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Time
Before you start Money Markets What’s next? Contents
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$ $ Instruments
Place Pace
Page i Page 153
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Coupon bearing instruments Discount instruments
Instrument Code page Instrument Code page
▼
Derivatives
Instrument Code page
i
Contents
Bill of Exchange/Banker’s Acceptance (BA) MMI:BA Options on FRAs – Interest Rate Guarantee (IRGs) MMI:IRG
Spot transactions – Currencies versus USD FXI:SPT Synthetic Agreements for Foreign Exchange (SAFEs) FXI:SAF
ii
Before you start
Time
■ Who is this workbook for? The learning materials for each area of information answer a series of Place Pace
▼
information information
This Level 3 workbook is primarily aimed at sales, client
training and customer sales staff who need an in-depth
understanding of markets and related Reuters products.
This greater understanding will enable them to discuss • What instruments • How are the
their customers’ problems and needs in the context of the are used? instruments used
markets in which they operate. in practice?
• Who uses the
Both the workbook and Web Level 3 learning materials have been instruments? • How is the
designed to answer questions concerning the latter two of the three Reuters product
fundamental areas of information that the Know your Markets package • How do the used?
is intended to address: instruments work
– calculations? • Who are the
❑ Customer information competition?
❑ Market information
Across the market sectors there are also areas of common
information required. For the Know your Markets package these have
❑ Product information
been divided into three workbooks.
iii
Before you start
Time
Place Pace
This workbook is designed to fit into the following series for the To access the Web site use the address below for the Markets Matrix
Money Markets and Foreign Exchange. page.
Before you start
iv
Before you start
Time
It is worth noting that although each Level 2 workbook has a section ■ What does this workbook contain? Place Pace
Endcheck
This section provides an opportunity for you to test your
understanding of the formulas, calculations and
products used.
v
Before you start
Time
Place Pace
Throughout the modules you will find that important terms or ■ How to use this package
concepts are shown in bold, for example, Yield. You will also find that
Before you start at certain points learning activities are included which are designed Before you start using the package you should discuss
to enhance your learning. The various activities use the following with your line manager how he/she will help by giving
icons: time for study and giving you feedback and support.
This means stop and think about the point being made. Although your learning style is unique to you, you will
You may want to jot a few words in the box provided – it find that your learning is much more effective if you
doesn’t matter if you don’t. allocate reasonable sized periods of time for study. The
most effective learning period is about 30 minutes – so
use this as a basis. If you try to fit your learning into odd
This indicates an activity for you to do. It is usually moments in a busy schedule you will not get the best
something written – for example, a calculation. from the materials or yourself. You might like to schedule
learning periods into your day just as you would business
This indicates a reference to an instrument in this or meetings.
MMI:CD another Level 3 workbook. A complete list of the
instruments and their codes is given in the Contents. A Being a successful open learner means more than just reading. Open
cross reference to an instrument will appear like this, learning is interactive – it is designed to enhance your learning by
for example, Certificate of Deposit. getting you to be active. There is an old Chinese saying which may
help:
This indicates that you should use the appropriate
3000 I hear and I forget
Reuters 3000 product or Reuters Terminal (RT) and
I see and I remember
follow the instructions. A screen dump of what you
I do and I understand
should see is usually included as well. It is important to
understand that the activities here assume you have a
RT basic knowledge of the Reuters product software. If The various types of activities and their icons have already been
you do not have this knowledge you may need to start mentioned – even thinking is an activity.
with this first!
Try to make sure your study is uninterrupted. This probably means
that your workplace is not a good environment! You will need to find
This indicates an important item of information worth both the time and place where you can study – you may have access to
i remembering. a quiet room at work, you may have a room at home, you may need to
use a library.
vi
Before you start
Time
Place Pace
■ Discount instruments 29
■ Derivatives
Forward Rate Agreement (FRA) 55
Guarantees (IRGs)
Options on IRSs – Swaptions 147
vii
Before you start
Time
Place Pace
You may find the following chart useful for planning your learning
and to decide the order in which you would like to study the
Before you start instruments
Discount instruments
Derivatives
viii
Money Market Deposits
■ What is it? Before you have a look at the deposit market in more detail you need $ $
to understand some of the terms used for trades in the market place
A Money Market Deposit is an unsecured, fixed rate – some of these have already been introduced. Coupon bearing
investment or loan between financial institutions.
If you are a borrower of funds, you refer to the trade as a taking. The
counterparty to the same trade refers to the deal as a placement.
Within the Money Markets the deposit market is often referred to as The borrower, or taker of the funds pays interest based upon:
the Interbank deposit market. This is because the market operates
essentially between banks. Deposits are fixed-term, non-negotiable ❑ An agreed interest rate
investments or loans which yield interest. The interest rates paid are
used as a basis for other Money Market and FX instruments ❑ A defined amount of loan – the principal
including:
❑ A specified period of the loan – the maturity or tenor
❑ Establishing the price of coupon bearing instruments such
as CDs and Repos, and the price of discount instruments ❑ An end date or maturity date on which the taker pays back
such as CPs and T-Bills the principal and any interest due
❑ Pricing derivative instruments such as FRAs and short A transaction is agreed on its trade date but the start date of the trade
Interest rate futures for the purpose of calculating interest is known as the value or
delivery date. This is the date on which the placer delivers the
❑ Setting the rates on instruments which have a ‘floating’ principal to the taker. The value date is usually taken as spot which is
aspect such as Interest Rate Swaps and Floating Rate Notes usually two working days after the trade date. However, as is described
later, the value date may differ depending on the maturity of the
❑ Pricing Forward FX rates deposit.
Within the Interbank deposit market there are two basic types – fixed At the end date – the maturity date – of the loan the taker pays back
and notice: the principal, plus any owed interest. The lender, or placer of the
deposit, receives the principal and interest from the taker at maturity.
A fixed deposit is one where the rate of interest and the
maturity date are agreed at the time of the transaction. Takers and placers are often referred to as buyers and sellers
respectively, even though the monies are not actually bought or sold.
A notice or call deposit is one where the rate of interest You should note that deposits are generally non-negotiable. This
may be changed or the termination of the deposit means that the deal remains on the books until the maturity date,
requested with effect from a specified number of working even if one of the parties wishes to terminate or ‘break’ the deposit
days. A working day means that the Money Market prior to the maturity date.
financial centre involved with the trade must be open for
business.
1
Money Market Deposits
2
Money Market Deposits
Components of a trade As in the FX Markets, the Deposit Markets have a bid side – taker, and $ $
The principal particulars of a deposit trade are: an offered side – placer. The table below compares some of the
terminology and components of FX and Deposit deals. Coupon bearing
Trade Date The date on which the trade takes place.
Value Date The start date of a deposit. On this date, the lender Term or component Spot FX contract MM Deposit contract
delivers the principal of the trade to the borrower.
Interest on the deposit begins to accrue on this date. No. of currencies 2 1
Maturity The end date of the deposit. On this date, the Value date Date on which the Date on which the
Date borrower repays the lender the principal of the currencies are placer delivers the
trade, plus all interest due. The last day for interest exchanged principal to the
accrual on a deposit is the day before the maturity taker. This is the start
date. date of the deposit
Rate The agreed upon interest rate expressed as a Maturity date Not applicable Date on which the
percentage on a per annum basis. This may also be taker repays the
called a yield. principal plus
interest to the placer.
Basis The number of days in a year used to calculate This is the end of the
interest. Most of the world uses a 360 day basis, deposit
meaning that a year is said to contain 360 days.
Countries such as Canada, Ireland, Singapore, Hong Price/rate The agreed upon The agreed upon
Kong, Belgium and the U.K. use a 365 day basis. rate expressed as an rate expressed as a
amount of the quote percentage per
Currency The currency of the deposit. currency per single annum
unit of the base
Amount The amount of the deposit. currency
Taking bank The bank that borrows the money. The deposit is Bid means Expression of an Expression of an
recorded as a liability on this bank’s books. intent to buy the intent to borrow the
base currency specified currency
Placing bank The bank that lends the money. The deposit is
recorded as an asset on this bank’s books. Offer means Expression of an Expression of an
intent to sell the intent to lend the
Payment Precise instructions advising each bank as to the base currency specified currency
Instructions appropriate details for the delivery of principal on
the value date to the taking bank, and subsequent Hit the bid means To sell the base To lend the specified
repayment of principal plus interest to the placing currency at the bid currency at the bid
bank on the maturity date. price price
Method/via The method used to transact the trade. (Direct, via a Take the offer means To buy the base To borrow the
broker, etc.) currency at the specified currency
offered price at the offered price
Confirmation Printed verification of all the terms of the trade.
