Understanding corporate finance: derivative contracts: interest rate future
Examples of interest rate futures
Typically, an exchange-traded interest rate future has a notional deposit of £500,000 as its underlying subject matter. As interest rates rise, the value of the notional deposit falls, so it is useful to be able to quote the price of the future in a way that reflects this. This is achieved by quoting a price which is 100 minus an interest rate. An example will illustrate how this works:
A 3-month sterling interest rate future is quoted on a recognised investment exchange. Its delivery day is 22 March 2009. The value of the future will reflect the market’s view of what short-term sterling interest rates will be on 22 March.
This is precisely the way in which, in the example at CFM13290, the value of the forward contract reflected expectations of future interest rates. The quoted price of the future tells you what the implied forward rate is: if the future is trading at 95.30 on a particular day (say 1 March 2009), it implies that the market believes 3-month LIBOR will be 4.70% (100 - 95.30) on 22 March.
Suppose that the market believes interest rates will fall. On 3 March the future is quoted at 95.35 - in other words, the market’s view is that 3-month LIBOR on 22 March will be 4.65% (100 - 95.35). This means that someone anticipating a fall in interest rates might buy the future on 1 March at 95.30 and sell on 3 March at 95.35, making a profit.
How much profit would they make? The asset underlying the future is a notional 3-month deposit of £500,000. For every 0.01% change in interest rates, the interest earned on such a deposit would change by:
£500,000 x 0.01% x 3/12 = £12.50
£12.50 is called the tick value - the standard minimum price movement on the particular contract concerned. In the example, the price of the future alters by 0.05 (95.35 - 95.30), or 5 ticks. So the profit on each contract would be:
£12.50 x 5 ticks = £62.50
A company may use interest rate futures as a hedging instrument.
Quilslant Ltd has a temporary surplus of £2 million in cash, which in early January 2009 it places on short-term deposit at a rate linked to 3-month LIBOR. If its fears of an interest rate fall in the future are realised, its return on its investments will decrease. Therefore the company decides to hedge by buying four of the March short-term sterling interest rate futures described in Example 1 above, closing out the position at the end of March. (Each futures contract is based on a notional £500,000 deposit, so four contracts will be needed to hedge a £2 million investment).
Interest rates do indeed fall: the company makes a profit on the futures, offsetting the lower return from the £2 million deposit.