Chapter 05

INTEREST RATE FUTURES: THE 3-MONTH
KLIBOR FUTURES CONTRACT
CHAPTER 5
Chapter Objectives
• This Chapter intends to provide an in-depth analysis and description of interest
rate futures contracts.
• On completion of this chapter you should have a good grasp of the working of
Malaysian 3-month KLIBOR futures contract.
• You should have a good understanding of interest rate futures contracts and its
applications.
CHAPTER 5: INTEREST RATE FUTURES: THE 3-MONTH KLIBOR FUTURES CONTRACT Copyright © 2017 by McGraw-Hill Education (Malaysia) Sdn. Bhd.
3
Interest Rate Futures
• The underlying asset for Interest Rate Futures (IRF) is typically an interest rate
linked asset like a treasury bill, bonds or simply monetary deposits.
• Interest Rate Futures can be used for locking in the interest rate at which to
borrow or lend.
• This enhances the scope of possible users for IRF since any business entity that is a net
lender/borrower would be exposed to interest rate risk.
• IRF were introduced on the International Monetary Market (IMM) in 1976.
4
What is Interest Rate Risk?
• It is a risk resulting from changes in the interest rate. It occurs through four major
reasons:
• Change in Cost of Funds: It leads to either higher cost of funds or lower revenue/earnings
depending on the position as net lender or borrower.
• Change in the Value of Assets. Changes in interest rates can lead to changes in the value of
traded assets. Depending on net exposure this fluctuation can reduce profits or revenues.
• Refinancing risk. This occurs when a business needs to refinance its funding and interest rates
have changed.
• Reinvestment Risk. This refers to the risk that one may not be able to earn the same rate of
returns as previously. Cash flows earned from an existing investment may not be reinvested to
earn the same rate of return because interest rates have changed.
5
Bond Pricing, Yields and Interest Rates
• Bonds are promissory notes that are market traded.
• Being debt instruments, interest is paid either as a fixed or floating in the form of annual or
semi-annual coupon payment.
• In a floating rate bond, coupon is determined typically as a premium to a reference interest rate.
• The fluctuation in the reference rate in itself pose an interest rate risk.
• Illustration: Assume Syarikat ABC has issued 1,000; 10-year bonds with the following features.
• Issuer : Syarikat ABC
• Face value : RM 1,000 (Total RM 1,000,000)
• Interest/coupon : 10% annual
• Required yield given risk class : 10%
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• Illustration: Assume Syarikat ABC has issued 1,000; 10-year bonds with the
following features.
• Issuer: Syarikat ABC
• Face value: RM 1,000 (Total RM 1,000,000)
• Interest/coupon: 10% annual
• Required yield given risk class: 10%
• The current price of the bond with this formula is RM1,000
7
• Illustration: Assume Syarikat ABC has issued 1,000; 10-year bonds with the following
features.
• Issuer : Syarikat ABC
• Face value : RM 1,000 (Total RM 1,000,000)
• Interest/coupon : 10% annual
• Required yield given risk class : 10%
• If interest rates rise by 2% causing the required yield to also rise by 2%, the bond’s price
at the new discount rate of 12% would be RM 887.00.
• Similarly, a reduction in interest rates causing required yield to fall would cause bond
prices to rise.
• Example If rates fall 2% and the required yield is now 8%, the bond’s price at an 8%
discount rate would now be RM 1,134.20.
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Bond Yield and Yield Curves
• Solving for a bond’s price, requires four variables as inputs.
• Face value,
• Time to maturity
• Coupon amount
• Face value, time to maturity and coupon amount are disclosed as part of a bond’s features
• Required yield as discount rate
• Required yield, has 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
• As bonds differ in risk quality and belong to different risk classes, there is typically a ‘family’ of
yield curves, with each yield curve representing a certain risk class.
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Bond Yield and Yield Curves
• As bonds differ in risk quality and belong to different risk classes, there is
typically a ‘family’ of yield curves, with each yield curve representing a certain
risk class.
10
Interest Rate, Bond Yields and Duration
• The impact of a change in interest rates on bond prices works through the yield
curves.
• Suppose the government through Bank Negara Malaysia (BNM) moves to push up interest
rates. With an increase in this base rate, one can visualize an upward shift of all the yield
curves.
• The required yields would increase and given the higher discount rates, cause bond and other
asset prices to fall..
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• The impact of a change in interest rates on bond prices works is not uniform.
• 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.
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• The duration of a bond is calculated as follows:
• The expected change in value/price is calculated using the equation as follows:
13
3-Month KLIBOR Futures Contract
• The 3-month KLIBOR futures contract was introduced in 1996 by Malaysian
Monetary Exchange (MME).
• KLIBOR is the interest rate determined by the borrowing and lending activities of
players in the interbank market for varying maturities.
• The underlying asset is a ringgit interbank time deposit of tenor 3 months in the
Kuala Lumpur Interbank market with a principal value of RM 1,000,000.
• Thus, when we go long on a 3-month KLIBOR futures contract, we get to lend RM 1.0 million
for a period of 3 months beginning the maturity day of the contract at the futures yield rate.
Correction
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Contract Code FKB3
