Topic 4: Interest Rate Futures

Problem 6.16
Suppose that it is February 20 and a treasurer realizes that on July 17 the company will have to issue $5
million of commercial paper with a maturity of 180 days. If the paper were issued today, the company
would realize $4,820,000. (In other words, the company would receive $4,820,000 for its paper and must
redeem it at $5,000,000 in 180 days’ time.) The September Eurodollar futures price is quoted as 92.00. How
should the treasurer hedge the company’s exposure?
The treasurer can hedge the company’s exposure by shorting Eurodollar futures contracts. The Eurodollar
futures position leads to a profit if rates rise and a loss if they fall.
The contract price of a Sept Eurodollar futures contract is $980,000. Note that the Eurodollar price of 92.00
implies a yield to maturity of 8% per annum or a discount of $25 per basis point times 800 basis points =
$20,000 or (8% x $1m x 90/360).
The number of contracts that should be shorted is, therefore, $4,820,000 / $980,000 = 4.92 or for, practical
purposes, 5 contracts
Note that the duration of the commercial paper is twice that of the of the Eurodollar deposit underlying the
Eurodollar futures contract. Therefore, we need to multiply our answer by 2 which gives an answer of 9.84
contracts (or 10 contracts rounded up).
For example, if Sept Eurodollars were quoted at 91.00 on July 17, the borrower would gain 100 basis points x
$25 per basis point x 10 contracts = $25,000 on the short Eurodollars position. This would offset the
incremental interest expense of a rise of 1 percent on the $5m loan ($5m x 1% x 0.5 years = $25,000).

Problem 6.25
The December Eurodollar futures contract is quoted as 98.40 and a company plans to
borrow $8 million for three months starting in December at LIBOR plus 0.5%.

(a) What rate can then company lock in by using the Eurodollar futures contract?
The company can lock in a 3-month rate of 100 − 98.4 =1.60%. The rate it pays is therefore locked in at 1.6 +
0.5 = 2.1%.

(b) What position should the company take in the contracts?

The company should sell (i.e., short) 8 contracts. If rates increase, the futures quote goes down and the
company gains on the futures. Similarly, if rates decrease, the futures quote goes up and the company loses
on the futures.

(c)if the actual three-month rate turns out to be 1.3%, what is the final settlement price on the futures
contract. Ignore timing mismatches between the cash flows from the Eurodollar futures contract and
interest rate cash flows.
The final settlement price is 100 − 1.30 = 98.70.
The futures contract is settled in December, but the interest rate on a loan starting in December is paid three
months later.

Additional Questions:
1.You have just bought a December 90 Day BAB futures contract at a price of 95.22. Immediately after your
purchase, the Reserve Bank announces a surprise increase in the cash rate to 5.00%. The yield on spot
90day BAB’s rises to 5.03% and the December futures contract price falls to 94.90. Calculate your gain or
loss on this trade (use formula not approximation technique).
Obligation to buy at 95.22 = $988,351 (value of contract)
Closed out contract at 94.90 = $987,581 (value of contract)
Therefore loss = $ 770
Check approximation: -32 points x $24 per point (approx) = - $768 (Loss)
2. With respect to 90 BAB futures traded on the SFE, which of the following statements is true:
(a) a borrower would take a long position in BAB futures to hedge against an interest rate rise
(b) an investor would take a short position in BABs to hedge against a decrease in interest rates
(c)a speculator anticipating a rise in interest rates would take a short position in BABs
(d) none of the above are true
Answer: C

3. You observe the following information relevant to Australian conditions:

Forward rate agreements available today:
3 x 6 FRA = 5.10%
6 x 9 FRA = 5.20%
90 day Bank Bill futures quotes maturing in:
3 months = 94.90
6 months = 94.75

Your company has a rolling 90 day bank bill facility with its bank. It has just issued 200 x $100,000, 90 day
bank bills at Bank Bill Rate (BBR) + 1.5% and intends to roll over this debt at the end of each quarter for the
next three quarters. Company management is concerned about the possible effect of forecasts for rising
interest rates over the forthcoming year and has instructed you to propose interest rate hedging strategies
using (i) forward rate agreements and (ii) bank bill futures.

Construct appropriate hedges for the next two rollover dates&evaluate the outcomes if BBR is
(a) 5.02% in 3 months time, and
(b) 5.50% in 6 months time (assume that 90 BAB futures close 94.98 in 3 months and 94.50 in 6 months
time).

(a)Hedging the first rollover using a Forward Rate Agreement

To hedge, buy a 3 X 6 FRA at 5.10% with face value of $20m.
Payoff from FRA =
FV FV
Payoff  
 days   days 
1  frate  1  r 
 DIY   DIY 

= $20m/[1 + .0510(90/365)] – $20m/[1 + .0502(90/365)]

19,751,617 – 19,755,467 = – $3,850

The payoff from the FRA was negative because the company was able to rollover its debt at 5.02% on the
rollover date which was below the rate of 5.1% locked in by the FRA. – that is, the company must pay the
bank $3850. All up, the company’s rate of interest for the 90 day period will be 5.1% which is the rate
locked in by the FRA.