Each counterparty sends the other a confirmation.
3
Money Market Deposits
Before moving on use the RT to have a look at some rates... These are
the maturities
The bid/offer rates from this bank
To see the rates from a typical bank type in BPNC are quoted in fractions
RT and BADD and press Enter after each entry.
4
Money Market Deposits
5
Money Market Deposits
❑ Present Value (PV) – the fair market value today Suppose now that the deposit had been 10,000,000 GBP. Using the
same tenor and rate the interest due is now:
❑ Future Value (FV) – the total repayment value, including 10,000,000 (P) x 6.5(R) x 92(N)
interest, on maturity Interest due (I) =
365 (B) x 100
( )
= P+ P x R x N
B x 100
The Basis for GBP is 365, seen as A/365. Note the difference in
interest amounts due to the different day bases.
Year day basis conventions Except GBP, CAD, BEF, ECU where:
Future Value
[ ( )]
= P x 1 +
R x N
B x 100
...Equation 3 i
Domestic 360 Domestic
Euro
365
365
Euro 360
6
Money Market Deposits
The difference in Basis can be important if you are comparing the ■ Summary $ $
Money Market Yields, MMY – interest paid – between different
instruments. To compare rates between instruments you have to Coupon bearing
compare like with like. To do this you need to calculate the true
Money Market Deposits
annual yield for both deposits.
7
Money Market Deposits
Coupon bearing The following exercises using Reuters products and the
RT may help your understanding of Money Market
Deposits and how they are used.
8
Money Market Deposits
$ $
3000 Exercise 1. Using the MMMW page in Money 3000 3000 You can also use the MMMW page to calculate Coupon bearing
can be useful as you can display Bid and Ask prices broken dates for deposits. But before you look at
for a number of currencies from different the page try the following:
contributors simultaneously. For example you want
to lend £5 million for 3 months and at the same time you need to
borrow 2 million DEM. You use MMMW to display GBP Bid rates
and DEM Ask rates from different contributors to select who you To calculate broken dates carry out the following:
want to trade with. Assume 3 months is 90 days in both cases.
1. Select maturity rates for either side of the broken date.
2. Calculate the rate change for each day between the maturities
selected.
3. Multiply the result from 2) by the number of days for the broken
date.
4. Add the result from 3) to the rate for the near deposit and this is
the broken date rate.
Exercise 2
It is 30th June 1997 and you need the GBP rate for a broken date of
15th August 1997 using TTKL Bid prices opposite. Value is 2nd July.
The 1 month deposit maturity date is 4th August and the maturity
1) Which GBP contributor would you deposit funds with for the best
date for 2 months is 2nd September. There are 29 days from 4th
rate of return and what interest would you expect to receive?
August until 2nd September, and 11 days to the broken date.
Answer:
Calculate the broken date rate for the bid.
Answer:
2) Which DEM contributor would you borrow funds from and what
interest would you pay?
Answer:
Before you check your answers on page 12, why not complete the following End
check?
9
Money Market Deposits
$ $ ■ End check 5. You are the Treasurer of a large corporation in London and at
times you need to deposit and borrow dollars. There are four
Coupon bearing banks you could deal with quoting the following Eurodollar rates
1. Which of the following Money Market instruments is not for one month (31 days) on a 360-day year basis.
negotiable?
Bank A Bank B Bank C Bank D
❑ a) Cash deposit
6 /16 – 69/16
11
63/4 – 65/8 67/8 – 611/16 613/16 – 63/4
❑ b) Certificate of Deposit
❑ c) Eligible Bill a) From which bank would you borrow Eurodollars and at what
❑ d) Commercial Paper rate?
b) From your answer in a), if you borrowed $5 million what is the
2. Which of the following Eurocurrency deposits is quoted on the total amount payable at maturity?
basis of Actual/365 days? c) With which bank would you deposit funds and at what rate?
❑ a) Euromarks Answer a)
❑ b) Euroyen
❑ c) Eurosterling
❑ d) Eurodollars
❑ a) 3.00% Answer b)
❑ b) 3.02%
❑ c) 3.04%
❑ d) 3.05%
10
Money Market Deposits
Your notes $ $
Coupon bearing
11
Money Market Deposits
12
Certificate of Deposit (CD)
What then is the difference between 1. The bank’s borrowing is less visible which influences their
an interbank deposit and a CD? The credit rating
Certificate of Deposit problem with a simple deposit is that
MegaBank
is for a fixed term and is non- 2. CDs issued through dealers may reappear in competition
$1,000,000 negotiable. By buying a negotiable to any new issue the bank may seek to launch
Maturity 3 months CD for a fixed period, if it becomes
Interest 6.75%
necessary to raise funds before the However, US banks do issue CDs on a commission basis through a
maturity date, then the buyer can sell number of Securities Houses who make a market in CDs. These
the CD in the secondary market. houses have distribution networks for the world-wide retail of new
issues.
The rate of interest paid on a CD depends on factors such as current
market conditions, the denomination of the CD and the standing of
the bank offering the instrument.
This section of
screen is
The depositor can retain the CD until maturity and receive the
taken from
guaranteed interest or if funds are required urgently the CD can be
Money 3000
sold in the money markets. The CD will be sold at the going market
page MMBW
price which reflects the current interest rates. CDs are issued at a
for USD
lower rate than LIBOR because they may not be held to maturity.
Domestic CDs
CDs were first issued in the US in 1961, in the Euromarkets in 1966
and in London in 1968.
USD denominated CDs issued by Foreign banks in the US are often called
i Yankee CDs
13
Certificate of Deposit (CD)
$ $ Euro CDs In addition to the fixed rate coupon CDs, there are also two
A Euro CD is a receipt for a Eurocurrency fixed term deposit typically variations which may be encountered:
Coupon bearing with a London-based bank. Euro CDs are mainly USD denominated
bearer instruments issued in $1 million units. It is common to see ❑ Discount CDs. In this case a CD offered at £1 million face
early and late prices quoted for CDs which reflects whether the CD value and a yield of 10% would be bought for, say, £900,000.
matures in the first or second half of the month respectively. On maturity the loan would be repaid at £1 million earning
£100,000 interest on an investment of £900,000. This
The main issuers of Euro CDs are branches of major US banks, represents a true yield of 11.11%.
British clearing banks, branches of major continental Europe banks
and Japanese banks. There is a secondary market in Euro CDs ❑ Floating Rate CDs. These are based on a benchmark –
although as much as 50% of current issues are lock-ups – the CDs are usually LIBOR and are similar in principal to Floating
bought and held to maturity, often in the safe custody of the issuing Rate Notes, FRNs, used in the debt markets. You may find
bank. it useful to compare these instruments with FRNs in the
Debt Markets section. Although not very common the two
types which may be encountered are 6-month instruments
with a 30-day roll and a 1-year paper with a 3-month roll.
The buyer of a Floating Rate CD has some protection
against rising interest rates but this is offset to some extent
This section of because this type of CD is less liquid than the normal fixed
screen is rate type.
taken from
Money 3000 On each roll date accrued interest is paid and a new coupon is set.
page MMBW i
for USD
Domestic
Euro CDs
14
Certificate of Deposit (CD)
15
Certificate of Deposit (CD)
$ $ ■ CDs in the market place Year day basis conventions Except GBP, CAD, BEF, ECU etc. where:
i
Coupon bearing Interest on short-term CDs is normally payable at maturity Domestic 360 Domestic 365
Euro 360 Euro 365
7 8 9 which in the US is termed a bullet security. For CDs issued
4 5 6
1 2 3 with maturities of 12 months and greater, interest is typically
0
paid semi-annually. The CD has an original maturity of 366 days – a leap year! The
interest due is simply calculated from the formula:
A bullet security is one where the principal of a loan is paid in whole on
i maturity
Principal (P) x Rate (R) x Amount of days (N)
On maturity the bearer of a CD will receive the instrument’s Interest due (I) =
Basis (B) x 100
principal plus the agreed interest which is due. But supposing the ...Equation 2
bearer requires cash for a project and decides to sell the CD. What is
a fair market value for the CD? What is its Present Value, (PV)? = 1,000,000 x 8.5 x 366
360 x 100
A dollar received in the future is worth less than a dollar today
because there is no opportunity to invest the dollar and earn interest.
