Hedging Interest Rate Risk Using Interest Rate Future
Futures contracts are of fixed sizes and for given durations. They give their owners the right to earn interest at a given rate, or the obligation to pay interest at a given rate.
Selling a future creates the obligation to borrow money and the obligation to pay interest
Buying a future creates the obligation to deposit money and the right to receive interest.
Interest rate futures can be bought and sold on exchanges such as Intercontinental Exchange (ICE) Futures Europe.
The price of futures contracts depends on the prevailing rate of interest and it is crucial to understand that as interest rates rise, the market price of futures contracts falls.
Think about that and it will make sense: say that a particular futures contract allows borrowers and lenders to pay or receive interest at 5%, which is the current market rate of interest available. Now imagine that the market rate of interest rises to 6%. The 5% futures contract has become less attractive to buy because depositors can earn 6% at the market rate but only 5% under the futures contract. The price of the futures contract must fall.
Similarly, borrowers will now have to pay 6% but if they sell the future contract they have to pay at only 5%, so the market will have many sellers and this reduces the selling price until a buyer-seller equilibrium price is reached.
- A rise in interest rates reduces futures prices.
- A fall in interest rates increases futures prices.
In practice, futures price movements do not move perfectly with interest rates so there are some imperfections in the mechanism. This is known as basis risk.
The approach used with futures to hedge interest rates depends on two parallel transactions:
- Borrow/deposit at the market rates
- Buy and sell futures in such a way that any gain that the profit or loss on the futures deals compensates for the loss or gain on the interest payments.
Borrowing or depositing can therefore be protected as follows:
Depositing and earning interest
The depositor fears that interest rates will fall as this will reduce income.
If interest rates fall, futures prices will rise, so buy futures contracts now (at the relatively low price) and sell later (at the higher price). The gain on futures can be used to offset the lower interest earned.
Of course, if interest rates rise the deposit will earn more, but a loss will be made on the futures contracts (bought at a relatively high price then sold at a lower price).
As with FRAs, the objective is not to produce the best possible outcome, but to produce an outcome where the interest earned plus the profit or loss on the futures deals is stable.
Borrowing and paying interest
The borrower fears that interest rates will rise as this will increase expense.
If interest rates rise, futures prices will fall, so sell futures contracts now (at the relatively high price) and buy later (at the lower price). The gain on futures can be used to offset the lower interest earned.
Students are often puzzled by how you can sell something before you have bought it. Simply remember that you don’t have to deliver the contract when you sell it: it is a contract to be fulfilled in the future and it can be completed by buying in the future.
Of course, if interest rates fall the loan will cost less, but a loss will be made on the futures contracts (sold at a relatively low price then bought at a higher price).
Once again, the aim is stability of the combined cash flows.
The summary rule for interest rate futures is:
- Depositing: buy futures then sell
- Borrowing: sell futures then buy
Source: Ken Garrett, ACCA