Interest Rate Derivatives - Part 1

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

http://www.cmegroup.com/trading/interest-rates/stir/1-month-libor_quotes_globex.html

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 20^th 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	-Borrow the money from internbank@6.7 -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.