The Future Value (FV) – the repayment amount – is the amount of = $86,416.67
money you would have if you invested a sum today, PV, for a period of
time at a given rate of interest. So the Future Value of the CD = $1,086,416.67
Future Value = Principal + Interest due ...Equation 1 You now decide that you must sell the CD for settlement on the 1st
November 1996 when there are only 61 days left to maturity.
The fair value, or settlement amount, of the CD should be that
amount of money (PV) which when placed on deposit today for the Suppose the current 2-month deposit rate is 9.75%. The fair value of
number of days left to maturity would result in the same FV if the CD the CD should be that amount of money, PV, which if placed on
were left to mature. So the return on the CD should equal the return deposit today at 9.75% for 61 days would also result in a FV of
currently available on a deposit for the same maturity. $1,086,416.67.
16
Certificate of Deposit (CD)
In this case the Principal is the Present Value: You may or may not be offered a fair price if you want to sell your CD. $ $
What is required is a measure of how good or bad the price you are
Present value = Future value ÷ Interest due offered is. The important factor for the value of a CD in the Coupon bearing
1086416.67 secondary market is its Yield To Maturity, YTM which is also known
= 1 + 9.75 x 61
[ 360 x 100 ] as the Money Market Yield, MMY. The YTM is:
Present Value
[ ( )]
= P x 1 +
R x N
B x 100
Future Value
Although YTM is the rate of return if an instrument is held to
maturity, short-term investors often liquidate their position before
maturity. These investors are therefore concerned with the horizon
Interest due
[ ( )]
1 +
r x n
B x 100
return on the instrument which has two components:
Where P = Principal or the CD face value This means the horizon return is the rate of return achieved on an
R = Quoted coupon rate for the CD investment, from purchase to sale, expressed as a percentage per
N = Number of days to maturity annum taking into account both components.
B = Year basis – 365 or 360
r = Current market interest rate If an investment is held to maturity, then its horizon return equals the YTM.
n = Current number of days to maturity
i
17
Certificate of Deposit (CD)
$ $ Example 2 ■ Summary
Using the CD details from Example 1 you are offered $1,065,000.00
Coupon bearing by a market-maker for its purchase with 61 days left to maturity. What
YTM does this represent? Should you sell to the market-maker?
Certificate of Deposit (CD)
Using Equation 3 and rearranging for R, where P is taken as the PV:
❑ A Certificate of Deposit is an IOU with a fixed coupon
R% = ( B x 100
N
)( x
FV – PV
PV
) ... Equation 5
and which is a negotiable instrument
This means that the market-maker will buy a CD from you (bid) for a
cash amount that produces a yield of 11.92% for him, or that the
market-maker will sell you (offer) a CD for a sum that will yield you
11.87%.
18
Certificate of Deposit (CD)
19
Certificate of Deposit (CD)
$ $
Coupon bearing 3000 Using Money 3000 CD prices can be displayed for
any currency of your choice using the MMCB page.
In the screen below prices for Domestic CDs from
Garvin Guy Butler are shown. You may find the
Calculator useful if you need to calculate the Horizon return for a
CD for a date before maturity. Simply make sure you have the
correct details for the CD required and change the Horizon Date
and press Enter – the new Horizon Return will be displayed.
20
Certificate of Deposit (CD)
■ End check 5. On 19th February you buy a 6-month (180 days) Euro CD at $ $
8.40% with the following details and which has 90 days to
maturity: Coupon bearing
1. When do Eurodollar CDs issued for 12 months generally pay
interest? CD face value: $100,000
Issue date: 20th November
❑ a) On the issue date Maturity date: 20th May
❑ b) At maturity
❑ c) Quarterly Coupon: 9.5% pa
❑ d) Semi-annually Year basis: 360 days
2. XYZ Bank wishes to invest in a very liquid instrument. Which of Calculate the following:
the following are they most likely to do? a) The purchase cost of the CD
b) The interest actually paid
❑ a) Buy a A2/P2 Commercial Paper c) If the CD was sold on 29th February at 8.30% how much profit
❑ b) Buy a CD rated AAA is made and what is the Horizon return?
❑ c) Buy a CD rated BBB
❑ d) Deposit funds in the Money Market Answer a)
21
Certificate of Deposit (CD)
Coupon bearing ✔ or ✖ ✔ or ✖
1. b) ❑ 5. c) Profit = $257.51 ❑
Horizon rate = 9.159% ❑
2. b) ❑
3. b) ❑
Selling cost = 100,000 x
[ (
1+ 9.50 x 181
100 x 360 )]
4. c) ❑
[ (
1+ 8.30 x 80
100 x 360 )]
Use Equation 3.
Sum at maturity = 1,000,000 x
[ (
1+ 6.75 x 90
100 x 365 )] = 1.0477638
1.0184444
= $102,878.84
5. a) Purchase cost = $102,621.33 ❑
Profit = Selling – Purchase price
Use Equation 4.
= 102,878.84 – 102,621.33
Purchase cost = 100,000 x
[ (
1+ 9.50 x 181
100 x 360 )]
[ (
1+ 8.40 x 90
100 x 360 )] Horizon return = 257.51 x 360 x 100 x 365
102,621.33 10 360
= 1.0477638
1.0210
How well did you score? You should have managed to get most of
these questions correct.
22
Repurchase Agreement (Repo)
■ What is it? The following diagrams illustrate the process of using a Repo. $ $
A Repurchase Agreement (Repo) is an agreement for the First leg – the sale Coupon bearing
,,
sale of an instrument with the simultaneous agreement by
the seller to repurchase the instrument at an agreed
,,
future date and agreed price.
,,
Dealer A sells instruments
A Reverse Repurchase Agreement – Reverse Repo – is an
worth $1 million
agreement for the purchase of an instrument with the
▼
simultaneous agreement by the seller to resell the
▼
instrument at an agreed future date and agreed price.
Dealer B pays A $1 million
▼
▼
The interest rate implied by the difference between the sale and Dealer B sells instruments
purchase price is known as the repo rate. worth $1 million
23
Repurchase Agreement (Repo)
24
Repurchase Agreement (Repo)
25
Repurchase Agreement (Repo)
Coupon bearing
Repurchase Agreement (Repo)
26
Repurchase Agreement (Repo)
27
Repurchase Agreement (Repo)
$ $
Coupon bearing 3000 US Treasury repo rates from Garvin Guy Butler can
be displayed from the MMDI page for USD.
28
Treasury Bill (T-Bill)
■ What is it? The results of the auction are published in The Wall Street Journal and $ $
look something like this:
A Treasury Bill is a short-term negotiable Bill of Discount
Exchange issued by a government to help finance 13 week 26 week
national debt.
Applications $55,735,696 $48,878,949
Accepted bills $13,073,966 $13,080,408
T-Bills are short-term government instruments issued in both the US
Accepted non-compet. $1.118,192 $861,519
and UK. Normally T-Bill prices are quoted at a discount which
Average price rate 99.227 98.352
reflects the prevailing short-term interest rate. If you buy T-Bills you
3.06% 3.26%
are effectively lending money to the government and as such there is
little risk attached. However, the main purpose of T-Bills is not to Yield
finance government spending but to help control monetary policy.
Yields on T-Bills are therefore lower than other short-term money UK T-Bills
market instruments because the loan is guaranteed by the On the last business day of each week the Bank of England issues 91-
government – less risk, less reward. As a result of their reliability these day bills usually for amounts £5000 – 250,000. Tenders are invited
instruments are used as benchmarks for other investments to be each Friday with bills being issued the following week.
compared with.
The results of the tenders are published in the Financial Times and
In the US and UK T-Bills are recorded centrally so there are no they look something like this:
physical certificates of ownership.
BANK OF ENGLAND TREASURY BILL TENDER
US T-Bills
In the US the Fed typically auctions 13- and 26-week T-Bills on behalf Friday 2 Friday 1
of the government every Monday for delivery on Thursday. It also
auctions 52-week bills every month. Bids can either be competitive or Bills on offer £700m £700m
non-competitive. Competitive bids state the actual price the investor Total of applications £2900m £2246m
is willing to pay whereas for non-competitive bids the investor is Total allocated £700m £700m
willing to pay the average of all bids accepted. Minimum accepted bid £98.475 £98.495
Allotment at minimum level 59% 83%
29
Treasury Bill (T-Bill)
$ $ ■ Who uses T-Bills? In contrast to the primary market, settlement in the secondary
market takes place on the following business day at the latest – T+1
Discount US T-Bill investors or Trade + 1.
