Interest Rate Risk (3) Flashcards
What are interest rate futures?
A contract to receive or pay interest on a national standard quantity of money at an agreed future date at a specified interest rate
Similarity between interest rate futures and FRA
Fix the outcome of a hedge
Difference between interest rate futures and FRA
It is for a standard amount of money and is traded on an exchange
If company makes a loss on a transaction due to interest rate movements?
It makes a profit in futures market to compensate for this
If company makes a profit on a transaction due to interest rate movements?
It makes a loss in the futures market
Outcome fixed in futures interest rate?
Yes
What is a contract to buy?
With interest rate futures what is being bought is the entitlement to interest receipts
What is a contract to sell?
With interest rate futures what is being sold is the promise to make interest payments
Who is a contract to buy for?
An investor as it’s a contract to receive interest
Who is a contract to sell for?
A borrower as it’s a contract to pay interest
What is step 1 in a futures contract (borrower)?
Enter into a futures contract to sell (pay interest) at a fixed rate
What is step 2 in a futures contract (borrower)?
Complete the actual transaction on the spot market
What is step 3 in a futures contract (borrower)?
Entering into contracts to buy (receive interest). Opposite to step 1
What happens if interest rates rise in futures contract for borrower?
There will be a gain on the future as interest received in Step 3 will be higher than interest paid in Step 1
What also happens if interest rates rise in futures contract for borrower?
There will be a loss on the future as interest received in step 3 will be lower tha interest paid in step 1
Advantage of interest rate futures (period)
Future can be used on any day between day it was entered into up to end of time period. More flexible than a forward
Advantage of interest rate futures (counterparty)
Counterparty risk is lower since future exchange guarantees the transaction
Disadvantage of interest rate futures (size)
Are only available in large, standard, contract sizes. So less suitable compared to forward contracts
Disadvantage of interest rate futures (deposit)
Deposit is placed to cover potnetial losses, which may need to be topped up if contract is making losses
Disadvantage of interest rate futures (basis risk)
There is a risk that futures interest rates do not move exactly in line with spot interest rates so hedge is not effective
