Interest Rate Futures

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Interest Rate Futures
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21 November 2006
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Outline of Presentation

• Managing Interest rate Risk
• Identifying market Expectations
• Using Charts
• Market Price Dynamics
• MosPrime

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Concept of interest rate risk

• Fixing of the interest rate on an Asset or
  Liability
• What is my exposure?
• How do I measure it?
• gt BPV

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Instruments hedging short term interest rate risk

• Available instruments
• Cash instruments Money Market and FX swaps
• Non-cash Derivatives OTC and Interest Rate
  Futures

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Cash instruments

• Money Market Instruments
• Allow for the perfect interest rate hedge
• Dates and notionals can be tailored
• But, credit line intensive
• FX Swaps
• Exchange of notional between two currencies for
  the duration of the transaction
• Allows for the perfect interest rate hedge in two
  currencies
• Dates and notionals can be tailored
• And use less credit lines than Money Market
  instruments.

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Cash instruments FX swaps

• Uneven swaps
• T0
• T1
• Even swaps
• T0
• T1

USD Notional
Bank A
Bank B
EUR Notional
USD Notional interest
Bank A
Bank B
EUR Notional interest
USD Notional
Bank A
Bank B
EUR Notional
USD Notional
Bank B
Bank A
EUR Notional (EUR interest EUR
equivalent of USD interest)
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Cash not always optimum to hedge the interest
rate risk

• Where derivative instruments are available, it is
  usually more efficient to separate cash and
  interest rate risk management
• This allows to take the preferred hedging
  decision for each exposure.
• For example, it may be preferable to hedge a
  disbursement on a 3 month loan with overnight
  funding (Cash management) and a DERIVATIVE
  instrument (interest rate risk management).
• i.e. we can take a curve view

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Derivatives

• Over The Counter Forward Rate Agreements (FRA)
• A FRA is an agreement about the future level of
  interest rates. Compensation is paid by one party
  to the other to the extent that on the interest
  fixing date, market interest rates deviate from
  the agreed rate.

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Derivatives

• Benefits of FRAs
• No cash involved (except at settlement) allows
  to separate cash management from interest rate
  risk management
• Dates and Notionals flexible (within limitations)
  gt more flexible than Futures
• No basis risk (as opposed to Futures)
• Drawbacks of FRAs
• Not perfect hedge (but if FRA dates close to
  those of the risk to be hedged, residual curve
  risk can be minimised)
• Credit risk
• ISDA legal agreement needed with every
  counterparty
• Pricing may not be transparent for non standard
  dates
• Legal and tax considerations in Russia?

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Derivatives

• Exchange traded derivatives
• Interest rate futures prices are defined as 100
  Interbank offered rate.

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Derivatives

• Exchange traded derivatives
• Benefits of Futures
• No cash involved (except for margin) allows to
  separate cash management from interest rate risk
  management
• Counterparty is the Exchange initial margin
  daily margin calls gt reduced credit risk
• Fewer Legal Agreements needed (with the Broker
  and Clearer only)
• Transparent pricing
• Brokerage fees cheaper than on OTC derivatives
• Fast and simple execution
• Drawbacks of Futures
• Not perfect hedge
• Basis risk with the cash risk (converging to 0
  towards Future settlement date gt no real risk if
  Futures held to settlement date)

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Derivatives

• FRAs vs. Futures
• In principle, a Forward and a Futures price have
  the same payoff

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Derivatives

• FRAs vs. Futures
• However,
• The margining can create a price bias, if there
  is a non-zero correlation between moves in the
  asset (Futures) price and movements in the
  interest rates
• Margin in-flows need to be reinvested
• Margin calls out need to be funded
• The cash-settlement value of a FRA is discounted
  at the settlement price over the fixing period

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Derivatives

• FRAs vs. Futures the basis

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Summary table of the different Instruments

• According to information provided to the EBRD by
  market participants

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Example BPV impact of the different instruments
MM and FX swap imply a perfect hedge in BPV
terms. However, BPV analysis ignores transaction
costs, which can only be recovered by taking some
risk. gt no risk no loss, but also no gain!
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Example BPV risk
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Example Scenario
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Example Scenario
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What drives price action?

• Heterogeneous expectations
• Speculators critical to provision of liquidity
• A special kind of speculator the Black Box

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MosPrime Origins

• In April 2005, a new Rouble money-market
  reference rate was launched in the Russian market
  - the Moscow Prime Offered Rate (MosPrime Rate) -
  under the auspices of the National Foreign
  Exchange Association (NFEA).

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MosPrime Description

• MosPrime is the yield for money-market time
  deposits offered by first tier banks in the
  Russian market to financial institutions of
  comparable credit standing.
• MosPrime is calculated daily for 1, 2, 3 and 6
  month tenors provided by eight Contributor Banks.
  
• MosPrime calculation procedure is based on
  international standards the arithmetic average
  of quoted rates after rejecting the highest and
  the lowest offers.

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MosPrime Contributing Banks

• A minimum of six banks contribute reference
  rates, and are selected on the basis of
  reputation, credit standing, scale of activity
  and experience in the Russian money-market.
• NFEAs Board reviews the contributors list at
  least once a year. There is no restriction on
  the recurring inclusion of a bank in the list.
• Currently the list of contributing banks consists
  ofABN Amro Bank, ZAO Citibank,
  ZAOGazprombank, CJSC International Moscow
  Bank, ZAO Raiffeisenbank Austria, ZAO Sberbank,
  OJSCBank for Foreign Trade (VTB), OJSC WestLB
  Vostok, ZAO

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MosPrime Bilateral Loans

• EBRD has arranged RUB 30 billion of
  MosPrime-linked corporate and municipal loans.
• MosPrime is used for long term mortgage lending,
  with one bank reporting 746 such loans in
  September 2006.
• MosPrime is used by a number of banks in their
  corporate loan programmes, as well as for
  internal benchmarking.

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MosPrime Bonds

• EBRDs inaugural RUB bond (RUB 5bn 5yr), May
  2005, was the first MosPrime-linked issue.
• To date, EBRD has issued three such RUB 5-year
  Floating Rate Notes totalling RUB 17.5 billion,
  for which a coupon will be set at 3 month
  MosPrime on every calendar month of the year.

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MosPrime Derivatives

• In May 2006 MosPrime-linked futures were launched
  on MICEX.
• Banks are quoting RUB interest rate swaps using
  MosPrime as the index for the floating leg.
• Expected legal changes, clarifying
  enforceability of swap transactions in Russian
  courts should expedite this activity, and allow
  the hedging of interest rate risk.

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MosPrime Additional Information

• NFEA undertakes to disclose MosPrime on a daily
  basis via its website, special Reuters pages and
  mass media. http//www.nva.ru
• Contributor Banks undertake to lend to the other
  panel banks at their MosPrime quotation rate,
  and to accept deposits from them at no more than
  50 basis points below that rate.
• Contributor Banks have agreed to lend to EBRD at
  their MosPrime quotation rate and accept
  deposits at no more than 50 basis points below
  it on the dates of bond coupon fixings.
• EBRD tests the validity of the rates quoted, and
  monitors the panel of Contributor Banks to ensure
  the credibility of the MosPrime rate.

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MosPrime Additional Information

• Mosprime quotations for 0/n, 1 week, 2 weeks will
  be officially launched in January 2007
• Technical start date 15 December 2006