between buyer and seller to deliver in the future an asset which pays interest. The price of that underlying asset is locked in now.
For example, I need to borrow money in 6 months' time and I am worried that interest rates may rise between now and when the loan starts. If I sell an interest rate future now and buy it back at the time of the loan, I can mitigate (hedge) the negative effects of an interest rate rise. Suppose interest rates now are 3 % so I can sell a future today for 97 (100 − 3).
If rates rise to 5 % in 6 months, I will be able to buy the future back at 95 (100 − 3).
So I have made a profit on the two future trades (sell now at 97, buy later at 95) which will help to offset the increase in interest charges.
Futures are standard products traded on exchanges, as opposed to forwards which can be any over-the-counter (OTC) agreement between counterparties. (See section 5.1 for a fuller explanation of forwards and futures.)
Futures have standard contract sizes, tick sizes and contract months. For example, US Treasury five-year T-note futures are traded in lots with $100,000 notional at maturity.
Their contract months are set at March, June, September and December.
Their tick size is 1/32. This means that prices are always expressed as whole numbers plus a certain number of 32nds. You cannot quote a price with a fractional part less than 1/32, for example 1/64 or 1/100.
Technically, a swap is an agreement to exchange one asset for another, however when used without a qualifier it means interest rate swaps (as opposed to equity, foreign exchange (FX) or other asset class swaps). Within the same currency, swaps can be customised to the requirements of the counterparties, but the standard trades are float-for-fixed and float-for-float between different indices. Swaps have agreed fixing periods throughout their life when money is transferred.
One counterparty pays fixed currency. The other pays a floating rate dependent on an agreed index such as LIBOR.
One counterparty pays a floating rate based on one index (e.g. Euribor) and the other pays floating based on a different index (e.g. TIBOR)
Although there is an agreed notional for a swap trade, this is only a nominal figure used to calculate the amount owed at each fixing. Swaps are used when a counterparty wants to hedge his exposure across different indices, or when he wants to transfer his payment streams from fixed rate to floating or vice versa.
Housebuilding Bank receives floating rate mortgage repayments (at LIBOR + 2 %) from its customers and needs to service the debt arising by means of a bond it has issued which has fixed coupon payments (5 %) (See Figure 4.1).
Figure 4.1 Motivation for a swap trade
Housebuilding enters into a swap trade with a counterparty (Countrybank).
Housebuilding receives 5 % from Countrybank and pays its bond holders.
Housebuilding pays LIBOR + 2 % to Countrybank which it receives from mortgage borrowers. Now, Housebuilding has removed his exposure (risk) to interest rate changes.
The combination of deposits, futures and swaps traded in one currency constitutes the market data necessary to produce an interest rate curve. This determines how much that currency will be worth in the future based on information available today. Interest rate curves are used extensively in the financial world. Most trades rely on the interest rate curves to discount future cashflows. The higher the future interest rates in a currency, the less money in that currency will be worth.
Interest rate products are traded in their own right by dedicated trading desks and are also traded as hedges for more complicated trades or cashflow scenarios (as in the swap example above). In most currencies they are very liquid products.
A forward rate agreement (FRA) is a forward contract, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. With this type of agreement, it is only the differential that is paid on the notional amount of the contract. It is paid on the effective date. The reference rate is fixed one or two days before the effective date, dependent on the market convention for the particular currency. FRAs are OTC derivatives. An FRA differs from a swap in that a payment is only made once at maturity.
Many banks and large corporations will use FRAs to hedge future interest or exchange rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates.
As well as being important in their own right, the class of interest rate products is vital for construction of the discount curve. We saw in the previous chapter that most trades give rise to cashflows in the future. If we are going to assess the worth of future cashflows we cannot take them at face value. Those due sooner are worth more than those due later because of the time value of money. Therefore we need a means to weight future cashflows according to their depreciation over time. This can be done in many ways; one of the most common is to construct a discount curve.
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