

Corporate
Finance FIN 622
VU
Lesson
41
INTEREST
RATE FUTURES
We
shall cover following topics
in this hand out:
Interest
rate future
Prices
in futures
Hedging
short term interest rate
(STIR)
Scenario
Borrowing in ST and risk of rising
interest
Scenario
deposit and risk of lowering interest
rates on deposits
Options
and Swaps
Features
of options
Option
terminology
Interest
Rate Future:
Interest
rate futures are also
contracts, which have
following features:
These
contracts are similar to
currency futures.
These
are traded in standardized
form on future
exchanges.
Settlement
dates on future exchanges
are calendar
quarters.
Each
future contract is for standardized
quantity of underlying
security.
Price
of the future is expressed in terms of
underlying item.
Interest
rate future, like currency
futures may be settled before the
maturity date.
Short Term
Interest Rate futures STIRs
are cash settled.
Longterm
interest rate futures are
settled through physical delivery of
bonds.
STIRs:
is a type of standardized interest rate
future on a notional deposit (for 3
months) of standard
amount of
principal.
Bond
futures: these are based on
standard quantity of notional
bonds. If buyer or seller does
not close his
position
before the final settlement date,
then the contract is settled through
physical delivery.
Prices
of interest rate
future are determined as
follows:
Bond
futures: these are priced
exactly the same way as
normal bonds.
For
example, an interest rate
future may be priced at 109.50
per 100 nominal value of
underlying notional
bonds.
Shortterm
interest rate futures are
price in unusual way: the
price is calculated by deducting interest
rate
from
100. For example, if the
interest rate is 6%, price
will be 94. If 8%, price is
92. It means that if
interest
rate
rises, the price will fall
and vice versa.
Hedging
with Short Term Interest
Rates:
A
company intends to borrow short term in
future may be concerned about the rising
shortterm interest
rates.
Or
A
company planning to place an amount in a
shortterm deposit may anticipate drop in deposit
interest
rates.
The
hedge is to establish a notional
position to fix the interest
rate in short term.
Scenario:
a firm plans to borrow in
short term and risk of rising shortterm
interest rates
A
notional position is established
with future. If the interest
rate goes up, it will earn
profit.
This
profit will be used to
offset the higher interest rate on loan
when it is taken.
On the
other side, if interest
rates go down, it will
result in loss with stirs,
and this will be added to
the
interest
on loan cost when loan will
actually be taken
out.
The
hedge will be to sell shortterm
interest rate future.
If
interest rates go up, it will
result in profit. Price of
future will fall. The
future will be closed by
selling at
higher
prices and then buying at
lower price.
138
Corporate
Finance FIN 622
VU
If
interest rates move down, it
will result in loss. Price
of future will increase. The
future will be closed
by
buying
at higher price and selling at
lower price.
Risk
of fall in short term
interest and firm plans to
invest
If the short term
interest rates fall the firm
will make profit and this
profit will be added to the
interest
earned
by deposit to arrive at net return on
deposit.
The
loss of return on deposit due to
fall in short term interest rates is
off set by the profit on
futures.
If
interest rates go up, there
will be loss on future contract
but the same will be off
set by higher interest
rate
on deposit.
The
hedge can be created by
buying shortterm interest
future.
Future
position should be closed when
actual deposit period begins by
selling the same number of
interest
rate
futures.
If
interest rate rise, price
will fall, loss will
incur.
If
interest rate fall, price
will rise, profit will be
generated.
We can
now note two important
issues while deciding to hedge
using STIRs:
A
hedge can be created by
buying and selling the exact
number of contract but in real life this
is not the case
and
the hedge is not perfect. If the number
of contracts needed to buy or
sell is not a whole number
then
the
company has to buy or sell
to the nearest whole number. This hedge is
not perfect. For example,
a
hedge
would need 7.6 contracts to
be bought or sold, and you
cannot trade this number because
contracts
are
available in whole number. The
firm will be buying or
selling seven or eight
contracts.
If the
intended loan or deposit period is less
than three months or longer than
three months, a
different
situation
will arise. In these
situations, where STIR
contract is less than three
months interest rate, the
hedge
will be created by adjusting the number
of futures contracts required by a factor of
X/3, where X, is
the planned
borrowing or investment period.
Options:
An
option is a contract that confers a
right to buy or sell a
specific quantity or asset
but not the
obligation,
at
agreed price on or before the specified
future date.
Options
are available for
commodities (like wheat,
coffee, sugar, etc) and
financial assets like currency
or
bank
deposits.
Features
of Options:
It is a
contractual agreement.
The
holder of option exercises
his/her right only if it is in
his/her favours.
Option
writer is seller and must
honor his side of contract.
(Sell or buy at agreed
price).
Options
like futures are standardized
transaction in terms of size &
duration.
Options
are Exchange traded
These
agreements are easy to buy
& sell
Options
either are call options or
put options.
The
option purchase price is
called option premium.
Call
option gives its holder a
right (not obligation) to
buy underlying item at the specified
price.
Put
option gives its holder a
right (not obligation) to
sell underlying item at specified
price.
Expiry
date:
Each
option has expiry date
and the holder must exercise
his/her right before this date
otherwise, it will
lapse.
Strike
or exercise price:
The
price mentioned in option at which the
holder exercises his right
is known as exercise or strike
price.
Options
pricing
The
strike price may be higher, lower or
equal to the current market price of
underlying item.
For
example, a call option gives
the right to its holder to
buy x number of shares of y company at Rs
10 per
share
and the current price could be greater
than Rs. 10/, less than
Rs. 10/ or exactly Rs 10/
per share.
If the strike
price is more favorable than the current
market price of underlying
asset or item, the option is
termed
as "inthemoney."
139
Corporate
Finance FIN 622
VU
If the strike
price is not favorable than the current
market price of underlying
asset or item, the option is
called
"outofmoney."
If the strike
price and current market
price are equal, then it is
known as "atthemoney."
An option
holder will only exercise
his option if it is
"inthemoney".
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