0:05 The last time we looked at FRA
0:08 and options on FRA which is uh also
0:15 still looking at how to manage interest
0:17 rate risk. And remember what we said
0:21 about it is the fact that we are exposed
0:24 to interest rate risk when we have
0:28 either loans that we pay interest or we
0:31 have an asset or a deposit investment
0:33 that gives us income based on interest
0:35 rate. And what does that mean? It means
0:38 that whenever interest rate changes, we
0:40 might lose or we might gain. But the
0:43 part where we are so concerned is the
0:46 fact that we might lose some money. And
0:49 when we say we might lose some money,
0:51 it's not that we cannot gain as well,
0:55 but we rather manage the loss aspect. So
0:58 for someone that has a borrowing or a
1:00 loan, where it might lose money is when
1:02 interest rate is going up. So that kind
1:05 of person will want to fix the interest
1:09 rate such that if it goes up he's not
1:13 affected. But for a guy that is thinking
1:16 of avoiding to lose money because of his
1:18 investment he's rather worried about
1:21 invest about interest rate going down.
1:23 So if he's trying to fix he's trying to
1:25 fix the amount of interest that he will
1:26 be getting. So that that will be his
1:28 worst case scenario. And that's the
1:30 bottom line of managing interest rate
1:33 risk. Whatever strategy you are using
1:35 that is what you are trying to achieve.
1:37 So we're going to look at a different
1:40 strategy today in fact couple of them
1:48 interest rate futures.
1:50 And the basic thing which I always tell
1:52 you about future is to always think
1:54 about three transaction. the fact that
1:58 you always have to initiate it,
2:00 you have to close it
2:03 and you have to do the real transaction.
2:07 The same thing is still applicable here.
2:08 Very important. So,
2:11 So,
2:13 which means
2:15 when you want to use features to do
2:17 interest rate edging, you're going to
2:20 either buy or sell the features. You do
2:22 the opposite to close it
2:25 and you will do the transaction. The
2:36 So which means this will usually give
2:40 you a P that either increases this or
2:50 But this is not exactly
2:53 straightforward the way you were looking
2:56 at FX features.
3:00 I need to give you like a clue on how to
3:02 deal with this
3:04 because you are not selling or you are
3:08 not buying interest rates but there's
3:11 there's an instrument that generates
3:14 interest rate which is probably a loan
3:16 or a bond.
3:19 So the best way to be able to interpret
3:22 your interest rate futures is to always
3:27 look at it in form of a bond.
3:29 So if you want to know what does it mean
3:32 to buy futures, interest rate futures or
3:34 sell interest rate futures, think about
3:38 it as a bond. If you look at a bond,
3:45 what are you doing? it means that you
3:58 it means that you are investing or you
4:01 are lending.
4:16 if you are looking for a future to use
4:19 like I always tell you your future must
4:23 always go in the same direction of the
4:27 transaction that you're trying to edge.
4:32 So which means if your transaction so if
4:35 you want to know your situation now
4:37 which should be your future. So if you
4:39 are trying to borrow so if you plan to borrow
4:45 you plan to borrow
4:52 and you want to edge
4:53 and you want to use interest rate
4:55 futures. What you are trying to say is
4:59 that borrowing means selling of bond. So
5:03 in that case your future
5:07 that you're going to be using
5:17 So it means that you'll be selling this future
5:18 future and
5:20 and
5:22 that is how you're going to edge that
5:24 kind of transaction
5:27 this situation that you find yourself.
5:29 But if your situation is the fact that
5:40 and I've told you if you plan to invest
5:43 your future as well that you are trying
5:46 to use to edge must reflect the same
5:49 exposure that you have. So what you will
6:07 I hope this will help you. This is
6:08 extremely important because this helps
6:11 you to be able to interpret what we're
6:14 going to be doing as we progress into
6:16 the into the lectures. Remember
6:18 Remember
6:22 two things. Number one, think about
6:26 the situation in terms of selling bond.
6:28 All right? So, which means your exposure
6:31 is either you are borrowing or you are investing.
6:32 investing.
6:34 Borrowing means you are selling bonds
6:38 because selling bonds is you trying to
6:39 borrow money from people and give them
6:42 PayPal to say give me your money. I give
6:44 you bond. I'll redeem later.
