a basis point mult iplied by one
quart er of a year.
HK$5,000,000 x 0.0001 x 0.25 = HK$125.00
Example: Price moves from 95.25 t o 95.15 (a fall of 10 t icks).
The loss on a long fut ure cont ract is HK$125 x 10 = HK$1,250
25
Profit and Loss Profit and Loss
contract month - 3 a in position long on s Profit/los =
( )
4
1
100
price purchase - price sale
size contract notional
contract month 3 a in position long on s Profit/los

=
4 100
26
OTC vs Exchange traded OTC vs Exchange-traded
t f t t t i t d di d amount fut ure cont ract is st andardized
delivery dat e fut ure cont ract is st andardized
margin fut ures requires init ial margin and variat ion
margin t o reflect days loss and profit
set t lement not discount ed for fut ures
liquidity/ spread liquid market and narrower spread for fut ure q y/ p q p
credit risk virt ually no credit risk for fut ure. why?
27
Simple Questions Simple Questions
If interest rates rise If interest rates rise
buyer of FRA will ?
buyer of futures will ?
If a trader sells an FRA to a counterparty
H h ld ? f hi i i He should ? futures to cover his position
28
FRA price from Futures prices FRA price from Futures prices
On 17 March for USD: On 17 March for USD:
June futures price (delivery 18 June): 91.75 (implied interest rate: 8.25%)
Sept futures price (delivery 17 Sept): 91.50 (implied interest rate: 8.50%)
D f t i (d li 17 D ) 91 25 (i li d i t t t 8 75%) Dec futures price (delivery 17 Dec): 91.25 (implied interest rate: 8.75%)
** The Eurodollar Future notional contract size is $ 1million per contract
Sell a 3 v 6 FRA for $10 million, to hedge - buy/sell futures? which month?
FRA will be for period 19 June to 19 Sept (92 days) and will settle against
LIBOR fixed on 17 June.
June futures will also be LIBOR on 17 June. The FRA rate should therefore be
the implied June futures rate of 8.25%
29
Hedging FRA with Futures Hedging FRA with Futures
360
92
LIBOR) - (0.0825 $10million
FRA for Settlement

=
360
92
LIBOR 1
FRA for Settlement
+
=
90
LIBOR) - (0 0825 million $1 contracts of number
futures sold on loss or Profit
=
360
LIBOR) - (0.0825 million $1 contracts of number =
92 92
01 . 10
360
92
0.0825 1
90
10
360
92
LIBOR 1
90
10 contracts of no. =
+
=
+
=
30
360 360
Hedging FRA with Futures Hedging FRA with Futures
3 v 9 FRA should be equivalent t o a st rip combining
rate FRA 9 v 3
3 v 6 FRA and 6 v 9 FRA
% 463 . 8
183
360
1
360
91
0.085 1
360
92
0.0825 1 =
(


|
.
|

\
|
+
|
.
|

\
|
+ =
183 360 360

. \ . \
Hedge required is t he combinat ion of t he hedges for each leg:
Sell 10 June fut ures and 10 Sept fut ures
Can you do t he same for 6 v 12 FRA?
31
y
Imperfect
FRA Hedging with Futures
Future contracts are for standardized amount
Futures P&L are based on 90-day period rather than 91 Futures P&L are based on 90-day period rather than 91
or 92 days as in FRA
FRA settlements are discounted but futures settlements
t are not.
Future price when the Sept contract is closed out in
June may not exactly match the theoretical forward- y y
forward rate at that time
Slight discrepancy in dates. On 17 June, the 3 v 6 FRA
period is 19 Sept to 19 Dec (LIBOR is fixed on 17 Sept) period is 19 Sept to 19 Dec (LIBOR is fixed on 17 Sept)
but the Sept futures delivery is 17 Sept (fixed on 16
Sept).
32
Volume and Open Interest Volume and Open Interest
O I t t Open Interest
number of purchases of contract not yet been reversed or
close out close out
Volume
total number of contracts traded during the day total number of contracts traded during the day
If futures price is rising, volume and open interest are also rising, If futures price is rising, volume and open interest are also rising,
suggest ?
If open interest is falling, suggest ? p g, gg
33
Speculation Speculation
If trader expects interest rates to rise, he ?
futures contract
If trader expects rates to fall, he ? futures
contract contract
Profit and loss ?
34
Arbitrage Arbitrage
Market prices:
2 v 5 FRA 7.22 / 7.27% 2 v 5 FRA 7.22 / 7.27%
3 month futures 92.67 / 92.68
futures delivery date is in 2 months time
Any must win strategy?
35