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Interest Rate FuturesPricing, Hedging, TradingAnalysis and ApplicationsVincent ChiaLast Updated on 30 Nov al Instruments2.Pricing Methodology3.Hedging Illustrations4.Trading Strategies5.Analysis Studies6.Application Examples7.Process Efficiency8.ConclusionAppendix2
Financial Instruments :A Review1.1 The Short Term Interest Rate (STIR) futures MarketA financial contract where settlement of a transaction happens at a future date while all otherfinancial aspects of the transaction is fixed today.1.Anonymous Trading, exchange, price-time priority.2.Equivalent to standardised Forward Rate Agreement (FRA) contract3.Standardised notional principal amounts, maturity dates and underlying interest rates,4.STIR futures are deemed to be Credit Risk Free as each contract is guaranteed by exchange :to achieve this, when entering into a contract, each party must place aninitial margin with the exchange (sufficient to cover an extreme movement in the market)plus variation margin because each contract is valued and settled daily.For exampleMaturity : 3 to 6 month contracts.The Underlying : 3 month BIBOR and 6 month THBFIX interest ratesMode of Settlement : Cash settlement4
1.2 The STIR futures MarketFor Cash Settlement Case,The buyer of a STIR futures contract has a long position.If the position is held until the Settlement date,then he/she will be received or asked to pay the relevant differencefor Cash Settlement .The seller of a STIR futures contract has a short position.If the position is held until the Settlement date,then he/she will be asked to pay or received the relevant differencefor Cash Settlement.51.3.1 Time Frames (USD STIR futures or ED futures)15 Dec to 15 MarH1Z0F1G1H1J1K118 May to 18 AugM1U115 Jun to 15 SepZ1year 201121 Dec to 21 Mar21 Sep to 21 Dec6
1.3.2 Time Frames (USD STIR futures or ED futures)H2M2U2Z2year 2012H3M3U3Z3year 2013H4M4U4Z4year 2014H5M5U5Z5year 2015H6M6U6Z6year 2016H7M7U7Z7year 2017H7M7U7Z7year 2018H8M8U8Z8year 2019H9M9U9Z9year 202071.3.3 Term Structure (USD STIR futures or ED futures)Price as the Reciprocal of forward interest rates.8
Pricing Methodology2.1 Birdeye View on Trading/Pricing/Hedging PlanesYield%90 dayPrice YieldRelationshipTHB Forward Interest Rates curve (30 day forward start)spot THB Interest Rates curveHedging Plane30-dayPrice TradingPlaneTerm or Tenor or Maturity120-dayLinearly Implied Rate and Spot Interest Rates convergeCash Settlement date30-day90 dayTime frame120-day 100for Pricing PurposeTime10
2.2.1 Zero Coupon Bond vs STIR futuresZero Coupon Bond. 100 for Pricing PurposeSome use Trade date as Reference dateSome use Spot date as Reference dateReference dateTime90 days or 92 days- PPzerocouponbond 100[1 r90 , 365 ]100or90 / 365[1 r92 , 365 ] 92 / 365STIR futures as forward starting Zero Coupon Bond. 100 for Pricing PurposeTradedateTime90 daysSpotdate- PSTIR futuresPSTIRfutures 100[1 f 30 ,120 ] 90 / 365112.2.2 Suggested Pricing via Zero Coupon Rates30d zero ratesTime120day zero coupon ratesTimeforward interest rates, fTime 100 for Pricing Purpose90day BIBOR futuresFebMarContractJunContractFor example , 90 d BIBORP90 d BIBORfutures Timefutures ,100 * [1 r30 , 365 ] 30 / 365[1 r120 , 365 ]120 / 365Future Value to “Mar”Present Value to Today100[1 f 30 ,120 ] 90 / 36512
2.3 Suggested Pricing via Deposit Rates30d depositTime120d deposit ratesTimerelevant FRATime 100 for Pricing Purpose90 day futuresMarContractFebForexampleP90 d BIBORTimeJunContract, 90 d BIBORfuturesfutures, 30 100 * [1 depo 30 d ] 365 120 [1 depo 120 d ] 365 100 90 [1 FRA ] 365 Day Count Fraction is not “powerof”but multiply beside depo rates13Hedging Illustrations
