Hedging Using Interest Rate Futures Contracts

1. Hedging Using Interest Rate Futures Contracts • There are two main interest rate futures contracts • Eurodollar futures • US T-bond futures • Eurodollar futures are the most popular and active contract • Open interest in excess of $4 trillion at any one point in time • Eurodollars in this case are not Eurodollar currency. They are US Dollar deposits in banks that are not subject to US banking regulations. Intermediate Investments F303

2. Hedging Using Interest Rate Futures Contracts • Eurodollar futures contracts are based on the interest rate payable on a Eurodollar time deposit • This rate is known as the LIBOR (London Interbank Offer Rate) and has become the benchmark short-term interest rate for many US borrowers and lenders • Interest rates are typically quoted as LIBOR + basis points (.0001, so 100 basis points = 1%) • LIBOR is an annualized rate based on a 360 day year Intermediate Investments F303

3. How is LIBOR Interest Calculated? • LIBOR is calculated on a notional principal amount of $1M. • The contract is settled in cash; there is no actual delivery of the time deposit • The interest on a 3 month (90-day) contract with notional principal of $1M and an 8% rate would be calculated as: .08 * (90/360) * 1,000,000 = ?? Intermediate Investments F303

4. Other Characteristics of LIBOR • Prior to expiration, the quoted futures price “implies” a LIBOR rate. So Implied LIBOR = 100 – Quoted Futures Price • At Expiration, the Futures Price is quoted at 100 – LIBOR So, if the LIBOR rate was 8% at expiration, the contract would be quoted at 92. Intermediate Investments F303

5. Other Characteristics of LIBOR • Contract is a Eurodollar time deposit • Traded on the Chicago Mercantile Exchange • Notional principal is $1,000,000 • Contracts are delivered in • March • June • September • December • Cash settlements based on a 3-month LIBOR • Minimum Price Movement is $25 or 1 basis point Intermediate Investments F303

6. An Example • Assume the following • On November 15 you purchase one December Eurodollar Futures contract • The quoted futures price at the time is 94.86 • What is your profit or loss if the LIBOR rate falls 100 basis points between now and the expiration date of the contract? • Remember • No money changes hands when you buy the contract • What was the implied LIBOR rate when the contract was purchased? Intermediate Investments F303

7. Example (cont) • What is the LIBOR rate if interest rates fall 100 basis points? • What is the new futures price? • What is our gain or loss based on the price? • What is the overall gain or loss on the contract? Intermediate Investments F303

8. Hedging Using Interest Rate Futures • As with any hedge, you are not locking in a rate per se. You are locking in an effective rate based on gains and losses on the contract! • Assume the following • Suppose a firm knows in February that it will be required to borrow $1M in March for a period of 3 months (90 days) • It will pay the loan off at the end of the period • The firm borrows at LIBOR + 50 basis points • The firm wants to hedge its interest rate risk Intermediate Investments F303

9. In Order to Hedge, Do You Buy or Sell? • If interest rates go up, your company’s borrowing costs go up. • So, to hedge your position, you want a strategy that will allow you to offset borrowing costs if rates go up! • So, you would sell a contract, because if interest rates rise, the cost of the contract goes down, but you will have an agreement to deliver the contract at a higher price Intermediate Investments F303

10. How Does the Hedge Work? • Assume the following: • The March Eurodollar futures price is 94.86 • What does that make the implied LIBOR rate? • If we lock in this effective borrowing rate, what will our interest expense be? • Now assume that LIBOR increases to 6.14%. How does the hedge work? • What is our borrowing cost now that interest rates have gone up? • What was our gain or loss on futures contract? • What does that make the net expense to the borrower? Intermediate Investments F303

11. How Does the Hedge Work? • Now assume that LIBOR falls to 4.14%. How does the hedge work? • What is our borrowing cost now that interest rates have gone up? • What was our gain or loss on futures contract? • What does that make the net expense to the borrower? Intermediate Investments F303