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