3.1 Transactions Involving HedgingExpected Transaction in Cash MarketIn STIR futures market (now)Borrow short-term fundsSell or short 3m BIBOR or6m THBFIX futures(known as short hedging,to protect against an increase in interest rates)Lend short-term fundsBuy or long 3m BIBOR or6m THBFIX futures(known as long hedging,to protect against a decline in interest rates)153.2.1 To compensate for rise in cost of borrowingSTIR futures contract can be used to hedge interest rate risk.Suppose that 7 months from today, we plan to borrow THB 10 million for 90 days,and that our borrowing rate is the same as BIBOR.3 month BIBOR futures price for 7 months from today is 96.000; 90-day rate of ( 100 - 96)*(90/365)*(1/100) 0.980%Now, suppose that 7 months hence, 3 month BIBOR fixing is 5.000%, 3 month BIBOR futures of 95.000 100 – annualised yield of 5.000%(linear)The linearly implied 90-day rates is (5%)*(90/365) 1.230%Our extra borrowing expense over 90 days on THB 10 million will therefore be(1.230 - 0.980)% or 0.250% or THB 25,000.0.980%Extraborrowingexpense ofTHB 25,0001.230%Linear Yield %16
3.2.2 To compensate for rise in cost of borrowingExtra borrowing expense is offset by gains on, short 3-month BIBOR futurescontract.The 3-month BIBOR futures price has gone down, giving us a gain ofTHB 250*100*( 96 - 95) THB 25,000.Since, from THB (125/0.005)*0.01 THB 250 per basis point or bp.Short position in the 3-month BIBOR futures contract compensates us for theincrease in our borrowing cost.Gain ofTHB 25,000 95Price 96In the same way, a long position can be used to lock in a lending rate.Note : Exchange and Clearing Fee are not included in the calculation.173.2.3 If 3m BIBOR starts to rise 3m BIBOR futures price will fallyield %relevant Linearly Implied yield curve at T date4% (Mar contract)(7 month forward start)spot THB BIBOR curve at T datePrice Term or Tenor or maturityat T dateSell at 96.000TradingPlane7-month10-month5% (3m BIBOR Fixing)Buy at 95.0007-monthlaterspot THB BIBOR curve (T 7 months)Term or Tenor or maturityMar3-month90-dayTime Frame 100for Pricing PurposeTime18
3.2.4 If 3m BIBOR indeed rises 3m BIBOR futures price fallsPrice Open to sell at 96.000for March ContractClose to buy at 95.000Time7-month laterorMarch Contract Expiryat Trade, T dateInitial Trade :Mar Contractopen to sell at 96.000After 7 months :(or naturally expiry)3-month BIBOR indeed risesclose to buy at 95.000Profits193.3.1 A possible way to price a Forward Rate Agreement (FRA)FRA may be created by spot money market transaction, using 2 deposit rates.73d depositTimeInterpolated 164d deposit ratesTime3x6 FRA2 Jan 20119 Apr 2011Time91 dayFuture value of 1, 164 [1 depo 365 164 d 73 ] [1 depo 365 164[1 365 365FRA 3 x 6 91 [1 73 365 depo depo 164 d73 d]]73 d 91 ][ 1 FRA 365 3x6] 1 20
3.3.2 To price or hedge a Forward Rate Agreement (FRA)However, FRAs are off-balance sheetwhereas cash trades are on–balance sheet, which is not a good mix.If a liquid interest rate (or deposit) futures market exists,then this is much more likely to be used to price and hedge FRAs.The current quotes for the 3-month BIBOR futures contract are :Mar ContractJun ContractMaturity Date16 Mar 201115 Jun 2011Futures Price 97.800 97.500Linearly Implied Rates2.200%2.500%Given these rates, we wish to price the FRA by estimating the fair 3 month rateout of 6 Apr 2011, this is usually done by simple linear interpolation betweenthe neighbouring linearly implied rates from STIR futures.213.3.3 To price or hedge a Forward Rate Agreement (FRA)Since6 Apr 2011 – 16 Mar 2011 21 days&15 Jun 2011 – 6 Apr 2011 70 daysLinearly Implied yield %Linear interpolation gives :(70/91)*2.200% (21/91)*2.500% 2.269%2.500%2.200%16 MarContract6 Apr15 JunContractMaturityThe reflects the contribution of each futures contact,Mar provides 77% & Jun provides 23% to the price estimates of the 3x6 FRA.If the bank has sold THB 100 million of a 3x6 FRA, therefore,to partial hedge: 8 of Mar contracts2 of Jun contracts.The profit gained via 3-month BIBOR futures viavariation margin should offset some of the loss on the 3x6 FRA.22
