Interest Rate Risk (3)

Question 1

What are interest rate futures?

Answer 1

A contract to receive or pay interest on a national standard quantity of money at an agreed future date at a specified interest rate

Question 2

Similarity between interest rate futures and FRA

Answer 2

Fix the outcome of a hedge

Question 3

Difference between interest rate futures and FRA

Answer 3

It is for a standard amount of money and is traded on an exchange

Question 4

If company makes a loss on a transaction due to interest rate movements?

Answer 4

It makes a profit in futures market to compensate for this

Question 5

If company makes a profit on a transaction due to interest rate movements?

Answer 5

It makes a loss in the futures market

Question 6

Outcome fixed in futures interest rate?

Answer 6

Yes

Question 7

What is a contract to buy?

Answer 7

With interest rate futures what is being bought is the entitlement to interest receipts

Question 8

What is a contract to sell?

Answer 8

With interest rate futures what is being sold is the promise to make interest payments

Question 9

Who is a contract to buy for?

Answer 9

An investor as it’s a contract to receive interest

Question 10

Who is a contract to sell for?

Answer 10

A borrower as it’s a contract to pay interest

Question 11

What is step 1 in a futures contract (borrower)?

Answer 11

Enter into a futures contract to sell (pay interest) at a fixed rate

Question 12

What is step 2 in a futures contract (borrower)?

Answer 12

Complete the actual transaction on the spot market

Question 13

What is step 3 in a futures contract (borrower)?

Answer 13

Entering into contracts to buy (receive interest). Opposite to step 1

Question 14

What happens if interest rates rise in futures contract for borrower?

Answer 14

There will be a gain on the future as interest received in Step 3 will be higher than interest paid in Step 1

Question 15

What also happens if interest rates rise in futures contract for borrower?

Answer 15

There will be a loss on the future as interest received in step 3 will be lower tha interest paid in step 1

Question 16

Advantage of interest rate futures (period)

Answer 16

Future can be used on any day between day it was entered into up to end of time period. More flexible than a forward

Question 17

Advantage of interest rate futures (counterparty)

Answer 17

Counterparty risk is lower since future exchange guarantees the transaction

Question 18

Disadvantage of interest rate futures (size)

Answer 18

Are only available in large, standard, contract sizes. So less suitable compared to forward contracts

Question 19

Disadvantage of interest rate futures (deposit)

Answer 19

Deposit is placed to cover potnetial losses, which may need to be topped up if contract is making losses

Question 20

Disadvantage of interest rate futures (basis risk)

Answer 20

There is a risk that futures interest rates do not move exactly in line with spot interest rates so hedge is not effective