In the primary market, market-players such as primary
dealers, large institutional investors, money-centre banks Bills are traded traditionally by large investors in minimum lots of $5
and non-professional investors buy T-Bills in competitive million. The US T-Bill is a very liquid market and with the easy
bids on a discounted basis. For example, a bill with a face value of availability of Repurchase Agreements (Repos) dealers build up
$100,000 may be bought for $97,000. The discount is $3000 which substantial long or short T-Bill positions running into many $100
represents the interest on the loan to the government if the bill is millions.
held to maturity. The professional market-players bid for the bills in
a competitive auction whereas non-professional investors can make UK T-Bill investors
non-competitive bids with no price. If successful the professional The main holders of UK T-Bills are the Discount Houses who
market-players pay their bid price; non-competitive bids are priced as dominate the secondary market and act as intermediaries between
an average of the professional market-players bid prices. the Bank of England and investors. The Bank of England can also
invite Discount Houses and Clearing banks to absorb surplus Money
Between the auction and settlement of new issues, primary dealers Market supplies on a particular day and issue T-Bills by allotment.
make a market in when issued (W/I) bills. This is attractive for
dealers who want to run positions as there is no immediate delivery Market prices
or costs involved. T-Bills are guaranteed instruments carrying no risk and as such the
yield is lower than on Money Market deposits and CDs. T-Bills are
The US T-Bill secondary market is the most active US Money Market. quoted on a discount to par basis not on a yield basis. The practice of
The Fed will only deal with primary dealers who must have adequate: discounting to par dates back to the issue of Bills of Exchange from
Merchant Banks.
• Capital
• Market turnover In the secondary market traders deal with each other using quoted
• Experience and knowledge of government markets bid and offer discount rates. A broker’s price run might look like
this:
Virtually all secondary T-Bill trading in the US is carried out using
InterDealer Brokers (IDBs). The 40 or so primary dealers use the US T-Bill
IDBs on a no-names basis. This means trades are settled with an IDB 13 week 6.50 – 49 2 x 5
directly rather than between counterparties which makes it difficult 26 week 6.70 – 69+ 10 x 12
to assess who is in the market and the size of their position.
52 week 6.96 – 95 1 x 10
Because T-Bills carry virtually no risk of default, brokers quote price
runs for different maturities. This is possible because all bills
maturing on the same date should have the same price, irrespective But what do these quotes mean?
of their issue date.
30
Treasury Bill (T-Bill)
Settlement amount , S = P x 1 –
[ ( R x N
B x 100 )] ...Equation 1
31
Treasury Bill (T-Bill)
$ $ By rearranging Equation 1 the Discount rate can be calculated using Example 2 – A UK T-Bill
Equation 2. Calculate the discount rate for the following UK T-Bill which has 91
Discount days to maturity.
R% =
( P – S
P ) (
x
B x 100
N ) ...Equation 2
T-Bill face value:
Settlement date:
£100,000
9th May
Maturity date: 8th August
Settlement value: £98,485
Example 1 – A US T-Bill Year basis: 365 days
Calculate the settlement amount for the following US T-Bill which
has 50 days to maturity. Using Equation 2:
T-Bill face value: $100,000
Settlement date: 9th May Discount rate = 100,000 – 98,485 x 365 x 100
Maturity date: 28th June 100,000 91
Discount rate: 8.12%
Year basis: 360 days = 6.0766%
Using Equation 1:
S = 100,000 x 1 –
[ ( 8.12 x 50
360 x 100 )]
Therefore the settlement value = $98,872.22. This is also written as
98.87% of face value.
32
Treasury Bill (T-Bill)
As in the case of other Money Market instruments, quoting a rate Example 3 – A US T-Bill $ $
may not be that useful if you need to compare rates of return from Using the same information from Example 1 calculate the MMY for
different instruments. Rates of return for instruments held to the US T-Bill which has 50 days to maturity. Discount
maturity are compared by calculating the Money Market Yield, MMY
for each instrument. T-Bill face value: $100,000
Settlement date: 9th May
The MMY for an instrument can be calculated as follows: Maturity date: 28th June
Discount rate: 8.12%
1. Calculate the profit to maturity on the instrument.
This is equal to (P – S). Year basis: 360 days
Therefore: [ (
1 –
8.12 x 50
360 x 100 )]
MMY =
( P – S
S ) (x
B x 100
N ) ...Equation 3
Therefore the MMY = 8.21%
To convert this yield into a true annual yield you would need to
multiply MMY by 365/360.
Equation 3 is very similar to Equation 2 which can be used to express
MMY in terms of the Discount rate as in Equation 4.
True annual yield = 8.21 x 365
360
R/100
MMY = ...Equation 4 = 8.32%
[ (
1 –
R x N
B x 100 )]
33
Treasury Bill (T-Bill)
$ $ Although the MMY is useful for comparing short-term Money Market ■ Summary
instruments a different yield basis is used for comparisons with
Discount coupon bearing instruments which are nearing maturity.
Treasury Bill (T-Bill)
The Bond Equivalent Yield, BEY allows such a comparison to be
made and is particularly useful for comparing T-Bills with Treasury
Bonds and Notes with only a short time to maturity. ❑ Treasury Bills are short-term, negotiable, government
instruments which are issued at a discount. In the US they
BEY takes into account compounding of interest for coupon are known as T-Bills and in the UK they are commonly
payments and adjusts for a coupon period of 365 days. A complicated called Gilts.
formula is used for calculations which will not be discussed here.
However, a good approximation for US T-Bills with a maturity of 6 ❑ T-Bills are used as benchmarks for other instruments to be
months or less is given by the following equation: compared with
34
Treasury Bill (T-Bill)
35
Treasury Bill (T-Bill)
$ $
Discount RT For UK T-Bills you can display the latest T-Bill
tender results by typing in BOE/MONEYOPS5 and
pressing Enter. To see the UK Government Debt
Speed Guide type in GB/GOVT1 and press Enter.
To display OTC prices for Treasury Bills double click in the
<GB/TBIL> field. Then double-click in the fields for prices – in
this case <BASD> and <3CLIVE> for Barclays Bank PLC and
Clive Discount Co Ltd respectively.
Compare T-
Bill prices
36
Treasury Bill (T-Bill)
■ End check $ $
Discount
1. You want to buy a UK T-Bill with a face value of £100,000 maturing 2. You check on the RT and find the latest price for a US T-Bill with
in 3-months (91 days). Barclays Bank is quoting 65/8% whilst Clive a face value of $100,000 with a 3-month maturity (90 days) is
Discount House is quoting 611/16% . 5.05%.
a) Which Bank would you buy the T-Bill from? a) What is the settlement rate for the bill?
37
Treasury Bill (T-Bill)
Discount ✔ or ✖ ✔ or ✖
1. a) Barclays Bank – the lowest discount rate ❑ 2. a) $98,735.50 ❑
Use Equation 1.
Settlement = 100,000 x
[ (
1– 5.05 x 90
100 x 360 )]
Settlement = 100,000 x
[ (
1– 6.625 x 91
100 x 365 )] = 100,000 x [(1 – (0.012625)]
How well did you score? You should have managed to get most of
these questions correct.
38
Bill of Exchange/Banker’s Acceptance (BA)
■ What is it? the bank issuing the L/C with the necessary documentation such as $ $
Bill of Lading, invoices, warehouse receipts etc the bank accepts the
A commercial Bill of Exchange, or Trade Bill, is an order draft and stamps it ACCEPTED. The resulting Banker’s Acceptance Discount
to pay a specified amount of money to the holder either means the importer’s bank will pay the full amount at the due date.
at a specified future date – Time draft – or on The actual instrument issued is simply a note specifying:
presentation – Sight draft. It is a short-term IOU in
support of a commercial transaction. ❑ The name of the accepting bank
A Banker’s Acceptance, or Banker’s Bill, is a Bill of ❑ A brief description of the underlying transaction
Exchange drawn or accepted by a commercial bank.
Once accepted the instrument becomes negotiable. The exporter can now keep the BA until maturity or if necessary sell
it in the secondary market to raise cash. The BA is now a negotiable
instrument which carries the bank’s obligation to pay.
These instruments have been used in financing international trade
for hundreds of years. A Bill of Exchange in the UK is essentially the If the exporter does sell the BA in the secondary market, then the
same as a BA in the US. These discount instruments are basically buyer pays less than the face value of the bill. In other words the bill
short-term IOUs issued to support a commercial transaction. trades at a discount which has a value determined by the difference
between purchase and face values. The buyer of the BA is effectively
Originally a Bill of Exchange was where an importer agreed to pay an lending money to the original holder and the discount is the interest.
exporter a specific sum of money at a definite future date for goods
or services. The exporter – the drawer – draws a Bill of Exchange on On maturity, the importer has to pay the accepting bank the face
the importer – the drawee. The bill can be drawn as a Sight draft value of the bill. If the importer fails to pay, then the accepting bank
which means that it must be paid immediately on presentation or it still has the obligation to pay the bearer. In consequence accepting
can be a Time draft which means payment is due a number of days banks need to be assured of the credit worthiness of the importer.
after it has been presented.