3.3.4 Case study on a Parallel ShiftConsider first of all a 10bp parallel shiftin the 3 month forward rate curve.Linearly Implied yield %10 bp up2.500%The bank would pay100 million * 10bp * (91/365) THB 24,931 extra on the 3x6 FRA2.200%& would receive 10 contracts * 10bp * 250 THB 25,000 from the 3-month BIBOR futures.(ignoring trading cost)16 Mar6 AprContract15 JunMaturityContractSo the hedge is fairly effective, given the slight day count mismatch.In theory, the size of the futures hedge could have been adjusted slightly,but this is obviously impractical.233.3.5 Case study on a Rotational ShiftConsider a rotational shift,pivoting around 1 Apr 2011.Implied yield %1 AprThis results in the following shifts :8 of Mar contract -6.8 bp2 of Jun contract 32.4 bp3x6 FRA contract 2 bpNet EffectTHBvalue -13,600value 16,200value -4,986value -2,3862.500%2.200%16 Mar6 AprContract15 JunContractMaturityThe hedge appears to be quite effective against both parallel and rotational shifts.However, if the rates move to increase their curvature, for example,both futures rates decrease but the FRA rate remains constant,then the hedge will fail.Implied yield %1 Apr16 Mar6 AprContract15 JunContractMaturity24
3.3.6 Further ConsiderationsAs time passes, the hedge needs to be re-balanced as the proportions of the2 contracts change.Eventually, the Mar contract will expire leaving the 3x6 FRA hedge only with theJun contract. This exposes the bank to rotational risk for the reminder of thecontract.3x6 FRAH1Mar ContractM1TimeJun ContractThis may be reduced by selling a small amount of Sep contracts,but this is unlikely to be effective given the short time to the FRA fixing.By this, we mean that the correlation between the remainder of the FRA contractand the Sep contract is likely to be quite small,and hence a large degree of curve risk has been introduced.The time of greatest risk therefore when hedging a FRA with futures is when oneof the bracketing contracts has matured.3x6 FRAM1U1Jun ContractSep ContractTime253.4.1 THB IRS with 6m THBFIX interest rates as floating indexTHB IRS structureFundManagementCompanyFixed-rate payments(pay 1% semi-annually)Float-rate payments(receive 6M THBFIX i/r)Swap Deskof a Bank26
3.4.2 Hedge THB IRS with 6m THBFIX interest rate futuresTHB IRS structure6M THBFIX i/rFixed-rate paymentsCompany’s ViewFundManagementCompany1%(pay 1% semi-annually)Float-rate payments(receive 6M THBFIX i/r)Swap Deskof BankShorting a series of6M THBFIX i/r futuresTime6M THBFIX i/rGain to Company1%Gain to Swap Desk of BankTime273.5 Curves Discrepancy : Convexity on Term StructureInterest rates %and LinearlyImplied Yield %FRA curve fromcubic spine interpolated spot deposit rate curveswiderLinear Implied Yield from STIR cContractMaturity or Expiry Date28
3.6 An example of Risk Management System : Reuters’ K Futures Maturities29Trading Strategies
4.1 Three month BIBOR daily time seriesHistorical data may be used tobuild model for simulation purpose(Econometrics , Monte Carlo Simulationetc)Life High yieldWidesttrading rangeso farSubprimeCrisisLife Low yieldRecenttrading range314.2 Six month THBFIX interest rates daily time seriesLife High yieldWidesttrading rangeso farSubprimeCrisiswithspot FXcomplicationLife Low yieldRecenttrading range32
4.3.1 Trade based on Interest Rates View (e.g. rising)BIBOR term structure on Nov 2010BIBOR term structure on Aug 2010 (3 month ago)Parallel shift being observed(may be due to more Economic Activities )BIBOR term structure on May 2010(6 month ago)BIBOR term structure on Nov 2009 (1 year ago)334.3.2 Trade based on Interest Rates View (e.g. rising)ProfitPrice Linear Price YieldRelationship 96.000 95.95 96Price 95.950Linearly Implied Yield %4% 4.05%LinearlyImplied Yield %Linearly Implied Yied curve4.000%Price Term or Tenor or maturityAt T dateMarContractOpen to sell 96.0004.050%Linearly Implied Yield curve (T 3 days)TradingPlaneClose to buy 95.9503 day laterMarContractTime34
