Interest rate derivative (IRD) is a derivative product, which is
used mainly to hedge the risk associated with interest rates movement. In IRD, the underlying asset is the right to
pay or receive the notional amount at a given interest rate. IRD is mainly used
by the institutional investors such as banks, iBanks etc.
Like other derivatives products there are two parties involved
in a transaction, IRD doesn't lend money to traders or investor rather it’s
typically used to manage the risk associated with interest rates movements.
Following are the list of IRD products. These products also have been classified as Vanilla, semi-vanilla (Quasi-Vanilla) and Exotic derivatives.
The selection of these products depends
on the maturity period and the liquidity required.
Maturity Period
|
Typical classification of the IRDs and its usage
|
< 1 year
|
Very Short term
Vanilla products - generally require
most liquidity
- Exchange Trades Futures
- FRA
- OTC Interest rate options
|
1-2 years
|
Short term
Vanilla products/Semi-vanilla
products
- Exchange Trades Futures
- FRA
- Interest rate Caps, Collars and Floor
|
2-5 years
|
Medium term
Semi-Vanilla and Exotic
products
- FRA
- Interest rate Caps, Collars and Floor
- Interest rate Swaps
|
5-10 years
|
Long term
Exotic products
- Interest rate Caps, Collars and Floor
- Interest rate Swaps
|
|
|
What is interest rate
risk?
Interest rate is the cost of borrowing the money. It’s a
rate on which depositor will deposit the money and borrower will borrow it. The
depositor is taking risk of lending the money on a specific rate and borrower
is taking risk of borrowing the money on a specific rate. The volatility in the interest rates movement
is a risk for both borrower and depositor of increased funding cost or reduced
yield for the investor.
The factors which typically affect the interest
rates are
·
Demand
and Supply of the credit-
An increase in the demand for the credit will increase the
interest rates, while decrease in demand will decrease the interest rates. For example
– when we open a bank account, basically we are depositing money with bank. Bank
can use this money for other investment purposes (depends on proposed Volcker' rule
implementation in future). Assume, if bank is getting regular cash flow from the
depositors (which means us ), equal to the demand from borrowers or out flow then
Bank may not need to borrow the money from other financial institutions, which
may result into lending it bit cheap to its borrowers.
· Inflation-
Inflation affects interest rate levels. The higher the rate
of inflation, the more interest rates are likely to rise. This occurs because
lenders would like to demand higher interest rates as compensation for the
decrease in the purchasing power of the money they will be repaid in the
future.
Inflation plays a major role in determining the returns on the investment or deposit.
Government time to time regulates or issue bonds to control the inflation. In case of Fx trades or sovereign bonds, inflation
is considered to be one of the key parameters.
· Govt. financial
policies and control-
In order to meet short term demand and supply typically financial
institutions/banks borrow the money from each other. In USA, federal fund rate is
charged for short term loans. The fed influences these rates by buying or
selling previously issued securities. By buying the securities, fed provides
more money to the banks and by selling it, fed takes away the liquidity from
the banks.
Typically, Repo (repurchase)
rate or reverse repo rates are the two terminology used for buying or selling
the securities. In India, RBI (Reserve bank of India), as part of Financial and Credit policy, controls the
interest rates movements, by changing the base, repo and reverse repo rates.
Derivatives Products
Type of Settlement
|
List of products
|
|
Single settlement products
|
Exchange traded financial futures
OTC – Forward rate agreements
OTC Interest rates options
|
These are the instruments have one fixing/settlement during the
lifetime of a transaction.
|
Multiple settlement products
|
Interest rate Caps, Collars and Floors
Interest rate swaps
|
These are the instruments have more than one fixing/settlement during
the lifetime of a transaction.
|
The scope of Part one of
this series is to cover Exchange traded financial futures.
What are Exchange-traded: financial futures
· Futures are primarily used by the banks, large
financial institutions and large multinational industries to hedge and trade
interest rates positions.
· Futures are legally binding agreement between
the parties at future date at the agreed price between the parties.
· Future Contract will not actually lend the money.
It’s just to protect the interest rate movement.