Hedging the second rollover with a Forward Rate Agreement

Go long on 6 X 9 FRA at 5.20% with face value of $20m.
Payoff from FRA =
FV FV
Payoff  
 days   days 
1  frate  1  r 
 DIY   DIY 
= $20m/[1 + .052(90/365)] – $20m/[1 + .055(90/365)]
19,746,808 – 19,732,397 = + $14,411
The payoff from the FRA was positive because the company rolled over its debt at 5.5% on the rollover date
which was above the rate of 5.2% locked in by the FRA. – that is, the bank must pay the company $14,411.
All up, the company’s rate of interest for the 90 day period will be 5.2% which is the rate locked in by the
FRA.
(b)Hedge first roll-over with Bank Bill futures
Short 20 x 3 month bank bill futures contract at 94.90 = 5.10%
Why short? - We have a future obligation to sell bank bills and are concerned about interest rates (YTM)
rising. Therefore, profit from a short position in futures but pay higher rate in physical market. Spot and
futures price must converge, so assume futures price to close out is 5.02%
Loss on futures
= BB at 5.10% - BB at 5.02
= $20m / [1 + 0.0510{90/365} ]
= $20m/ [1 + .0510(90/365) ] - $20m/[1 + .0502(90/365)]
= 19,751,617 – 19,755,467 = – $3,850

Hedge second roll-over with Bank Bill futures

Short 20 x 3 month bank bill futures contract at 94.75 = 5.25%
Spot and futures price must converge, so futures price to close out is 5.50%

Profit on futures
= BB at 5.25 - BB at 5.50% -
= 19,744,405 - 19,732,397 –= + $12,008
Note: this answer is lower compared to the FRA hedge because the interest rate locked into with BAB
futures was higher at 5.25% (compared with 5.2% for the FRA). On this basis, the FRA was the better
(cheaper) hedging instrument to choose

4. On March 24 an investor went short a June 10 year bond futures contract on the SFE at a price of 94.310.
Three weeks later the investor closed out this futures position at a price of 94.515. Calculate the investor’s
approximate gain or loss on this trade.
Short at 94.310
Close at 94.515
Change 0.205

Prices quoted in yield per cent per annum. The minimum fluctuation of 0.005 per cent equals
approximately $40 per half basis point.
Therefore, the change of 20.5 basis points x $40 per half basis point = $1,640 approx.

Using the provided formula to value a 6% coupon 10 Year Treasury Bond futures contract trading at 94.31
(yield = 5.69%)
i= 5.69/200 = 0.02845
v = 1 / (1 + i) = 0.972337
n = 20 and c = 6% / 2 = 3
P = 1000 x [c(1 – v 20) / i + 100v20]
= $102,339.40

If the futures price rises to 94.515, the yields declines to 5.485%, then
i= 5.485/200 = 0.027425
v = 1 / (1 + i) = 0.973307
n = 20 and c = 6% / 2 = 3
P = 1000 x [c(1 – v 20) / i + 100v20]
= $103,923.77

Loss for short position = (102,339.40 - 103,923.77) = 1,584.37

illustration Topic 4:
Example 1
X Ltd. has just issued 100 x $100,000, 90 day bank bills ($10m total, borrow at fixed rate) and intends to roll it

Risk: Interest rate rise (Price falls) prior to the rollover date
Plan: Wants to lock in interest rate for the next 90 days
Action: Sells 90 Day BAB futures maturing in 3 months at 95.76 (4.24%)
How many contracts?
contracts = total exposure / size of contract
= (100x 100,000 / 1,000,000)
= 10

In 3 months: The 90 day BAB futures price in 3months time turned out to be 95.06
Short Hedge BaB Futures BaB price
90Days SELL 95.76 lock in interest rate for the next 90days
Close up BUY 95.06 (rate increase/ price falls)

Note: For simplicity, we assume here that the delivery date of the futures is the as the rollover date.
Therefore, interest rate on rollover of facility will be the same as that on BAB futures (convergence).

Example 2
Company A intends to issue a zero coupon note with a face value of $1m in 3 months time, repaying the loan
180 days after issuing. Current 180 day interest rate is 9% p.a.

Risk: Interest Rate continues to increase

Plan: Lock in interest rate using FRA
Action now: Company A enters into a 3 x 9 FRA with Bank B at a rate of 9.50%.
Action in 3 months: Sells discount at market interest rate of 10.25%,
Now (Time 0): Company A enters into a 3 x 9 FRA with Bank B at a rate of 9.50%.

3 months from now: Co A issues a 180 day, Zero Coupon Note at 10.25% and receives
$1m / (1 + .1025*[180/365]) = $951,884.21

9 months from now – Discount matures: Co A repays $1m to Note holder, interest amount is
$1,000,000- $951,884.21 = 48,115.79

9 months from now – FRA matures: Since the seller has agreed to provide funding at 9.5%, the seller
compensates Co A with the difference: Co A receives $3,363.11 from Bank B (seller)

= $ 48,115.79 - $ 3,363.11 = $ 44,752.68

= $951,884.21 - $955,247.32 = - $3,363.11

Net Payment, FRA net payment + interest:

Alternatively, if you had locked in your cost of borrowing at, 9.5 % for 180 days
$1,000,000 – 955,247.32 = $44,752.68

Buy going into a 3 x 9 FRA at 9.5%, you have locked in your Zero coupon note at 9.5%
Long Hedge 3x9 FRA
Now BUY 9.50% 
Close out SELL 10.25% 
GAIN 0.75%