4.3.3 Interest Rates indeed rises 3m BIBOR futures price fallsPrice Open to sell at 96.000for Mar ContractClose to buy at 95.950Time3-day laterat Trade, T dateInitial Trade:Mar Contractopen to sell at 96.000After 3 days: close to buy at 95.950Profits354.3.4 How about THBFIX interest rates term structure ?THBFIX interest rates term structure on Nov 2010Inverted at this endFlattening after 3m tenorTHBFIX interest rates term structure on Nov 2009 (1 year ago)36
4.4.1 Riding the Yield Curve (Roll-down)As long as the forward interest rates curve remains upward sloping this is a possible strategy.Linearly Implied Yield %Linearly Implied Yied curve1.800%Price Term or Tenor or maturityAt T dateOpen to buy 98.200JunContractLinearly Implied Yield curve (T 14 days)TradingPlane1.750%Close to sell 98.250Term or Tenor or maturity14 day laterJunContractTime374.4.2 Riding the Yield Curve (Roll-down)Price Close to sell at 98.250Open to buy at 98.200for Jun ContractTimeat Trade, T date14-day laterJun ContractInitial Trade : open to buy at 98.200After 14 days: close to sell at 98.250Profits38
4.5.1 Calendar Spread Trading with STIR futuresTraders, who anticipatepotential changes in the relative value of two different contracts,may employ a speculative trading strategy known as Calendar Spread TradingLinearly Implied Yield %Linearly Implied Yied curve4.300%4.000%Price Term or Tenor or maturityAt T dateOpen to buy 95.700Open to sell 96.000JunContractMarContract4.100%Linearly Implied Yield curve (T 5 days)4.250%TradingPlaneClose to buySell 95.750 95.900Term or Tenor or maturity5 day laterMarContractJunContractTime394.5.2 Calendar Spread Trading with STIR futuresPrice Open to sell at 96.000for Mar ContractClose to buy at 95.950Close to sell at 95.750Open to buy at 95.700for Jun ContractTime5-day laterat Trade, T dateMar ContractInitial Trade : open to sell at 96.000Jun Contractopen to buy at 95.700After 5 days: close to buy at 95.900close to sell at 95.750ProfitsProfits40
4.6.1 3m BIBOR and 6m THBFIX interest rates correlation analysisSuggestion: “Basis Trade”During positive correlation, borrow low & Lend high,unwind when correlation starts to drop towards zero.90 day time frame414.6.2 Suggestion: “Basis Trades” during known In-Sync periodBIBOR term structureLend high with3m BIBOR or “BIBID” related instrumentsSuggestion: “Basis Trade”For normally upward sloping yield curves,during positive correlation, borrow low & lend high,unwind when correlation starts to drop towards zero.3m BIBORfuturesMar3m BIBORfuturesJunTimeSep6m THBFIX i/r futuresMarTimeTHBFIX interest ratesterm structureSepBorrow low with6m THBFIX interest ratesrelated instruments42
4.7 Closely monitor Surprises or Disappointment over Economics Indicators434.8 News that moves Financial MarketsUp to 13 months of Historical News could be retrieved.44
Analysis Studies5.1.1 The Success Story of Australia (Futures) Exchanges46
5.1.2 A ComparisonSTIR futures(yield based)Bond futures(yield based)90d Bank Bill futures3y Gov Bond futures10y Gov Bond futuresSuccessful, mainly because, the futures are embraced by the domestic markets.The futures are used actively as hedging tools by Aussie Corporations.STIR futures(yield based)Bond futures(price based)3m BIBOR futures6m THBFIX interest rate futures5y Gov Bond futures475.2.1 Which operation is preferred by your Central Bank ?More or Less FX operations ?If More FX operation, apart from FX trading,you may want to consider FX-linked interest rates :6 month THBFIX interest rate futuresLess or More Interest Rates operation ?If More Interest Rates operation,Both 3-month BIBOR futures and6-month THBFIX interest rate futures (related to THB IRS)activities will likely be more too.48