Underlying Ringgit Interbank time deposit in the Kuala Lumpur Wholesale Money Market with a
Shares three month maturity on a 360-day year.
Contract Size RM1,000,000 - Quoted in index terms (100.00 minus yield).
Minimum Price 0.01% or 1 tick Which is equivalent to RM25.00 (RM 1000000 x 3/12 x 0.01%)
Fluctuation
Contract Months Quarterly cycle months of March, June, September and December up to 5 years
ahead and 2 serial months.
Trading Hours • First trading session: Malaysian Time 9:00 a.m. to 12:30 p.m.
• Second trading session: Malaysian Time 2:30 p.m. to 5:00 p.m.
Final Trading Trading ceases at 11:00 a.m. (M’sian time) on the 3rd Wednesday of the delivery
Day Maturity month or the 1st Business Day immediately following the 3rd Wednesday of the
Date delivery month if the 3rd Wednesday of the delivery month is not a Business Day.
Final Settlement Cash Settlement based on the Cash Settlement Value.
Final Settlement i. Calculated as 100.00 minus the Three Month KLIBOR as published by Reuters
Value Ltd. On reference page "KLIBOR" at 11:00 hours (Malaysian time) on the Final
Trading Day.
ii. In the event that the above calculation (i) cannot be made, the final settlement
value shall be calculated as 100.00 minus the Three Month KLIBOR as
published by Dow Jones Telerate Ltd on page number 46387 at 11:00 hours
(Malaysian time) on the Final Trading Day.
iii. In the event that the above calculation (i) and (ii) cannot be made, the final
settlement value shall be calculated as 100.00 minus the Three Month KLIBOR
as obtained from Bank Negara Malaysia at 11.00 hours (Malaysian time) on the
Final Trading Day.
In the event that none of the above 3 calculations can be made, the final settlement
value shall be determined by the Exchange.
Speculative Maximum number of net long or net short positions to be held:
Position Limits • 5,000 contracts for all months combined.
Source: Bursa Malaysia Website
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• The contract specifications for 3-Month KLIBOR has some important features
worth noting.
• The delivery months are the usual calendar quarterlies up to 5 years ahead.
• In addition to the quarterly months, the exchange has also introduced two serial month
contracts.
• The tick size in percent is equivalent to one basis point (one basis point is one hundredth of
one percent) or RM 25.
• The contract similar to other financial futures, is Cash-settled at maturity.
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• Pricing Interest Rate Futures Contracts.
• KLIBOR interest rate futures contracts are priced in terms of an index.
• The index is essentially 100 minus the annual percentage yield to two decimal places.
• Example: If the required yield or going interest rate on the KLIBOR futures is 7.5%, the price will be
quoted as 92.50 which is:
100 – 7.5 = 92.50
• Given such an index quotation, the index will increase as the required yield falls, and fall when
the yield rises.
• Example:
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Equilibrium Price: The Implied Forward Rate
• The equilibrium price of a interest rate futures contract is determined using the
implied forward rate.
• The IFR technique makes use of the 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.
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• Illustration:
• Suppose today is January 1st and the following rates are quoted in the interbank market:
3-month KLIBOR 6% (Maturing; March 30)
6-month KLIBOR 7% (Maturing; June 30)
• Question: Given the above information, what is the correct price of a 3-month KLIBOR futures
contract?
• Answer: 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.
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• Illustration:
• We compute the implied 3-month rate (for the 2nd three-month period) given the two
KLIBOR spot rates. This computed rate is known as the implied forward rate (IFR).
• Since the IFR is 7.88%, the correct price quotation for the 3-month KLIBOR futures contract
should be: 100 – 7.88 = 92.12
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3-Month KLIBOR Futures: Applications
• Hedging Interest Rate Risk
• Managing interest rate risk is an important application for interest rate futures contracts. It is
explained via two approaches
• How a borrower could hedge against rising interest cost using KLIBOR futures?
• How a banker could protect his profit margin from eroding when interest rates fall?
• 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 RM 10 million in 3 months for goods from the supplier.
• You have arranged with your banker for a 3-month RM 10 million 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.
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• Locking in the Cost of Borrowing
• Assume it is now 25 June. Loan will be taken in September (exactly 90 days from 25 June). The
following quotations are available on 25 June.
3-month KLIBOR = 7.00%
September KLIBOR futures = 92.00
• Given the above quotes, the target interest cost you would want to ‘lockin’ is the yield (25
June) on the KLIBOR futures + the 2% premium.
• What should the right strategy be?
Hedge strategy: Short, 10 September KLIBOR futures contracts
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• Protecting Interest Income/Revenue
• From the banker’s point of view, when the banker quotes a floating interest, in doing so, the
banker is passing on the interest rate risk to the borrower.
• What if the banker has to quote a fixed interest rate but his cost of funds are floating? In this
case, the customer/borrower faces no risk but the banker does.
• Example: As a Credit Officer bank you have agreed to provide a customer with a fixed rate, 3-
month, RM 20 million loan 90 days from today. You had priced the loan at 12% annual interest
rate.
• The following quotes are available in the market.