6:46 But if you plan to invest, it means
6:48 you're actually buying the bond. So if
6:51 you want to edge investment, then you
6:54 need to buy future. And if you want to
6:56 edge borrowing, then you have to sell
6:58 interest rate future. Remember, we're
7:12 The next thing that we need to
7:17 understand is how features been priced
7:20 because this is different from what you
7:22 are used to
7:25 because in FX features you just see the
7:27 rate the same way the FX rate is being
7:29 quoted. You they give you the similar
7:32 rate and all but for feature is slightly
7:35 different. It's not quoted in rates.
7:38 is quoted like a price.
8:00 100 minus applicable interest rate. So
8:03 which means for instance if what you're
8:07 trying to do is to fix rates at 5%.
8:09 This particular feature will be quoted
8:12 at 100 - 5%. And you will see that the
8:24 it just be quoted as 95. So which means
8:27 whenever you see a future price quoted
8:30 like that you know that the rate is actually
8:33 actually
8:36 95 5%.
8:41 >> Um sorry is the 95 like a basis point?
8:47 >> No because 95 basis point is 95%.
8:54 So anytime you have basis point that is
9:01 So don't look at it as basis point please.
9:03 please.
9:08 It's just a quote system for future.
9:11 Does it make sense?
9:14 >> Um yes. So the 95 is just a number
9:16 without any unit or
9:19 >> is the price. Yes. It's just a 95. They
9:22 just say 95. Once they say 95 is for you
9:25 to understand that 95 means 100 minus 95
9:27 and that means the applicable interest
9:30 rate for that loan or for that deposit
9:32 is 5%.
9:36 I also need to mention to you for sure
9:38 sometimes question can be very confusing.
9:39 confusing.
9:41 They might give you two types of future prices.
9:43 prices.
9:45 You might say there is an open future price
9:54 and there's a settlement
9:56 future price. This one I'm just mention
9:58 it quickly.
10:02 There's nothing to waste time on on this
10:04 opening. Yes, beginning segment is the
10:07 final one. Please is the final one that
10:10 you always have to use. Don't bother
10:11 yourself anytime you see open future
10:14 price not a business this is what we
10:16 always use it's always settlement future
10:20 price that is relevant for what we are doing
10:22 doing
10:25 so please take note of that
10:28 there's something I also mention to you
10:31 that whenever you are given a traded
10:35 instrument to do edging unfortunately
10:39 it's not in your control to determine
10:41 what is available in the market. Market
10:44 will have to determine that for you. And
10:46 what does that mean? It means that you
10:47 might need some quantity and that
10:49 quantity might not be available in full
10:53 because of the way market is quoted.
10:55 And that takes me to you knowing how to
10:58 calculate number of contracts because
11:00 you must always work with number of contracts.
11:02 contracts.
11:04 The reason being that if you don't work
11:06 with number of contracts, you might
11:08 assume like you are able to hedge
11:11 everything and in reality you might not
11:15 be able to hedge all your exposure
11:20 because of the volume or quantity of
11:22 contract that is available or the unit
11:24 of contract available in the market. So
11:26 you must always know that you must work
11:28 out your number of contract before you
11:30 calculate whether it's cost or whether
11:32 it's benefit or whatever you're trying
11:35 to do because you might have a portion
11:37 that is not edged and that will not be
11:39 part of your calculation for your edge
11:41 strategy. When you are done with your
11:43 edge strategy and the rate transactions
11:46 then you can see what that comes to and
11:48 also consider what has not been edged.
11:50 as we've seen in the previous example
11:51 that we've actually done I think under
11:55 options that have been traded. So, but
12:03 I mean I RF as your
12:06 edge strategy and you need to calculate
12:10 how many contract you would need. Please
12:13 just note is very straightforward. The
12:14 easy thing to think about is to say
12:17 number of contract will just be the loan
12:20 amount or even you can say the
12:29 divided by
12:33 your contract size. Remember sometime
12:37 you might say each contract is 20,000
12:40 and if your loan is 100,000
12:42 100,000
12:44 then you can easily say you need five contract
12:47 contract
12:48 but I'm going to give you one one
12:51 quickly now you cannot use just this
12:55 formula and I will tell you why
12:56 because what you're dealing with is
13:04 So which means you must be able to
13:07 mirror like for like very important and
13:16 So you cannot have take for instance a 6
13:20 month contract and you are edging
13:22 two month contract I mean two month transaction.
13:25 transaction.
13:28 If you use it the formula as it is then
13:30 the you the interest you're going to be
13:32 getting here will be for 6 months
13:34 whereas you are trying to edge a two
13:37 month transaction. So it's not like for
13:39 like you're not mirroring the period.