Typically the exporter sells the BA to his own bank. The bank can
Once the importer acknowledges his obligation to honour the bill he either hold the BA to maturity or re-discount it in the secondary
writes ACCEPTED across the bill which now becomes an acceptance. market.
If the acceptance is between the importer and exporter directly it is Most BAs are now issued to support international trade and are
known as a Trade Bill. If the bill is accepted by the drawer’s/drawee’s bearer instruments drawn on banks having the best credit ratings.
bank then it is known as a Bank Bill. Once a bill has been accepted BAs are drawn for various maturities and face value amounts reflects
then it must be paid at maturity. the nature of the business transaction. BAs are usually created and
traded in lots of USD 1 million or equivalent in other currencies,
In many cases a Time draft is drawn by an exporter under a Letter of although some accepting banks issue smaller lots to attract smaller
Credit, L/C from the importer’s bank. The L/C is a non-negotiable investors.
order from a bank which is required by the exporter who wishes to
have proof that he or she will be paid. Once the exporter provides
39
Bill of Exchange/Banker’s Acceptance (BA)
$ $ The following diagram summarises the processes described in issuing ■ Who uses BAs?
and trading a typical BA.
Discount Banks
Sight or Time draft In London Bills of Exchange and Banker’s Acceptances
Importer Exporter have been issued by Merchant Banks or Accepting House
▼
Drawee Drawer for centuries. In taking on the credit risk for the original
▼
Accepted/Trade Bill drawee, the bank charges a fee to guarantee payment of the bill’s face
▲ value at maturity. The more credit worthy the accepting bank, the
easier it is to sell the bills in the secondary market.
BA sold
L/C The accepting bank’s fee is derived from the difference between the
at
Accepting Bank discount rate the bank buys the original bill from its customer and
Bill of Lading discount
the lower re-discount rate at which it sells the accepted bill in the
▼ ▼
Accepted/Bank Bill secondary market.
▲
The majority of BAs in the US are created by international
BA re-discounted ▼ subsidiaries of money-centre banks. Originally the US market
Secondary market developed to finance US import and export markets – in much the
Investors same way as Bills of Exchange had developed in the UK. However,
many BAs now issued in the US finance trade in which neither
importer nor exporter are US organisations.
Eligible BAs
On this Bill of Exchange of 1898 you
The type of BA described so far is one created for a commercial
can see that it has been Accepted
transaction involving the supply of goods or services and which is
usually supported by a Letter of Credit. However, BAs are also issued
on the basis of less formal contractual agreements as a means of
satisfying credit demand which avoids Central Bank rules and
penalties.
During the 1960s and 1970s Central Banks in both the US and the
UK attempted to control the growth of money supply through bank
credit rationing rather than by raising interest rates. If banks
exceeded their domestic lending targets, then they were penalised by
their Central Bank.
This photograph is reproduced by kind permission
of the Archives Department, Midland Bank plc
40
Bill of Exchange/Banker’s Acceptance (BA)
To overcome these difficulties banks developed the following tactics: ■ BAs in the market place $ $
❑ Lending was channelled through the Eurocurrency markets Within the discount markets, instruments have two values Discount
which were not subject to the same Central Bank rules and 7 8 9 which you need to understand:
4 5 6
regulations 1 2 3
0
❑ Present value (PV) – the settlement amount payable
❑ Working Capital BAs or Finance Bills were created which today
were then sold in the secondary markets. Finance Bills are a
major source of working capital for organisations which ❑ Future value (FV) – the redemption amount
lack the credit rating to issue a Commercial Paper. payable on maturity
The result was that both the Bank of England and the Fed made The settlement amount payable on a discount instrument is
these bills ineligible for re-discount at the Central Bank and they calculated using Equation 1.
made the sale of such bills subject to reserve requirements.
In broad terms an eligible bill is an acceptance which has been Where P = Redemption value, FV
created to fund specific types of short-term – usually up to 6 months – R = Discount rate as a decimal
commercial transactions. N = Number of days to maturity
B = Year basis – 365 or 360
Eligible BAs issued in the US tend to track T-Bill rates quite closely.
The distinction between eligible and ineligible BAs is therefore
important and it is normal to see quotes only for eligible BAs.
41
Bill of Exchange/Banker’s Acceptance (BA)
$ $ Example 1 Example 2
You are a Corporate Treasurer who needs to borrow £500,000 for the What would be the settlement amount for the following BA issued by
Discount next 182 days. Your bank offers you the following BA. If you took this Barclays Bank Plc.
BA what would be the redemption value or cost of the instrument at
maturity? Underlying trade: Beet export
Face value: £200,000
Settlement value: £500,000
Days to maturity: 142
Issue date: 5th January
Quoted rate: 6.5% pa
Maturity date: 5th July
Year basis: 365 days
Rate: 615/16% pa
Year basis: 365 days
Using Equation 1:
Using Equation 1:
500,000 = P x 1 –
[ ( 6.9375 x 180
365 x 100 )] Settlement amount
[ (
= 200,000 x 1 –
6.5 x 142
365 x 100 )]
Therefore the redemption or face value, P
Settlement amount = 200,000 x (1 – .02529)
P = 500,000
= £194,942. 46
[ (
1 –
6.9375 x 180
365 x 100 )]
In this case you would expect to pay £194,942.46 if you purchased this
BA with 142 days remaining to maturity. At maturity you would
= 500,000 receive £200,000. The difference between the two values is the
(1 – 0.03421) discount – the amount you receive to lend your money.
= £517,705.52
42
Bill of Exchange/Banker’s Acceptance (BA)
43
Bill of Exchange/Banker’s Acceptance (BA)
Compare T-
Bill prices
44
Bill of Exchange/Banker’s Acceptance (BA)
$ $
3000 US Domestic BA rates from Garvin Guy Butler can Discount
be displayed from the MMDI page for USD.
45
Bill of Exchange/Banker’s Acceptance (BA)
$ $ Your notes
46
Commercial Paper (CP)
They are used as an alternative to bank loans where the issuer CPs do not pay interest but are discount instruments issued to raise
promises to pay the buyer a fixed sum at a future date but without working capital. The CP to a corporation is what a Certificate of
being backed by assets. Large corporations often borrow large sums Deposit (CD) is to a bank. Although many large corporations issue
for capital investment using debt instruments and then ‘park’ the CPs, many banks now use short-term CPs to raise money which is
money temporarily in the CP market. used to swap USD into a LIBOR funding basis in other currencies.
Most CPs issued by banks have maturities of 30 days or less so that
Maturities range from a few days to 270 days – the usual period is 30 they do not compete with the CD market.
days. The rates offered are typically higher than for T-Bills of the
same maturity. Issuers of CPs tend to ‘roll-over’ the paper on maturity. This means
they sell a new CP to obtain funds to redeem the maturing paper.
A CP is a bearer instrument and because it is unsecured only the However, there is a risk that the new CP issue will not take place on
credit rating of the borrower is available as security. A CP does not the required day. To avoid this risk most CP issues are backed by a
pay interest and is issued on a discount basis. line of credit from a bank.
Investors
In general the CP market is a wholesale market for large institutional
investors although some large US issuers make some provision for
smaller investors.
A secondary market exists in CPs but most are sold to investors who
hold them to maturity. Dealers will buy back CPs they handle but only
after adding a wide spread to ensure a profit. CPs are not therefore as
liquid as T-Bills and CDs.
47
Commercial Paper (CP)
$ $ The yield differential between A1/P1 and A2/P2 rated CPs can be as ■ CPs in the market place
high as 200 points and as low as 15 points depending on the name of
Discount the issuer and the availability of credit. Within the discount markets, instruments have two values
7 8 9 which you need to understand:
4 5 6
Yields on CPs are usually slightly higher than those on T-Bills which 1 2 3
Euro Commercial Paper, Euro CP or ECP ❑ Future value (FV) – the redemption amount
Alcoa, the US corporation, issued the first Euro CP in 1970 at a time payable on maturity
when US corporations were seeking USD funding outside the US.
The settlement amount payable on a discount instrument is
A Euro CP is a commercial paper issued on a Eurocurrency basis. calculated using Equation 1.