5.2.2495.3.1 How does your STIR behaves ?THBFIX interest ratesterm structureRate will rise,open to sell6m THBFIX i/r futuresRate will fall,open tobuy 6m THBFIX i/r futuresHow True ?Is the probability distribution of interest rate Normal ?That is , most of time (68%) stays between thedistance of 1 standard deviationfrom the average interest rates (time series)50
5.3.2 How does your STIR behaves ?THBFIX interest ratesterm structureor Skew probability distribution ?For example , more Resistance on interest rates risingand less Resistance on interest rates falling.Rate will fall more often,more people will open to buy6m THBFIX futures Skewed Market.515.4 Economic Situation affects Supply & Demand of STIR futuresOpen Interests for STIR futuresNotional amount for FRAEase of Hedging and Speculation over OTC productsHigher level of awareness and sensitivitybut likely to decay with time.Usual level of activitiesLess and Delayed due toNegotiation andSubjected to Credit Limits Approval etcStagesNormal TimesCrisisRecovery to NormalOTC : Over The Counter financial product,for example, Forward Rate Agreement (FRA) 52
Application Examples6.1 Use STIR futures to construct a Cost-of-Funding CurveA Zero Coupon Curve could be interpreted as a Cost-of-funding Curve.Zero Coupon Curve is an interest rate proxy because it1. provides a continuous interest rates from T/N (Tom./Next) to, say 30 years.2. is usually constructed using real time tradable liquid financial instruments.3. is coupon-free, unburdened by frequency payments of coupons(e.g. quarterly, semi-annual payment frequency). 54
6.2 Zero-coupon Curve (Cost-of-Funding Curve) as Basic EngineBond CalculatorAsset SwapCaps, Floors & CollarSwap Pricer(IRS. CRS, CMS etc)SwaptionZC BuilderForward RateAgreement (FRA)Currency Option556.3 Thomson Reuters’ default THB Zero-coupon CurveConvexity unadjustedInterbank-rate-derivedZero-coupon Curve56
6.4.1 Construct a Zero-coupon Curve from most liquid instrumentsFactors to consider if you would like to construct it yourself :1. Liquidity (ease of hedging)2. Real-time (e.g. Deposits, Libor Fixings, STIR futures, IRS etc)yield %(spot rates)Interbank-rate-derivedZero-coupon CurvefromfromDepo-rates STIR FuturesorImplied DeposTerm(maturity)fromInterest Rate Swaps, IRS576.4.2 Construction of your own Zero-coupon Curve with Reuters’ functions58
6.5 Structured Products from STIR futures3m BIBOR futuresPar Swapor6m THBFIX futuresorSynthetic Floating Rate Notes, FRN Deposits oror OthersInterest Rate LinkedStructure Products59Process Efficiency
7.1 Evolution StagesNew to the STIR futures MarketsNext StagePricing MethodologyDocumented ProcessHedging ApproachCost EffectiveTrading StrategiesTime EfficiencyetcIntelligence built-in(example : Algo Trading)etc617.2 Thomson Reuters AUTEX NetworkThomson Reuters Autex networkis one of the world’s largest networks thatsupport trading of multiple markets and asset classes.The network provides youthe connectivity to your global and regional brokers.Being a member of the networkwill allow you to access the broadest pool of liquidityand to trade with the largest community in the worlds.6262
7.3 RTEx – Reuters Trading for ExchangesFor those without a Seat in Exchanges to trade Interest Rate Futures,they can do trading via RTEx Broker.Exchanges3000Xtra orEikon - RTExExchangesFIX 4.2AUTEX leasedOrdersSimply install an x BrokerSimple arrangement63637.4 Trading out of 3000Xtra or Eikon (Market Data Terminal)6464