13:42 You're not mirroring the tenor.
13:43 So for you to be able to mirror the
13:46 tenor you must be able to adapt your
13:50 contract size to the transaction
13:53 your contract period to your transaction period.
13:56 period.
13:58 So which means the best thing to do is
14:01 to always divide the results
14:04 by the contract duration. So that you
14:07 know that you have
14:10 you have number of contract for one duration
14:16 and whatever the duration of a
14:19 transaction is then you can multiply by
14:21 that. Just the same way you would say oh
14:23 if you are doing if you're trying to
14:27 convert 3 month to years you say okay
14:29 first of all divide by 12 then multiply
14:31 by 3 that is exactly similar thing that
14:33 I'm saying here so this you need to
14:36 multiply by the transaction which is
14:40 your loan or your deposit tener
14:43 so loan or your deposit tener
14:53 any question. Very important. And this
14:56 that's how you make your
15:00 contract to reflect the tenor of the
15:01 transaction that you're actually trying
15:04 to edge.
15:07 And like we did for other future
15:10 transactions, there's always a tick,
15:12 which I've always told is your minimum.
15:14 anytime you add tick that's your minimum
15:20 movement of that value of future
15:22 because usually what you use stick for
15:25 is to calculate profit makes life easy
15:27 for you to calculate your profit or loss
15:31 right and tick is just
15:34 an absolute value but you might also
15:36 need to know how to calculate the value
15:38 for this one
15:42 is slightly different from FX and for
15:47 interest rates it's quite much easier
15:48 maybe just the fact that okay you've not
15:51 done any interest rate edging before
15:53 like in FM you've been exposed to some
15:56 kind of FX edging so this might sound a
15:58 bit new but by the time we start solving
16:00 more questions and more questions then
16:03 you realize that it's actually pretty
16:07 better than the FX1 so if you want to
16:11 get your tick value just easy there's
16:13 always one basic basis point. And you
16:15 know what one basis point means? One
16:20 basis point just means 1 / 100%. So that
16:25 That's what one basis point means. So
16:28 one basis point multiply by the fraction
16:31 of the year.
16:34 So the contract
16:36 fraction of the year. So if the contract
16:38 is for 6 month now you're going to be
16:45 So don't confuse that
16:47 with this. They're different things.
16:49 This is talking about number of
16:52 contracts. This is about the value of a tick.
16:53 tick.
16:57 Yeah. Then this multiply by the value of
17:05 which is your loan value which will be
17:08 given anyway for each contract in terms
17:12 of the value of the contract. Yeah. So
17:15 take for instance if you are saying you
17:18 are looking at a contract say let's take
17:23 for instance say there's a contract value
17:25 value
17:28 of remember interest rate edge will
17:31 always have a principal loan. Yeah. So $500,000
17:58 Multiply by 500,000
18:02 * 6 / 12.
18:04 If you use your calculator, what you have
18:25 >> right?
18:27 So if you see the global
18:30 this guy wants to borrow
18:32 and he wants to borrow 9 million euro
18:35 for just a month and he plans to do it.
18:38 So this is now
18:41 in 5 weeks
18:43 he wants to borrow. This is transaction
18:45 time transaction date when he will
18:50 borrow and he will borrow for just one
18:52 um for one month.
18:54 So this is now
18:56 in 5 weeks time there's a transaction
19:02 and that transaction is just for a
19:04 month. So what we want to edge is one
19:11 So that's what we want to edge. We want
19:15 to edge one month interest.
19:19 H the base rate is currently 3%. The Tri
19:21 of Global decides to fix the rate by
19:24 selling interest rate futures at 96.9.
19:26 What interest rate is that? If he's
19:28 selling interest rate features at 96.9,
19:35 What rate is he trying to fix?
19:37 >> Fantastic. Fantastic.
19:40 Nice. The market rate subsequently rises
19:44 by 25 basis points to 3.25.
19:46 As soon as the loan is agreed, the
19:49 treasurer closes out the global position
19:51 by buying a matching number of contract
19:55 at 96.65, which is what you will expect.
19:57 You have to close it out. Yeah. The
19:59 first one is how how many contracts do
20:02 we need to buy?
20:04 I told you that number of contracts you
20:07 have to buy
20:09 is a function of the principle that you
20:11 the total principle that you want to edge.
20:14 edge.
