Presentation on theme: "Intermediate Investments F3031 Hedging Using Interest Rate Futures Contracts There are two main interest rate futures contracts –Eurodollar futures –US."— Presentation transcript:
Intermediate Investments F3031 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.
Intermediate Investments F3032 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
Intermediate Investments F3033 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 = ??
Intermediate Investments F3034 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.
Intermediate Investments F3035 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
Intermediate Investments F3036 An Example Assume the following –On November 15 you purchase one December Eurodollar Futures contract –The quoted futures price at the time is –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?
Intermediate Investments F3037 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?
Intermediate Investments F3038 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
Intermediate Investments F3039 In Order to Hedge, Do You Buy or Sell? If interest rates go up, your company’s 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
Intermediate Investments F30310 How Does the Hedge Work? Assume the following: –The March Eurodollar futures price is –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?
Intermediate Investments F30311 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?