1. Interest Rate Futures The 3 month KLIBOR Futures Contract
Chapter 5
Interest Rate Futures The 3 month KLIBOR Futures Contract
Chapter Objective :
This chapter is designed to provide an indepth analysis and description of interest rate futures contracts. Emphasis is placed on the workings of the Malaysian 3 month KLIBOR futures contract. At the end of this chapter, you should have a good understanding of interest rate futures contracts and its applications.

2. Introduction
Interest rate futures contracts are yet another financial derivative. The underlying asset is typically an interest rate linked asset like a treasury bill, bonds or simply monetary deposits
Since its introduction in 1976, interest rate futures contracts have been among the most popular derivative instruments introduced
Most businesses, regardless of their industry/product would have interest rate exposure by virtue of the fact that most businesses are either net lenders or net borrowers at any one time
The obviously more important reason for the popularity of interest rate futures is the increased volatility of interest rates

3. The major causes of the increased interest rate volatility
(i) volatility in inflation rates
(ii) floating exchange rates and the increased volatility in currencies and
(iii) shifts in government policy; particularly in interest rate targeting and deregulation.
What Is Interest Rate Risk?
Interest rate risk refers to risk resulting from changes in the interest rate. This risk can occur in several forms.

4. Continue to Interest Rate Risk’
Change in Cost of Funds
Change in the Value of Assets
Refinancing risk
Reinvestment Risk
Bond Pricing, Yields and Interest Rate Risk
Bonds are essentially promissory notes that are market traded. The issuer is the borrower while the buyer of bonds, the lender. Bonds therefore are debt instruments.
interest is paid either as a fixed, annual or semi annual coupon payment. Interest or coupon of a bond could also be floating as opposed to being fixed. In a floating rate bond, coupon is determined typically as a premium to a reference interest rate.

5. E.g. a bond might have a floating interest rate quoted as 6 month KLIBOR + %.
if the 6 month KLIBOR is quoted as 10% on the due date, if  is 2% and the face value of the bond is RM1,000 then the coupon payment would be;
(10% + 2%) x RM1,000 = RM120
Assume Syarikat ABC has issued 1,000; 10 year bonds with the following features;
Issuer : Syarikat ABC
Face Value : RM1,000 (Total RM1,000,000)
Interest /Coupon : 10% Annual
Required Yield
Given risk class : 10%

6. The bond’s correct price could be determined by
Where;
Ct = annual coupon payments in Ringgit
FVn = Face Value received at maturity in year n.
y = required yield or required return given the risk class of the bond.
Solving the above equation gives a value of RM1,000 as the correct price for Sykt. ABC’s bond.
if rates fall 2% and the required yield is now 8%, the bond’s price at an 8% discount rate would now be RM1,

7. Bond Yield and Yield Curves
required yield would have to be determined from the yield curve
the yield curve is a locus of points relating the required yield to the time to maturity for a given risk class of bonds
Required yield
Corp. Bond (Low quality)
Corp. bond (Medium quality)
Corp. bond (AAA)
Yield Curve for Govt. bonds
Time to maturity
3 months year year year year

8. Interest Rate Change, Bond Yields and Duration
The impact of a change in interest rates on bond prices works through the yield curves.
changes in interest rates are inversely related to bond and asset prices.
Interest Rate
Required Yield
Bond/Asset Values  

9. Bond’s duration
The extent to which a bond falls in value for a given increase in interest rates will depend on its duration.
Duration can be thought of as a measure of a bond’s sensitivity to interest rate changes.
The higher the bond or an asset’s duration, the more sensitive it is to interest changes.

10. Duration can be used to estimate this expected change in value/price
Where;
CFt = Coupon and Face Value received from the bond
y = required yield
Po = current market Price of the bond
Duration can be used to estimate this expected change in value/price
Where;
D = duration of the asset
i = interest rate
 = change in variable

11. Malaysia’s Interest Rate Futures Contract The 3 month KLIBOR Futures Contract
The contract was introduced in 1996 by Bursa Malaysia Derivatives Bhd.’s predecessor, the Malaysian Monetary Exchange (MME). The MME was then a newly established subsidiary of the Kuala Lumpur Commodity Exchange (KLCE)
KLIBOR which stands for Kuala Lumpur Interbank Offer Rate is really the interest rate determined by the borrowing and lending activities of players in the interbank market
The underlying asset of the 3 month KLIBOR futures contract is a Ringgit deposit of RM1 million.
The interest rate futures contract, we lock-in the interest rate at which we will borrow or lend