· Short term Future Contracts are quoted on the
“index basis” typically LIBOR.
· Future Contracts are designed to buy at low and
sell it high or vice-versa
Contracts Available – Different Future Contracts are available in different
currencies. Common short-term interest rate futures are in Eurodollar, Euribor,
Euroyen, Short Sterling and Euroswiss, which are calculated on LIBOR at
settlement, with the exception of Euribor which is based on Euribor.
For graphs and other future rates contract, refer to below link
Abbreviated Contract
Format-
This is abbreviated format of the
contract. The main purpose is to provide the understanding of key elements.
Key
Elements
|
Example
of Values
|
Definition
for better understanding, not part of actual contract
|
Unit of trading
|
£5,00,000
|
Contract Size
|
Delivery Month
|
March, June, Sep, Dec
|
Delivery month is the month in which
seller must deliver to buyer. Financial future contract such as bonds, Short
term interest rates tend to expire quarterly.
|
Last trading day
|
11:00 AM last trading day of the month
|
Last trading day of the Delivery
month.
|
Quotation
|
100 minus the rate of interest
|
|
Minimum price movement
|
.01%
|
Tick, refer below for the definition
|
Hours
|
7:30 -18:00
|
|
Trading Platform
|
LIFFE Connect
|
London International Financial Futures
and Options Exchange.
|
Market
Operations-
Both buyer and seller must put up minimum
margin/collateral for each open contract. The actual margin amount is
calculated by exchange in conjunction with clearing house typically using
standard portfolio analysis of risk (SPAN) developed by Chicago Merchandise
Exchange in 1988. SPAN is used to calculate the risk for future/options
portfolio and assess the margin requirements.
Positions are marked-to-market on a daily
basis by comparing the level on the client’s trade and the settlement price on
that day. Profit and loss are developed daily. If positions loose the money
during the day then client must pay his losses and if position gains then
client gets the profit. These daily payments are known as “Variation Margins”.
How
to calculate profit and loss
Key terminologies
Terminology
|
Definition
|
Comments/Example
|
Tick
|
Each tick represent market moment of
0.01%
|
|
Tick
Size/ Minimum fluctuations
|
The tick size is known as the minimum
price change.
|
For example, the EUR futures market
has a tick size of 0.0001, which means that the smallest increment that the
price can move from 1.2902, would be up to 1.2903, or down to 1.2901.
|
Tick
value
|
Value of a tick for calculating profit
and loss
Formula
–
Tick value =Contract size * minimum
tick size moment* notional time deposit underlying the contract.
|
For example Euro currency
->contract size 5,00,000-> 3 months contract size-> tick value
5,00,000*.01%*3/12=12.50 (tick value)
|
Typical
Calculation of Risk (1% Risk )
|
There is no hard and fast rule but many professional traders adhere
to 1% risk. This means that no more than one percent of trading amount can be
put on risk on each trade.
The reason for the one percent risk rule is to keep the maximum
possible loss for each trade at an acceptable amount, and to make sure that
no single trade has the ability to blow up a trading account (i.e. lose so
much money that the account cannot be traded).
A trader generally uses this
approach to find out the value of Spot loss.
|
Example- The one percent risk rule for a €30,000 trading account,
making a short futures trade on a market with a €10 tick value, with an entry
price of €4,125, and a stop loss price of €4,150, would be calculated as
follows:
Maximum Capital = €30,000 *1% = €300
Trade Size = €300 / ((€4,125 - €4,150) x 10) = 1 contract (actually 1.2 contracts, but this is not
possible)
The maximum size of the example futures
trade is one contract, because if the trade makes a loss (by trading at its
stop loss price), the one contract will lose €250 (which is less than 1% of
the trading account).
|
Initial Margins
|
In order to mitigate the credit risk of both the counterparties, the
clearing house will take some collateral/margin at the time of trading. This
is known initial margin.
|
Assume the initial margin is £400 per contract on the short sterling
future. It the client had opened a position of 10 contracts then he would
have to deposit with exchange
400*10=£4000
The extend of daily losses should not exceed the initial margins. For
example, £400 per contract represents a possible loss of 400/tick value
(12.50 )=32 ticks or .32% movement in the implied interest rates.
