Hedging Using Interest Rate Futures Contracts

1
Hedging Using Interest Rate Futures Contracts

• There are two main interest rate futures
  contracts
• Eurodollar futures
• US T-bond futures
• Eurodollar futures are the most popular and
  active contract
• Open interest in excess of 4 trillion at any one
  point in time
• Eurodollars in this case are not Eurodollar
  currency. They are US Dollar deposits in banks
  that are not subject to US banking regulations.

2
Hedging Using Interest Rate Futures Contracts

• Eurodollar futures contracts are based on the
  interest rate payable on a Eurodollar time
  deposit
• This rate is known as the LIBOR (London Interbank
  Offer Rate) and has become the benchmark
  short-term interest rate for many US borrowers
  and lenders
• Interest rates are typically quoted as LIBOR
  basis points (.0001, so 100 basis points 1)
• LIBOR is an annualized rate based on a 360 day
  year

3
How is LIBOR Interest Calculated?

• LIBOR is calculated on a notional principal
  amount of 1M.
• The contract is settled in cash there is no
  actual delivery of the time deposit
• The interest on a 3 month (90-day) contract with
  notional principal of 1M and an 8 rate would be
  calculated as
• .08 (90/360) 1,000,000 ??

4
Other Characteristics of LIBOR

• Prior to expiration, the quoted futures price
  implies a LIBOR rate. So
• Implied LIBOR 100 Quoted Futures Price
• At Expiration, the Futures Price is quoted at
• 100 LIBOR
• So, if the LIBOR rate was 8 at expiration,
  the contract would be quoted at 92.

5
Other Characteristics of LIBOR

• Contract is a Eurodollar time deposit
• Traded on the Chicago Mercantile Exchange
• Notional principal is 1,000,000
• Contracts are delivered in
• March
• June
• September
• December
• Cash settlements based on a 3-month LIBOR
• Minimum Price Movement is 25 or 1 basis point

6
An Example

• Assume the following
• On November 15 you purchase one December
  Eurodollar Futures contract
• The quoted futures price at the time is 94.86
• What is your profit or loss if the LIBOR rate
  falls 100 basis points between now and the
  expiration date of the contract?
• Remember
• No money changes hands when you buy the contract
• What was the implied LIBOR rate when the contract
  was purchased?

7
Example (cont)

• What is the LIBOR rate if interest rates fall 100
  basis points?
• What is the new futures price?
• What is our gain or loss based on the price?
• What is the overall gain or loss on the contract?

8
Hedging Using Interest Rate Futures

• As with any hedge, you are not locking in a rate
  per se. You are locking in an effective rate
  based on gains and losses on the contract!
• Assume the following
• Suppose a firm knows in February that it will be
  required to borrow 1M in March for a period of 3
  months (90 days)
• It will pay the loan off at the end of the period
• The firm borrows at LIBOR 50 basis points
• The firm wants to hedge its interest rate risk

9
In Order to Hedge, Do You Buy or Sell?

• If interest rates go up, your companys borrowing
  costs go up.
• So, to hedge your position, you want a strategy
  that will allow you to offset borrowing costs if
  rates go up!
• So, you would sell a contract, because if
  interest rates rise, the cost of the contract
  goes down, but you will have an agreement to
  deliver the contract at a higher price

10
How Does the Hedge Work?

• Assume the following
• The March Eurodollar futures price is 94.86
• What does that make the implied LIBOR rate?
• If we lock in this effective borrowing rate, what
  will our interest expense be?
• Now assume that LIBOR increases to 6.14. How
  does the hedge work?
• What is our borrowing cost now that interest
  rates have gone up?
• What was our gain or loss on futures contract?
• What does that make the net expense to the
  borrower?

11
How Does the Hedge Work?

• Now assume that LIBOR falls to 4.14. How does
  the hedge work?
• What is our borrowing cost now that interest
  rates have gone up?
• What was our gain or loss on futures contract?
• What does that make the net expense to the
  borrower?