12. Month KLIBOR Futures; Contract Specifications
outlines the Contract Specifications for the 3 month KLIBOR futures. Sorced from Bursa Malaysia website (see Page 103)
Pricing Interest Rate Futures Contracts
In the Contract Specification that the price of 3 month KLIBOR Futures contract is quoted in terms of an index
This index is essentially 100 minus the annual percentage yield to two decimal places.
For example if the required yield or going interest rate on the KLIBOR futures is 7.5%, the price will be quoted as which is;
100 – 7.5 = 92.50

13. Determining the Equilibrium Price: The Implied Forward Rate
To determine the correct price of an interest rate futures contract, a slightly more circuitous but intuitively logical method known as the Implied Forward Rate (IFR) is used.
The IFR technique makes use of available spot price of different tenors to solve for the price of the 3 month KLIBOR futures
The basic logic of IFR is that a futures price is an expected future spot price

14. Example: 3-month KLIBOR 6% (Maturing; Mar. 30)
6-month KLIBOR 7% (Maturing; June 30)
For simplicity; assume today’s date is Jan. 1st.
The 3-month KLIBOR has a tenor = 90 days.
The 6-month KLIBOR has a tenor = 180 days.
(Note: February = 28 days, Jan, Mar. & May = 31 days).
Question: Given the above information, what is the correct price of a 3-month KLIBOR futures contract?
Given the above information, what is the correct price of a 3-month KLIBOR futures contract?

15. Since the interest rate implied in the price quoted for a futures contract is for money borrowed for 3 months from the maturity date, the price today would be the expected 3-month interest rate, between March and June.
Jan Mar Jun 30
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3 month KLIBOR (spot) = 6%
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3 month KLIBOR futures?
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6 months KLIBOR (spot) = 7%

16. The Implied Forward Rate (I.F.R.) can be computed as
So, in above question,
[1 + IFR x (90 / 360)] = [ x (180 / 360)]
[ x (90 / 360)]
[1 + IFR x (90 / 360)] = 1.035/1.015
[1 + IFR x (90 / 360)] =
IFR = X (360/90)
IFR = or 7.88%

17. Since the IFR is 7.88%, the correct price quotation for the 3-month KLIBOR futures contract should be:
100 – 7.88 = 92.12
If the price for the futures contract is anything other than 92.12, there is mispricing and arbitrage would be possible

18. Month KLIBOR Futures; Applications
Hedging Interest Rate Risk
Interest rate futures contracts can be used by borrowers to hedge their costs and lenders to hedge their profit margin
Locking In the Cost of Borrowing
Your company has just signed an agreement, with a foreign supplier. The agreement calls for your company to pay RM10 mil. in 3 months for goods from the supplier. As you would not have the needed funds, you have arranged with your banker for a 3-month RM10 mil. loan. Your banker has agreed to provide the loan at an interest rate of KLIBOR + 2%. You now fear that an increase in interest rates between now and when the loan is taken might increase your cost of funds and thereby erode your profits.

19. Assume it is now June 25. Loan will be taken in September
Assume it is now June 25. Loan will be taken in September. (exactly 90 days from June 25th). The following quotations are available on June 25.
3-month KLIBOR = 7.00%.
September KLIBOR futures = 92.00
So, to “lock-in” is the yield (June 25th) on the KLIBOR futures + the 2% premium. i.e; 10%, since the KLIBOR Futures is yielding 8%; (8% + 2%) = 10%.
Hedge Strategy :
Short, 10 September KLIBOR Futures Contracts

20. Scenario 1 : Interest Rates rise over the period by 1.5%
As such on Sept. 25 the quotes would be:
- 3-month KLIBOR = 8.5% (higher by 1.5%)
- Sept. KLIBOR Futures = (since the futures matures on that day, the implied rate is 8.5%; same as spot due to convergence).
Result of Hedge
Profit from futures = [(92.00 – 91.50) x (RM25 x 100)] x 10 contracts
= RM12,500
Interest on loan = [8.5% + 2%] x 90 / 360 x RM10 mil.
= [10.5%] x 1 / 4 x RM10 mil.
= RM262,500

21. Net Interest Cost = RM262,500 – RM12,500
Effective Interest Rate with Hedge =RM 250,000 x100% = 2.5%(3 months)
RM10mil
Annualized Interest Rate = 2.5% x 4 = 10%
This equals exactly 8.00% + 2%. (KLIBOR futures was 8.00% in June) As a result of the hedge you were able to borrow at the futures rate in June of % instead of 8.5% + 2% which you would have had to pay in September if you had not hedged. Thus, you saved 0.5%.