This means the regulatory conditions which apply to normal CPs
in their country of issue do not apply to ECPs which are issued
outside the country in which the corporation or bank is located.
Settlement amount , S = P x 1 –
[ ( R x N
B x 100 )] ...Equation 1
Euro CPs are similar in most respect to CPs in that they are usually
issued in bearer form with maturities ranging from 30-270 days.
Where P = Redemption value, FV
However, the main difference between the instruments is as follows:
R = Discount rate as a decimal
N = Number of days to maturity
❑ CPs are quoted on a discount to par or face value basis
B = Year basis – 365 or 360
❑ Euro CPs are quoted on a discount to yield basis. This
means that the quoted rate is the same as the Money By rearranging Equation 1 the Discount rate can be calculated using
Market Yield, MMY Equation 2.
Euro CPs face stiff competition from CPs and the Eurocurrency
deposit and lending markets which tend to be used for short-term
corporate financing. R% =
( P – S
P ) (
x
B x 100
N ) ...Equation 2
48
Commercial Paper (CP)
Therefore: [ (
S = 100,000 x 1 –
8.83 x 30
360 x 100 )]
MMY =
( P – S
S ) (x
B x 100
N ) ...Equation 3 Therefore the settlement value = $99,264.17
Using Equation 4:
Equation 3 is very similar to Equation 2 which can be used to express
MMY in terms of the Discount rate as in Equation 4. 8.83/100
MMY =
R/100
[ (
1 –
8.83 x 30
360 x 100 )]
MMY = ...Equation 4
[ (
1 –
R x N
B x 100 )] Therefore the MMY = 8.8955%
49
Commercial Paper (CP)
[ ( )]
Settlement value, S = P x 1 +
R x N
B x 100 ...Equation 5
[ ( )]
1 +
r x n
B x 100
[ (
1 +
r x n
B x 100 )]
50
Commercial Paper (CP)
51
Commercial Paper (CP)
3000 To see prices for US CPs use the MMDI page for
USD. Select COMM PAPER to view prices from
Garvin Guy Butler. You can also select the rating of
the CP you require by selecting A1P1, A1P2 or
A2P2. Why not select all three and compare the rates?
b) Calculate the Money Market Yield and the true annual yield for
Remember these the CP.
are discount
prices not the
yields
52
Commercial Paper (CP)
$ $
RT To see prices for US CPs for the primary market Discount
type in US/MMKT and then double-click in the
field < CPAPERA>. This page displays BAs for large
US organisations for 5 – 240 days. You can also
double-click in the <RMFA> field to see a Reuters overview of US
CP, CD and BA rates.
53
Commercial Paper (CP)
Discount ✔ or ✖
a) $990,650.00 or price 99.065 ❑
Use Equation 1.
Settlement =
[ (
100,000 x 1 –
5.61 x 60
360 x 100 )]
= 100,000 x [(1 – (0.0093500)]
Use Equation 4.
MMY = 5.61/100
[(1 – (0.009350)]
MMY
54
Forward Rate Agreement (FRA)
❑ The amount and its currency The seller of a FRA will be paid in cash by the buyer for any fall in
❑ A future date for the loan/deposit to be drawn/ the reference interest rate, below the agreed contract rate. Depositors
placed wishing to hedge against any future falls in interest rates therefore
❑ The term sell FRAs
,,
Example
,,
A Corporate Treasurer has a forward borrowing requirement in 3
months time for a 3-month loan, but he believes that interest rates If interest rates rise
,,
will have risen by the time he requires the loan. To hedge the
▼
possibility of future borrowing costs the Treasurer buys a FRA for the
forward period. At the start of the FRA, interest rates have risen and
the Treasurer has to borrow in the cash markets at a higher rate.
▼
However, the Treasurer receives cash compensation from the
If interest rates fall
settlement of the FRA for the difference between LIBOR and the
FRA agreed rate. The Treasurer has in effect locked-in the cost of the
forward borrowing at the FRA rate. Buyer Seller
The buyer of a FRA will be paid in cash by the seller for any rise in It is important to remember that a FRA is an agreement to fix a
the reference interest rate, over and above the agreed contract rate. forward rate – there is no obligation to borrow or lend the notional
Borrowers wishing to hedge against rises in future borrowing costs principal amount involved.
therefore buy FRAs.
55
Forward Rate Agreement (FRA)
❑ Cash settlement. As the loan/deposit is for notional funds Term Which means...
there is no exchange of principal. Cash compensation is
paid at the beginning of the notional loan/deposit period. Contract currency and amount The currency and amount of the
notional loan/deposit
❑ Flexibility. As the loan/deposit is for notional funds there is
no obligation by buyers/sellers in the markets to actually Trade date The date the deal is actually
lend or deposit their funds. Market players can use other made
instruments which offer the best returns for their specific
needs. Fixing date This is two business days before
the start of the FRA. It is the date
❑ Lock-in rate. Like Forward FX contracts, if future interest when the LIBOR, or other,
rates fall the buyer will have to compensate the seller and reference rate is fixed. The
forego any benefit from lower interest rates. Equally, if settlement amount is calculated
interest rates rise the seller has to compensate the buyer. using this rate.
FRAs effectively lock-in future interest rates for market
players. For domestic currency FRAs the
fixing date is usually the same as
❑ Low credit risk. As there is no exchange of principal a FRA the settlement date.
is an off-balance sheet instrument. The credit risk is low
because the main risk is concerned with finding a
replacement counterparty should the original party default. Settlement date This is the date when the
The risk involved is therefore on the settlement amount contract period starts and cash
rather than the notional amount. compensation is paid
❑ Cancellation and assignment. A FRA is a binding contract Maturity date The date the contract ends
and cannot be cancelled or assigned to a third party
without the agreement of both counterparties. As with Contract period This is the term of the notional
other instruments with binding contracts, FRA positions loan/deposit – the period from
can be closed using off-setting contracts. settlement to maturity in days
56
Forward Rate Agreement (FRA)
The events of the following 3 month FRA are summarised here: Before moving on use Money 3000 to have a look at BBALIBOR ... $ $
3 month FRA Use the Benchmark Watch page, MMBW for GBP Derivative
3000 and select BBALIBOR from the drop down menu.
Contract LIBOR Contract Contract
agreed rate fixed starts ends You can also use page FRASETT on the RT to see a
10th April 12th June 16th June 15th Sept list of all the fixings.
Trade Fixing Settlement Maturity
You should see pages similar to those shown here.
▼
Contract period – 92 days
Rules
1. The start and end dates are calculated from spot dates.
2. The fixing date is 2 days before the start date.
57
Forward Rate Agreement (FRA)
$ $ Market pricing of FRAs In most financial centres market-makers quote the bid price first
The FRA is quoted as a two-way price with bid/offer prices in the whereas in London it is the offered rate which is quoted first – the
Derivative same way as for Money Market deposit rates. FRA market-makers take rate at which they sell. Either way the market-taker always pays the
on large trades because the credit risk is low as there is no notional higher rate!
exchange of principal. This means that the bid/offer spreads
available are tighter compared with cash deposit rates – typically 3 – 5 New York London
basis points for Eurodollar FRAs. These tighter spreads are available
only for standard minimum deal sizes of USD 5 million or equivalent.
Prices quoted are for standard or fixed dates. The table below gives
examples of the conventions for 3- and 6-month series of FRAs:
1 x 4 FRA
Contract period
Contract Start – 3 months End
▼
58
Forward Rate Agreement (FRA)
How are FRA prices determined? The Zero coupon yield curve, also known as the Spot curve, is a $ $
In most cases today, FRA prices are derived from short-term Interest graphical representation of the theoretical Yield To Maturity (YTM)
Rate futures contracts for the same currency. For example, estimate of the yield which should be paid on non-coupon bearing Derivative
Deutschemark FRAs are typically priced off the EuroDeutschemark instruments of different maturities, given the yields currently
future contracts traded on LIFFE or MATIF. It is for this reason the available for coupon bearing instruments.
FRA market has been referred to as the new Interbank Future
Interest Rate market. Because of the close relationship between FRAs Before moving on use Money 3000 to have a FRA analysis page...
and the futures market, FRAs are often quoted for the same periods
as are traded on Futures Exchanges. Use the Analysis page, FRA for GBP and select
3000 Deposits-MID, Futures curve and Zero curve from
There are a number of ways FRA prices can be calculated including the drop down menus for the same FRAs in the TV
those derived from: fields. You can now compare the rates derived from
the different methods.
❑ Cash deposits
For example, to price a 3 x 6 FRA the 3-month and 6-month
deposit rates are used.