20:21 but you must always
20:25 aortion it based on the
20:28 reality of the transaction period which
20:32 is the transaction tenor
20:40 So in this case the content that is available
20:43 available
20:54 >> 1 million said yeah one 3 month contract
20:56 is for 1 million. So we have the
20:59 contract size 1 million and it's for 3
21:09 So which means that we are only
21:10 interested in edging [clears throat] one
21:12 month interest but the contract that we
21:14 have will always be giving us 3 months.
21:17 So we need whatever size we get here we
21:19 need to divide it by three to get our 1
21:22 month and that's why if you apply this
21:23 formula now what you are trying to edge
21:26 is 9 million
21:29 the contract size is 1 million then time
21:34 divided by three then times 1
21:37 and that is why the contract size the
21:39 number of contract that we need will be
21:46 If you if you had not done this, you
21:48 would have bought nine contracts which
21:51 would be too much for you.
21:54 Now do you understand what we're talking
21:57 about? Now when we do question you will
21:59 get it. That is what I was trying to
22:02 explain here.
22:06 So because the interest if you buy nine
22:09 contracts you'll be edging 9 million for
22:11 sure. However, by time you multiply by
22:14 the interest for 3 months, that interest
22:16 will be three times the interest that
22:19 you're actually trying to edge. Good.
22:21 Now, we should demonstrate that in this
22:23 case, the gain on the futures will match
22:26 the extra interest on the loan. First of
22:29 all, what is the extra interest on the
22:33 loan? Let's try and look at that
22:35 because that is actually the risk, the problem.
22:37 problem.
22:40 The interest rate has gone up by 25
22:42 basis point
22:45 and the loan is for 9 million. So 9
22:53 And this is for 1 month. So divided by
22:57 12 * 1. So the extra interest if we had
23:19 If you have something different, let me
23:23 know. But that's what I got.
23:25 So, which means that if we did not edge
23:27 at all,
23:30 we would have had to pay this total amount.
23:32 amount.
23:34 But this is what we are trying to edge.
23:36 And let's see whether the edge that we
23:44 Which means if there's an additional
23:46 payment of this because this is an
23:48 increase in interest rate. So this is a loss.
23:51 loss.
23:53 We would definitely expect that the edge
23:55 that we have done
23:58 must be a gain
24:02 that is of that amount. But let's find
24:04 out whether that's the truth. So for
24:07 each contract, what we know that each contract
24:13 will
24:21 value of tick? So each contract let me
24:30 Yeah, we move by 20. be said 25 basis
24:32 point that is the movement of interest
24:36 rate so that's 25 ticks
24:38 and we know that the value of each tick
24:46 we got it did we calculate it
24:48 not if we have not can you quickly
24:56 okay so let's look at it remember we
24:58 said the value of each tick
25:02 is always going to be
25:04 the principle
25:13 multiply by one basis point
25:17 multiply by the contract signal
25:19 signal
25:32 multiply by the
25:35 one basis point and one basis point I'm
25:39 sure you know that is 01%
25:42 01%
25:44 >> but a quick question
25:45 >> go ahead please
25:48 >> in in the question it said it's 25 basis point
25:54 >> that is how the interest rate movement
25:57 we are calcul value of tick now. >> All right.
25:58 >> All right.
26:00 >> So for value of tick, please note that
26:03 this is fixed. This does not change for
26:04 value of t.
26:07 >> Okay. Okay.
26:10 >> This is a fixed formula that you must
26:13 always use. It's always one basis point
26:15 multiply by your contract principle
26:17 multiply by the contract tenure in
26:19 years. And if you do that, that will
26:22 give you $25.
26:24 Sir, could you explain
26:27 >> why the contract principle is 1 million again?
26:28 again?
26:30 >> Uh, okay. It stated they gave us they
26:32 told us that is 1 million. Let me show you.
26:34 you.
26:39 >> Yes, sir. Yes, sir.
26:42 >> Yeah. Yeah. 3 month contract for 1
26:45 million. Yeah. The contract the the
26:47 value of the contract for one contract
26:50 will always be given to you.
26:52 Okay. So
26:54 now we're fine. We know the value of one
27:02 and we know that
27:05 how many contracts do we need three
27:13 the PL
27:16 straight away is equals to the 25 ticks
27:20 because our interest has moved 25 times
27:23 basis point and five basis point times
27:27 the value of each movement that is 25
27:35 we bought three contract
27:45 see that give us a profit of 1875.