22. Result of Hedge Scenario 2: Interest Rates fall by 1.5%.
With the fall in interest rates, the quotes on Sept. 25 would be:
3 month KLIBOR = 5.50% (lower by 1.5%)
Sept. KLIBOR Futures = (Same as spot since it is maturity day for futures; convergence)
Result of Hedge
Loss On Futures = [(92 – 94.50) x (100 x RM25)] x 10ctrts
= RM62,500
Interest On Loan = [5.50% + 2.0%] x 90 /360 x RM10 mil.
= 7.50% x 1 / 4 x RM10 mil.
= RM187,500

23. Net Interest Cost = RM187,500 + RM62,500
Effective Interest
Rate with Hedge = RM250,000 x 100 = 2.5% for 3 months
RM 10 mil.
= 2.5% x 4 = 10%
the effective interest rate has been locked in at 8.00% + 2%, Notice that regardless of whether interest rates go up or down, you have locked-in the 10% cost of borrowing

24. Hedging: Protecting Interest Income / Revenue
We now examine the hedge strategy from the viewpoint of a banker / financier. In the earlier example, the banker quotes a floating interest rate KLIBOR + 2%
Example:
As a Credit Officer of a large Malaysian bank you have agreed to provide an important institutional customer with a fixed rate, 3 month, RM20 million loan 90 days from today. You had priced the loan at 12% annual interest rate. Assuming your cost of funds is the KLIBOR rate and the following quotes are now available,
3 month KLIBOR = 9 %
3 month KLIBOR Futures = 90.0 (mat. 90 days)

25. Short, 20, 3 month KLIBOR Futures Contracts.
Note the KLIBOR Futures priced at 90.0 is yielding 10%, since you priced the loan at 12%, you have essentially priced in a 2% profit margin
Hedge Strategy:
Short, 20, 3 month KLIBOR Futures Contracts.
assume that interest rates rise 2% over the next 90 days
With interest rate  by 2%
At Maturity
3 month KLIBOR = 11% ( 2%)
3 month KLIBOR Futures = 89.0 (convergence implies 11% yield)
Without hedging, with spot rate at 11%, your profit spread would have reduced from 2% to 1% (12% - 11%)

26. Result of Hedge
Profit from Futures = (90 – 89) x (RM25 x 100) x 20 contrs
= RM 50,000
Interest Spread = ( )
(Price – Cost)
Interest Earned = [(.01) x RM20,000,000] x 3 /12
Total Earning = RM 50,000 + RM 50,000
= RM100,000
% Earning = RM100,000 x 100 = 0.50% for 3 months
RM 20,000,000
Annualized % = 0.50% x 4 = 2.0%

27. Speculating On Interest Rate Movements
Scenario 1:
Your analysis of economic conditions leads you to believe that interest rates are likely to fall over the next few months. Can you use KLIBOR futures to take advantage of your analysis?
Today’s date : Jan 10 : Quotations;
3-month KLIBOR = 8.00%
March KLIBOR Futures = (tenor = 90 days)
Strategy : Long (Buy) 1 March KLIBOR futures.
(Going long would be the right strategy since falling interest rates would mean rising KLIBOR futures prices. To take advantage of rising KLIBOR prices you go long)

28. March KLIBOR Futures = 94.00 (since it matures; convergence)
Suppose your analysis was correct and interest rates go down by 2%. Then, the March 25 quote:
3-month KLIBOR = 6.00% (↓ 2%)
March KLIBOR Futures = (since it matures; convergence)
Profit on Futures = (94-91) x (RM25 x 100)
= RM7,500
Since your expectation came true, you profit from the speculative position. If interest rates had gone up instead, you would have made losses.

29. Today’s Date: April 1st Quotation; 3-month KLIBOR = 6.00%
Scenario 2: Your friend, a Technical Analyst tells you that interest rates are going to increase. Since he has made several accurate calls previously, you have confidence in his forecast. How can you profit from your friend’s projection?
Today’s Date: April 1st Quotation;
3-month KLIBOR = 6.00%
June KLIBOR Futures = 93.00

30. June KLIBOR Futures = 92.50 (convergence)
Strategy: Short 1, June KLIBOR Futures
Suppose, your friend was right and interest rates go up by 1.5%. Then on June 25th;
3-month KLIBOR = 7.50% (↑ 1.5%)
June KLIBOR Futures = (convergence)
Profit on Futures= ( ) x 100 x RM25
= RM1,250 per contract

31. Arbitraging with Interest Rate Futures
When the quoted futures price has a yield different from that of the implied forward rate, there is mispricing and arbitrage is possible
two types of arbitrage strategies, Cash & Carry and Reverse Cash & Carry
The Cash & Carry strategy would be appropriate when the
futures contract is overpriced relative to the 3 month and 6 month spot KLIBOR rates.
The Reverse Cash & Carry applies when the interest rate futures contract is underpriced

32. Example : Cash and Carry Arbitrage
Suppose today’s date is June 23rd and you observe the following spot rates and futures price.
3 month KLIBOR = 7% [90 days till 24th September]
6 month KLIBOR = 8% [180 days till 23rd Dec.]
3 month KLIBOR Futures = [maturing 23rd September]
Given these quotations, in order to determine if arbitrage is possible, we first check for mispricing by computing the implied forward rate (IFR)