7.5 RTEx Trading TicketGo for your preferred Brokerwith/without Algorithmic TradingAn example of Algo Trading is trading based on optimising VWAP(Volume Weight Average Price, low on Buy & high on Sell)Order Bookreflects Market Depth(in this example,presented in ladderformat)Blotter : A record of trades and the details of the trades made over a period of time.65658. ConclusionBy presenting1. financial instruments (example: 3m BIBOR & 6m THBFIX futures)2. method to price(example: time value of money)3. hedging examples(example: protect against rise of interest rates)4. trading strategies(example: Calendar Spread Trading)5. Economic analysis and understanding Central Bank policy6. cost-of-funding curve construction(example: Zero-coupon curve)7. process efficiency for trades effectiveness and deals managementWe attempt to help you understand the Risk and Rewards embedded-inand appreciate the Hedging and Speculation aspects ofthe 3m BIBOR and 6m THBFIX interest rate futures.66
Any Questions?67Christmas Gifts for youDrop me an email (vincent.chia@thomsonreuters.com)for soft copy orto request for free subscription of :1.“Reuters Insider”(web-based News in Video Format for Internet Explorer, iPhone/iPad , Blackberr2.“The Day Ahead”3.“Insider Debt”4.“The Morning Benchmark”68
Reuters Insider (“News in video format”) for professionals69Steps Thailand is taking to counter Hot Money ?70
Construction of Interbank-rate-derived Zero-coupon Curve ( 1 year)yield %(spot rates)Interbank-rate-derivedZero-coupon CurveTerm (maturity)SWFrom Money Market, depositON depositTN 3.3%, depositSW 3.42% (ask)For Spot-week (SW)’s “ask” using the Time Value of Money :(1 sS / W %)ActAct117 1 (depositO / N %) 1 (depositT / N %) 1 (deposit S / W %) 360360360 117 (3.3%) 1 (3.3%) 1 (3.42%) (1 sS / W %) 366 1 360360360 9 sS / W 3.499% 1*(1 3.499%)9/366O/NT/NS/WTime(Trade date 2d) 7din general- 171Construction of Interbank-rate-derived Zero-coupon Curve (1 2 years)yield %(spot rates)Interbank-rate-derivedZero-coupon CurveTerm (maturity)1yFrom Money Market, depositON depositTN 3.3%, deposit9m 4.09% (ask)Eurodollar futures mid price ED9m to 1y (mid) USD 95.6 using Time Value of Money :(1 s1Y %)(1 s1Y %)ActAct3663661127490 100 ( ED9 m to 1 y ,mid convex 9 m to 1 y ) ( deposit ON , ask %) 1 ( deposit TN ,ask %) 1 ( deposit 9 m , ask %) 1 1 360360360100 360 1127490 100 (95.6 0 ) (3.3%) 1 (3.3%) 1 ( 4.09%) 1 1 360360360100 360 (0 s1Y 4.256 % convex1Y or below convex beyond 1Y) 1*(1 4.256%)366/366O/N- 1T/N9m90dTime(Trade date 2d) 366din general72
Construction of Interbank-rate-derived Zero-coupon Curve ( 2 years)yield %(spot dZero-coupon Curve2y 4.491yTerm3y (4.49 100) 4.492y3yTimeGiven fixed rate for mid IRS3 year (mid) 4.49% or 4.49 for notional of 100like a 3 yearBehave 100 4 . 49(1 4 . 256 %)Bond ,par1 4 . 49(1 4 . 468 %) 2 ( 4 . 49 100 )(1 s 3 y %) 3 s 3 y 4 . 494 %This conditions holds only if the payment schedule is the sameas the LIBOR benchmark used & the swap starts on Spot Date.73Convexity Bias (adjustment) for STIR futuresPrice Average Price of anSTIR futuresUnadj. Implied yield0.290Implied Yield%Adj. implied yield0.2919The STIR futures pays us at the time we borrow, but we do pay interest until the loanmatures, 90 days hence. Since we have time to earn interest on the change in the value ofthe contract.74
Convexity Bias (adjustment) for STIR futuresTypically, a convexity adjustment is made to convert implied yieldfrom STIR futures into forward interest rates.For short maturities (up to one year), the linearly implied yield fromSTIR futures can be assumed to be the same as the correspondingforward interest Rate.But for longer maturities, the difference between futures andforward contracts become important when interest rates varyunpredictably.75
120-day Term or Tenor or Maturity Yield % spot THB Interest Rates curve 120-day 30-day 30-day 90 day Time frame 2.1 Birdeye View on Trading/Pricing/Hedging Planes Hedging Plane Trading Plane Price Price Yield Relationship 100 for Pricing Purpose Cash Settlement date Linearly Implied Rate and Spot Interest Rates converge