3-month KLIBOR = 9 %
3-month KLIBOR futures = 90.0 (matures in 90 days)
• How would you protect yourself from a rise in interest rates?
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• Protecting Interest Income/Revenue
• Hedge strategy: Short, 20, 3-month KLIBOR futures contracts.
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• Speculating on Interest Rate Movements
• Since your expectation came true, you profit from the speculative position.
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• Arbitraging with Interest Rate Futures
• Cash and Carry.
• The cash and carry strategy would be appropriate when the futures contract is overpriced relative
to the 3-month and 6-month spot KLIBOR rates.
• Example: Today is 23 June and you observe the following spot rates and futures price.
• 3-month KLIBOR = 7% [90 days till 24 September]
• 6-month KLIBOR = 8% [180 days till 23 December]
• 3-month KLIBOR futures = 92.50 [maturing 23 September]
• Implied Forward Rate is computed (using the earlier formula) is 8.84%.

• Given IFR of 8.84%, the correct 3-month KLIBOR futures price should be: 100 – 8.84 = 91.16.
• Since the 3-month KLIBOR futures is quoted at 92.50, the futures is overpriced.
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• Cash and Carry.
• The appropriate strategy would be:
Long 6-month KLIBOR (spot) of RM 1 million face value.
Short 1, 3-month KLIBOR futures contract.
• Since our arbitrage strategy is based on mispricing we should make a profit regardless of interest
rate movements between 23 June and 23 September.
• We test on two plausible Scenarios.

Scenario 1: Interest Rate up by 2%
Scenario 2: Interest Rate down by 2%
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• Cash and Carry.
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• Cash and Carry.
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• Reverse Cash and Carry
• The reverse cash and carry applies when the interest rate futures contract is underpriced.
• A cash and carry arbitrage would be applicable when the futures contract is overpriced relative to
spot, we do a reverse cash and carry arbitrage when the futures is underpriced relative to spot.
• Example: Suppose in the previous example, the 3-month KLIBOR is quoted on 23 June 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, relative to spot.
• Reverse cash and carry strategy, would be;

Long 1, 3-month KLIBOR futures contract.
Short 6-month KLIBOR (spot) of RM 1 million face value.
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34
Determinants of IRF Prices
• Interest Rate Changes
• The most important determinant is changes in interest rates.
• Changes in interest rates lead to changes in yields (required returns) and thereby cause
changes in futures contract values.
• Economic Cycles and Demand and Supply of Credit