33. the implied forward rate (IFR)

34. Long 6 month KLIBOR (spot) of RM 1 million face value
the correct 3 month KLIBOR futures price should be; 100 – 8.84 = Since the 3 month KLIBOR futures is quoted at 92.50; the futures is overpriced
Arbitrage strategy:
Long 6 month KLIBOR (spot) of RM 1 million face value
Short 1, 3 month KLIBOR futures contract
notice that we go long the 6 month spot and not the 3 month KLIBOR spot.
note the above strategy is consistent with the arbitrage rule; buy low, sell high. Since the futures is overpriced, we short (sell) the futures and long (buy) the relatively underpriced 6 month KLIBOR spot

35. Since our arbitrage strategy is based on mispricing we should make a profit regardless of interest rate movements between June 23rd and Sept. 23rd.
Scenario 1; Interest Rate  by 2%
The 3 month KLIBOR will be 9%, while the Sept. KLIBOR futures which is maturing on that day will be priced at 91.0 due to convergence.
Arbitrage Payoff
Profit on Futures = [(92.50 – 91.0) x (RM25 x 100)]
= RM3,750
Loss on Spot = [(0.08 – 0.09) X RM 1 mil.] x 90 / 360
= (RM2,500)
Arbitrage Profit = RM3,750 – RM2,500
= RM1,250

36. Scenario 2; Interest Rate  by 2%
At maturity on September 23rd, the spot and futures quote would be;
3 month KLIBOR = 5%
3 month KLIBOR Futures = 95.0 (convergence)
Arbitrage Payoff
Loss on Futures = (92.5 – 95) x RM25 x 100
= (RM6,250)
Profit on Spot = [(0.08 – 0.05) x RM1 mil.] x 90 / 360
= RM7,500
Arbitrage Profit = (RM6,250) + RM7,500
= RM1,250

37. Example: The Reverse Cash and Carry Arbitrage
Suppose in the above example, the 3 month KLIBOR is quoted on June 23rd at 90.0 while the 3 month and 6 month spot rates are unchanged. Since the correct yield on the 3 month KLIBOR futures as computed earlier was 8.84% and its correct price 91.16, the futures contract is now underpriced
Reverse Cash and Carry strategy would be:
Long 1, 3 month KLIBOR futures contract.
Short 6 month KLIBOR (spot) of RM1 mil. face value

38. Scenario 1; Interest Rate  by 2%
At maturity on September 23rd, the Quotes would be;
3 month KLIBOR = 9%
3 month KLIBOR futures = (convergence)
Arbitrage Payoff
Profit on Futures = [(91 – 90) X RM25 X 100]
= RM2,500
Profit on Spot = [(0.09 – 0.08) x RM 1mil.] x 90 / 360
Arbitrage Profit = RM2,500 + RM2,500 = RM5,000

39. Scenario 2 : Interest Rate  2%
At Maturity on September 23rd the Quotes would be;
3 month KLIBOR = 5%
3 month KLIBOR futures = 95 (convergence)
Arbitrage Payoff
Profit on Futures = [(95 – 90) x (RM25 x 100)]
= RM12,500
Loss on Spot = [(0.05 – 0.08) x RM1 mil.] x 90/360
= (RM7,500)
Arbitrage Profit = RM12,500 + (RM7,500) = RM5,000
Notice once again that regardless of interest rate movement, you make a profit of RM5,000. This is pure arbitrage profit and arises solely from the inherent mispricing

40. Determinants of Interest Rate Futures Prices
Interest Rate Changes
Interest Rate  = Yields ; Futures Price 
Interest Rates  = Yields ; Futures Price 
Economic Cycles and Demand & Supply of Credit
The Role of Government
Reserve Ratio   Money SS   Interest Rates 
The Rate of Inflation
Nominal interest = (1 + real interest ) (1 + inflation rate) -1
Expectations

41. KLIBOR Futures : Newspaper Price Quotation see Page 115
Contract Performance
Figures 5.2 and 5.3 provide an overview of trading activity of the 3 month KLIBOR futures contracts since its launch in may 1996.

42. Total Monthly Volume; 3-Month KLIBOR Futures (May 1996 – March 2006)
Figure 5.2

43. Total Month End Open Interest of 3-Month KLIBOR Futures (May 1996 – March 2006)
Figure 5.3

44. Key Terms Interest rate risk Refinancing risk Reinvestment risk
Floating interest rates
Bond yields
Yield to maturity
Yield curve
Bond ratings
Duration analysis
Price sensitivity
KLIBOR rates
Implied forward rate
Tenor
Interest spreads
Nominal vs. real rates

45. The End