59
Forward Rate Agreement (FRA)
Trading It is an OTC contract between counterparties. In some Contracts are traded in pits or electronically on an
cases the deal may be made via a broker. Exchange.
Contract terms Amount, period and settlement procedures are Amounts, expiry dates and settlement periods are fixed
negotiated between the counterparties. and standardised by the Exchange.
Confidentiality There are no obligations placed on the counterparties Deals are transacted open out cry or using electronic
to divulge the terms of the contract. Different market- systems. Orders and trades are immediately visible and
makers may well quote different bid/offer prices. transparent to all market players. On an exchange there
is only one market price at any one time.
Margin payments No margin payments are required. Usually Initial margin is paid as a % of the trade amount –
compensation payments are made on the settlement marked-to-market. The margin payments are held by
date. the Clearing House. Variation margin is also paid to the
Clearing House on a daily basis depending on the
market price movement.
Credit risk Each side is taking a risk on the counterparty, so each After a trade is made on the Exchange, the Clearing
side accepts a small credit risk. House stands as the counterparty, acting as seller to
every buyer and vice versa. The Clearing House
guarantees the performance of contracts and so there is
no credit risk to the contract parties.
Right of offset A FRA contract is binding and cannot be cancelled or Futures contracts can be off-set.
assigned to a third party without the agreement of both
sides.
60
Forward Rate Agreement (FRA)
The ways FRAs and futures contracts can be used to hedge a rise/fall ■ Who uses FRAs? $ $
in interest rates is summarised in the chart below:
Banks Derivative
To hedge rise in interest Within banks, Money Market desks are regular users of
To hedge fall in interest
rates FRAs. The larger US, UK, European and Australian banks
rates
are active market-makers and use FRAs for a number of
Futures Sell contract reasons including the following:
Buy contract
Interest Loss Banks make a profit from the bid/offer FRA price spread.
Profit
rate falls
Corporations and non-bank financial institutions
These organisations also use FRAs to manage interest rate risk. The
credit risk to the market-maker is small as it only involves risk to the
potential settlement involved. No premium is paid by clients for FRAs
– the only costs they incur are those for any compensation payments.
61
Forward Rate Agreement (FRA)
(L – R) x D x A ...Equation 1a
Settlement payment =
(B x 100) + (L x D)
(R – L) x D x A ...Equation 1b
Settlement payment =
(B x 100) + (L x D)
62
Forward Rate Agreement (FRA)
Example 1 In either case the XYZ loan will be based on the current LIBOR. The $ $
It is the 10th April 1997 and the XYZ Corporate Treasurer foresees a FRA payment acts as a subsidy bringing down the net cost of
forward funding requirement for 3 months (92 days) from 16th June borrowing. Derivative
to 15th September 1997. The Treasurer thinks that there is a possible
rise in interest rates and therefore wants to hedge against any interest But what would have happened if the Treasurer’s fears of an interest
rate rise. The Treasurer buys a 2 x 5 FRA on the 10th April from rate rise were unfounded and on fixing LIBOR was 6.50%? This time
OkiBank with the following terms: XYZ have to compensate OkiBank. The settlement amount can be
calculated using Equation 1b.
FRA contract amt. $10,000,000
Fixing date: 12th June 1997 (6.75 – 6.50) x 92 x 10,000,000
Settlement payment =
Settlement date: 16th June 1997 (360 x 100) + (6.50 x 92)
Maturity date: 15th Sept. 1997
230,000,000
Contract rate: 6.75% pa =
36598
Year basis: 360 days
= $6,284.50
What is the settlement due if the BBALIBOR 3-month fixing rate is
7.25% the 10th June fixing date, and who receives payment?
Even though XYZ have bought a FRA contract they still have to raise
the funds they require for 16th June to 15th September in the Money
Markets at the increased rate of 7.25%. However, as the interest rates
have risen, OkiBank have to compensate XYZ a cash sum. The
settlement amount is therefore calculated using Equation 1a.
460,000,000
=
36667
= $12,545.34
At this point the FRA contract ceases to exist and the XYZ Corporate
Treasurer can now either reinvest the FRA settlement payment in the
Money Markets or arrange a loan for $10,000,000 – 12,545.34.
63
Forward Rate Agreement (FRA)
▼
Spot 3 months 6 months
B x 100
▼
DS = Number of days from spot to near date Borrow
B = Day basis This means that the Forward/forward Ask rate is calculated in
...Equation 2 Equation 2 using:
Fwd/fwd BID
Borrow
▼
Lend
This means that the Forward/forward Bid rate is calculated in
Equation 2 using:
64
Forward Rate Agreement (FRA)
In many cases FRA strips of contracts are used to hedge against If you need to calculate the effective annual interest rate for a strip of $ $
longer term interest rate rises. A strip is simply a number of FRAs the following equation can be used which is based on Equation 3.
consecutive contracts. For example, a strip of four FRA contracts, Derivative
1 x 3, 3 x 6, 6 x 9, 9 x 12 could be used to hedge for a 12 month Effective annual rate, R =
period. However, if a strip of FRAs are used what is the effective rate
over the whole period as different contract rates are used for each
FRA? [[1+
( )] [ ( )] [ ( )] [ ( )]]
L0 x 3
4
x 1+
F3 x 6
4
x 1+
F6 x 9
4
x 1+
F9 x 12
4
–1
Suppose the following strip of two FRAs spans the two period 0 to n
and 0 to N. The rate of return for the time period n to N can be L0 x 3 = Current LIBOR or reference rate
calculated using an equation based on the interest rates due for the
F3 x 6, F6 x 9, F9 x 12 = FRA rates for periods 3 x 6, 6 x 9
time periods.
and 9 x 12 respectively
Rate = Rate = Rate = ...Equation 4
r RN - n RN
FRA1 FRA2
period period period XYZ Corporation now needs to protect interest rates for a six month
0 n N
period beginning in 6 months time – a 6 x 12 forward position. The
XYZ Corporate Treasurer could use a 6 x 12 FRA. However, a strip of
two 3-month FRAs, 6 x 9 and 9 x 12, offers the Treasurer the
Interest due for
time period, N
= ( Interest due for
time period, n )(
x
Interest due for
time period, N – n ) flexibility of reversing the hedge at the 9 month period if necessary.
The strip also provides a market limit for a 6 x 12 FRA quote.
Therefore: XYZ need to borrow $5,000,000 in 6 months time for a loan period of
6 months, but the Treasurer thinks interest rates will rise in this time.
[ (
1+
RN x N
B x 100 )] [ (
= 1+
r x n
B x 100 )] [ (
x 1+ RN - n x N – n
B x 100 )] The Treasurer investigates quotes from a number of banks offering
FRAs indexed on a 3-month LIBOR basis.
RN - n =
[ ( 1+
RN x N
B x 100 )] – 1 x 360 x 100 6 x 9 (91d) 6.21 – 6.15 6.23 – 6.18
[ ( 1+
r x n
B x 100 )] N
...Equation 3
9 x 12 (92d) 6.28 – 6.22 6.30 – 6.25
65
Forward Rate Agreement (FRA)
$ $ The Treasurer accepts the bid FRA prices from Bank A as the ■ Summary
cheaper and buys a strip of two FRAs – 6 x 9 plus 9 x 12. This
Derivative effectively locks in the interest rates for the 6-month borrowing
period.
Forward Rate Agreement (FRA)
6 x 12 month exposure of $5,000,000
▼
❑ FRAs are OTC contracts used to hedge interest rate risk
Buy @ Buy @ Rate = based on a notional future loan or deposit
6.21% 6.28% ?
Time Time Time ❑ Rises and falls in future Money Market interest rates are
period period period
6 mths 9 mths 12 mths compensated by payments/receipts at the settlement date
▼
❑ FRA contracts involve no transfer of principal. The only
The effective FRA rate for the strip is calculated using Equation 3. cash payments made are those associated with settlement
payments
[ (
1+
R6 x 12 x N
B x 100 )] [ (
= 1+
R6 x 9 x n
B x 100 )] [ (
x 1+ R9 x 12 x N – n
B x 100 )] ❑ Most FRA contracts use LIBOR as the reference rate
[ (
= 1+
6.21 x 91
360 x 100)] [ (x 1+ 6.28 x 92
360 x 100 )] (Start month forward) x (End month forward). For
example, 6 x 12 means the contract starts in 6 months
time and ends in 12 months, therefore lasting 12 months
= 1.0157 x 1.01605
= 1.03200
66
Forward Rate Agreement (FRA)
67
Forward Rate Agreement (FRA)
$ $ From the 3-month and 6-month Bid and Ask deposit rates shown
3000 Exercise. Using the FRMW page in Money 3000 can opposite calculate the forward/forward Bid and Ask rates. Assume 3-
Derivative be useful as you can display Bid and Ask prices for a months is 90 days and 6-months is 180 days.
number of currencies from different contributors
simultaneously. For example, you decide to look at a) Forward/forward Bid rate
3 x 6 rates for DEM FRAs from 3 different contributors in order
to select the best rates for you for buying and selling. You look at
the rates and decide that those from HBEL are best. You now
decide to check these rates and calculate the forward/forward
bid and ask prices from deposit rates you display in the MMMW
page.