If clearing house felt that there is a potential of greater loss
because of excessive volatility then they may ask for more initial margin or
collateral.
|
Variation Margins
|
At close of business every day, each open position is marked to
market and compared with day’s official settlement price. If the position is
in profit or , the margin account will be credited or debited with the profit
or loss. These payments are known as variation margins.
|
Example – Consider a client who has taken a view those interest rates
will fall. He turns out to wrong. On each day his initial position will make
some loss that he must fund on a daily basis. If the original trade was of 10
contracts and the initial margin was £400 per contact (total of - £4000)
If position moved against him by 20 ticks per contract
20*10*12.50=£2500
Clearing house will deduct £2500 from his initial margin of £4000.
The balance money £1500 can only support 3 future contract (rounded). This means he need to add £2500 otherwise
exchange will close out any un-margined
outstanding contracts.
|
Example of
calculating Profit and Loss – At the beginning of October a trader feels
that Euro interest rates will fall by Dec. The current 3 months LIBOR rates
today is , say, 4.15%, he wishes to make profit form the downward movement of
in rates, his trading amount is £5m.
He bought 10 contract of 3 months sterling interest rate future at the
current level of 100-4.15= 95.85
In the month of Dec, 3 months LIBOR rates is 3.65 percent, he decided to
close out his position.
He bought 100-4.15= 95.85
He sold 100-3.65=96.35
Profit - .50 = 50 Ticks
The
total profit trader had made in this process –
10
contracts * 50 ticks *12.50 each tick =£6250
Example
of hedging
A trader of a larger Indian Company would
like to borrow £5M on 20th Dec. He has no requirement of cash today.
But, he has invested in a venture that requires him to invest £5M for a period
of 3 months. He believes that sterling interest rates will rise. The current
LIBOR rates are 5.5 %. The current future markets rates for Dec are 5.8%. This
means that market is already anticipating interest rates hike. The trader
decides to hedge with futures.
Date
|
Action
|
|
10th Dec
|
Short
|
Trader sells (short) 30 Dec short sterling futures at the current
level of 94.20.
Over the next few months, treasurer receives/pay
daily variation margins.
|
20th Dec
|
-Close out the future position
|
Interest rates increases and trader borrows the money from the
interbank market at 6.7%. He then closes out his future position by buying
the future contract at prevailing rates of 93.3.
|
Profit
-Calculation of profit/hedging with future
Sno
|
Potential
Action
|
Month
|
Potential interest
|
Comments
|
1
|
50,00,000 @5.5% for 3 months
|
Oct
|
£2,75,000
|
If borrowed the money in the Month of Oct
then the trader would have paid £2,75,000 as interest.
|
2
|
50,00,000 @5.8% for 3 months
|
Oct (implied future rates)
|
£2,90,000
|
If borrowed the money at future
interest rate then the trader would have paid £2,90,000 as interest rate.
|
3
|
50,00,000 @6.7% for 3 months
|
Dec
|
£3,35,000
|
Money made after closing the future position. 94.20-93.3= 90 ticks
Contracts -10
Tick value – 12.50
Profit – 90*10*12.50= £11,250
|
4
|
50,00,000 borrowed for 3 months
|
Dec
|
£3,35,000-£11,250=£3,23,750
@6.475 lower than the prevailing rates
|
Actual interest paid £3, 23,750 after adjusting
the profit from future.
|
Conclusion-
Futures offer banks and other financial institutions excellent hedging and trading opportunities. At-times, it gets difficult for companies to manage a portfolio of future contract efficiently. In addition to the documentations, the user must install the system to monitor the margins and accounting , manage risk and settlement date etc. Financial future can be packed into a friendly product, known as FRA (Forward Rate agreement ).
Part 2 Topics:(Click here link for part 2)
· Forward rate agreement, benifits and usage of FRA, key terminologies and an example explaining the scenarios for profit and loss.
· OTC:
interest rate options, benefits and usage of OTC options with example.