• Interest rates are affected by the demand and supply of money (or credit).
• The demand and supply of credit is cyclical. In that, it depends on economic cycles.
• During times of economic expansion (boom), the demand for credit, both for the purpose of
consumption and investment increases. The result would be an increase in the demand for credit
but supply has little net increase. Thus, during a boom cycle, interest rates tend to rise.
35
• The Role of Government
• A government’s goal in economic management is to reduce cyclicality. Governments use
measures in the form of monetary and fiscal policy to reduce the fluctuations.
• It is through monetary policy that governments influence interest rates.
• Expectation
• Expectations are simply perceptions formed by market participants regarding potential
economic performance.
• Economists have long believed that expectations play an important role in economic decision
making of participants.
• Example, if the market/participants have good expectations of future economic performance, they
would be more likely to make investments. Increases in investment increases the demand for credit
and thereby puts an upward pressure on interest rates.
36
• The Rate of Inflation
• In financial economics, the relationship between the interest rate and the inflation rate is
formalized as the ‘Fisherian Equation’.
• The nominal interest rate is made up of two parts; the real rate and the rate of inflation. Thus,
when an economy experiences inflation, the nominal interest rate will be higher than the real
interest rate.
• The difference between the two interest rates is known as the inflation premium.
• The higher the prevailing inflation rate, the higher would be the premium and therefore the
nominal interest rate.
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• The Rate of Inflation
• In financial economics, the relationship between the interest rate and the inflation rate is
formalized as the ‘Fisherian Equation’.
• The nominal interest rate is made up of two parts; the real rate and the rate of inflation. Thus,
when an economy experiences inflation, the nominal interest rate will be higher than the real
interest rate.
• The difference between the two interest rates is known as the inflation premium.
• The higher the prevailing inflation rate, the higher would be the premium and therefore the
nominal interest rate.
38
3-Month KLIBOR Futures: Performance
39
MGS Futures Contracts
• The MGS futures contracts are a series of bond futures contracts of 3- and 5-year
maturities.
• The underlying assets are Malaysian Government Securities (MGS) of 3- and 5-

year maturities.
• The primary issuance of MGS by BNM is through auction and subscription is by

appointed Principal Dealers of the central bank.
• The coupon is usually paid on a semi-annual basis. In most countries,
40
Contract Code FMG3
Underlying 3-Year Malaysian Government Securities.

Instrument
Coupon Rate 6%
Contract Size RM 100,000

Minimum Price 0.01 or RM10
Fluctuation
Contract Months Four Nearest Quarterly cycle months (March, June, September and December).
Trading Hours • First trading session: Malaysian Time 9:00 a.m. to 12:30 p.m.
• Second trading session: Malaysian Time 2:30 p.m. to 5:00 p.m.
Final Trading Day Trading ceases at 11:00 a.m. (Malaysian time) on the 3rd Wednesday of the delivery month or the 1st
Business Day immediately following the 3rd Wednesday of the delivery month if the 3rd Wednesday of the
delivery month is not a Business Day.
Final Settlement Cash Settlement Method.
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Cash Weightage
Settlement The final settlement value will be weighted equally on the eligible MGS.
Method In the event of new eligible MGS being introduced, unless otherwise determined by the Exchange in
consultation with the Commission:
i. If there are four or more MGS in the basket of eligible MGS (including the new/reissued MGS), the new
MGS/reissued MGS will be assigned a 30% weighting while the rest will receive equal weights;
ii. If there are three MGS in the basket of eligible MGS (including the new MGS/reissued MGS), the new
MGS/reissued MGS will be assigned a 40% weighting while the rest of the MGS in the basket will receive
equal weights; and
iii. If there are two MGS in the basket of eligible MGS (including the new MGS/reissued MGS), the new
MGS/reissued MGS will be assigned a 60% weighting while the other MGS will receive 40% weight.
Yield
i. At 1100 hours on the Final Trading Day, from the quotation contributed by selected institutions on Reuters
Ltd, the arithmetic mean of the eligible MGS mid price shall be calculated, after discarding the two highest
and the two lowest prices. It will be converted to yield in percentage, rounded to the nearest four decimal
places.
The final yield for all the eligible MGS in the basket is derived from the yield for each MGS as per the
weightage announced by the Exchange.
The final settlement value shall be calculated from the final yield in accordance with the following formula
rounded to two decimal places:
-2N -2N
Price = {(C/Y)[1 - (1 + Y/2) ] + (1 + Y/2) } x RM100
Where C = Coupon, Y = Yield.
ii. In the event that the above calculation (i) cannot be made, the final settlement value shall be calculated as
published by another financial news vendor approved by the Exchange at 1100 hours (Malaysian time) on
the Final Trading Day. (iii) In the event that the above calculation (i) and (ii) cannot be made, the final
settlement value shall be calculated as obtained from Bank Negara Malaysia at 1100 hours (Malaysian time)
on the Final Trading Day.
In the event that none of the above 3 calculations can be made, the final settlement value shall be determined
by the Exchange.
Eligible MGS a. Subject to sub-clause (c) hereinbelow, for an existing MGS in the market, or in the case of new
MGS/reissued MGS that fulfil the requirement of a minimum issuance size of RM500 million 2½ to 3½ years
term to maturity bon the 1st calendar day of the Contract month will be included;
b. The eligible MGS and its weightage for the following quarterly month Contract will be announced on the 10th
day of the expiry month for the current quarterly month (March, June, September, December) or the next
Business Day immediately following the 10th day of the current quarterly month if the 10th day is not a
Business Day; and
c. No new MGS will be included after the announcement of Eligible MGS for the spot quarterly month Contract.
Speculative Maximum number of net long or net short positions to be held:
Position Limits • 10,000 contracts for all months combined.
Source: Bursa Malaysia website
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• Hedging Interest Rate Risk with MGS Futures.
• MGS futures contracts are intended for hedging interest rate risks of the medium/longer term
fixed income securities.
• The underlying hedging principals are essentially:
To protect from rising interest rates by going short in the MGS futures contract
To protect from falling interest rates by going long in the MGS futures contact
• The number of futures contracts to use would depend on two factors:

• The size of the underlying asset position
• The duration of the underlying bonds vs the duration of the futures contract.
43
• Speculating with MGS Futures
• Since bond prices/values are inversely correlated with interest rates, the speculative strategy
would be similar to that of 3-month KLIBOR futures.
• When one expects interest rates to rise: short MGS futures.
• When one expects interest rates to fall: long MGS futures contracts.
• Arbitraging with MGS Futures Contracts

• Arbitraging is done by taking advantage of mispricing as represented by the differential
between the MGS futures contract and the value of the deliverable bond’s forward price.
• If MGS futures price > spot price of deliverable bond + net carry cost, then MGS futures is
overpriced. Short futures; long spot deliverable bond.
• If MGS futures price < spot price, the MGS futures is underpriced. Long futures; short spot
deliverable bond.
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MGS Futures Contracts: Performance
• The MGS futures contracts have been plagued with very low trading volume from
their beginning
• A 10-year MGS futures contract has since been delisted due to a lack of activity
• The 5-year MGS futures which started off impressively have also seen a steady
decline in volume
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MGS Futures Contracts: Performance
There are two potential reasons for this sad state of affairs:
1. Minimal interest rate risk due to global decline in interest rates
2. Malaysia’s market structure for bonds and private debt securities (PDS) - highly
concentrated with a few large financial institutions:
• Large denominations (typically RM 5 million face value) prevent small players from
participating illiquid secondary market
• The large players typically buy up bonds at issuance and hold them to maturity – not much
‘price’ risk
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Thank You

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INTEREST RATE FUTURES: THE 3-MONTH

KLIBOR FUTURES CONTRACT

• IRF were introduced on the International Monetary Market (IMM) in 1976.

• The current price of the bond with this formula is RM1,000

• Duration can be thought of as a measure of a bond’s sensitivity to interest rate

• The expected change in value/price is calculated using the equation as follows:

• The contract similar to other financial futures, is Cash-settled at maturity.

• Locking in the Cost of Borrowing

• What should the right strategy be?

Hedge strategy: Short, 10 September KLIBOR futures contracts

• The following quotes are available in the market.

• Implied Forward Rate is computed (using the earlier formula) is 8.84%.

• We test on two plausible Scenarios.

• Reverse cash and carry strategy, would be;

• Economic Cycles and Demand and Supply of Credit

• The underlying assets are Malaysian Government Securities (MGS) of 3- and 5-

• The primary issuance of MGS by BNM is through auction and subscription is by

• The coupon is usually paid on a semi-annual basis. In most countries,

Underlying 3-Year Malaysian Government Securities.

Contract Size RM 100,000

• The underlying hedging principals are essentially:

• The number of futures contracts to use would depend on two factors:

• Arbitraging with MGS Futures Contracts

1. Minimal interest rate risk due to global decline in interest rates

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