68
Forward Rate Agreement (FRA)
■ End check 5. Bank A sells Bank B a 3 x 6 USD FRA at a contract rate of 5.86%. $ $
On the settlement the LIBOR 3-month fixing rate is 5.75%. The
FRA contract details are as follows: Derivative
1. If you as a customer buy a FRA you are:
FRA contract amt.: $50,000,000
❑ a) Protecting against a rise in interest rates Contract period: 90 days
❑ b) Protecting against a fall in interest rates Contract rate: 5.86% pa
❑ c) Taking a cash delivery of principal from the counterparty
Year basis: 360 days
❑ d) Making a cash delivery of principal to the counterparty
a) What is the cash settlement amount involved?
2. Today is the fixing date for a 1x4 FRA which you sold for 5.67%. b) Who receives payment?
LIBOR has been fixed at 6.00%. Which of the following
statements is true? Answer a)
❑ a) You pay the counterparty
❑ b) The counterparty pays you
❑ c) No payment takes place until later
69
Forward Rate Agreement (FRA)
Derivative Exercise ✔ or ✖
a) Forward/forward bid rate = 2.976% 1. a) ❑
Use Equation 2 – for Bid use Far depo Bid and Near depo Ask
(3.0625 x 180) – (3.125 x 90) 2. a) ❑
Interest =
(180 – 90) x
270.00
[ (
1 + 3.125 x 90
360 x 100 )] 3. d)
4. c)
❑
=
90.703125
5. a) $13,555.14 ❑
b) Forward/forward bid rate = 3.349%
Use Equation 2 – for Ask use Far depo Ask and Near depo Bid Use Equation 1b.
(5.86 – 5.75) x 90 x 50,000,000
Settlement =
Interest (360 x 100) + (5.75 x 90)
(3.1875 x 180) – (3.00 x 90)
=
0.11 x 90 x 50,000,000
(180 – 90) x
303.75
[ (
1 + 3.00 x 90
360 x 100 )] =
36000 + (517.5)
=
90.6750 b) Bank B pays Bank A ❑
By inputting the correct details in the FRA you require you can
check your calculations using the Model FRM page.
How well did you score? You should have managed to get most of
these questions correct.
Bid = 2.9762
Ask = 3.3493
70
Interest Rate futures
■ What are they? particular currency deposited outside the country of origin. For $ $
example, a 3-month Eurodollar Interest Rate future is settled based
Interest Rate futures are forward transactions with on US Dollars deposited outside the US. Derivative
standard contract sizes and maturity dates which are
traded on a formal exchange. An exchange traded futures contract has the following characteristics:
Short-term Interest Rate futures contracts are almost ❑ A standardised specification in terms of unit of trading,
exclusively based on Eurocurrency deposits and are cash trading cycle of contract months, delivery days, quotation,
settled based on an Exchange Delivery Settlement Price minimum price movement etc
(EDSP) or the last price traded.
❑ The opportunity to trade the instrument and offset the
Long-term Interest Rate futures contracts are settled original contract with an equal and opposite trade. Very few
based on government bonds or notes with a coupon and contracts, less than 2%, reach maturity
maturity period specified by the exchange.
❑ A public market in that prices for contracts are freely
If you need an overview of futures derivatives or you need available. Trading takes place open outcry on an exchange
to remind yourself about derivatives in general, then you Derivatives floor and prices are published on exchange indicator
may find it useful to refer to the Introduction to Derivatives Section 2 boards, in the financial press and by providers such as
workbook, Section 2 at this stage. Reuters.
Interest Rate futures are some of the most common futures contracts ❑ Once a trade has been made a Clearing house acts as the
traded on exchanges. Their growth stems from the mid 1970s after counterparty to both sides of the trade. The contract is not
the breakdown of the Bretton Woods Agreement in 1973. The directly between buyer and seller. The Clearing house takes
resulting floating exchange rates in currencies created much more on the credit risk should a counterparty default. This is
volatility in interest rates and the subsequent need to hedge important because it means anyone can have access to the
investments. markets provided they have the required creditworthiness
by the Clearing house – in this way large organisations have
The Chicago Board of Trade (CBOT) introduced the first futures no advantage over smaller organisations or investors.
,,
contracts to hedge interest rate exposure in 1975 when it introduced
,,
contracts on the US Government National Mortgage Association
certificates – known as Ginnie Maes. These contracts are no longer
,,
traded but by 1977 CBOT has added contracts on T-Bonds and in
▼
1982 LIFFE started trading futures contracts on 3 month Sterling
time deposits.
▼
▼
Interest Rate futures are essentially forward contracts in underlying
fixed coupon instruments such as bank deposits and government Clearing house
bonds, notes and bills. Short-term Interest Rate futures based on
Eurocurrencies are cash settled based on interest rates for the Buyer Seller
71
Interest Rate futures
$ $ Exchange contracts
Short and long-term Interest Rate futures contracts are traded on
Derivative exchanges worldwide. Some of the more important contracts are
summarised in the charts below.
LIFFE CME
Short-term Cash settled based on LIBOR Unit of trading Short-term Cash settled based on interbank rates Unit of trading
Three month Sterling (Short Sterling) GBP 500,000 Three month Eurodollar USD 1,000,000
Three month Eurodeutschemark (Euromark) DEM 1,000,000 One month LIBOR USD 3,000,000
Three month Eurolira ITL 1,000,000,000 One year T-Bills USD 500,000
Three month Euroswiss Franc (Euroswiss) CHF 1,000,000 Three month Euromark DEM 1,000,000
Three month ECU ECU 1,000,000 Three month Euroyen JPY 100,000,000
Three month Eurodollar USD 1,000,000 13-week US T-Bills USD 1,000,000
(This contract is for physical delivery)
72
Interest Rate futures
73
Interest Rate futures
$ $ This means that a tick has a specific value determined using the Long-term
following equation: The contract specifications for these Interest Rate futures are very
Derivative similar to those for short-term instruments. The major difference is
Tick = Unit of x Basis points x Proportion of year over that settlement is by physical delivery of bonds or notes with coupon
trading 100 which contract runs rates and maturity dates stipulated by the exchange.
Example Although some long-term futures for bonds have prices and
The tick value for the 3-month LIFFE Short sterling contract is: minimum price movements quoted as hundredths of a basis point,
UK Gilts and US T-Bonds are quoted as thirty-seconds of a percentage
point.
= £500,000 x 0.01 x 1
100 4
Example
= £12.50 A UK Long Gilt futures quoted at 111-23 means a price of 111 23/32.
However there are indications that the market convention for UK
On the last day of trading, if a futures position is still open, most Gilts and US T-Bonds may be changed in the near future to that of
short-term Interest Rate futures are cash settled against the EDSP. using basis points.
The exception is the 13-week US T-Bills contract which involves
physical delivery of the instruments. Tick values are easy to calculate for long-term futures:
The EDSP depends on the exchange but typically involves a Tick = Unit of trading x minimum price movement
calculation of interest rates for the Eurocurrency deposit in question.
For example, LIFFE use the British Banking Association Interest
Settlement Rate (BBAISR) and the CME uses an average of a survey The contract details for CBOT T-Bonds are shown opposite.
of rates of the London interbank rates for Eurodollars, LIBOR and
Euromark.
On the last day of trading the futures contract ceases to exist and the
underlying cash market instrument and futures prices are the same.
It is the difference in contract and settlement prices that is paid in
cash – as the principal of these contracts is notional no delivery can
take place on expiry .
74
Interest Rate futures
Quotation Points and 32nds The futures price is quoted At the delivery date the 3-month LIBOR stands at 6.10% which
of point according to the type of represents a price of 100 – 6.10 = 93.90.
future
Minimum 1/32 of a point The contract has therefore gained in value and the number of ticks
price equals 93.90 – 93.75 = 15.
movement
(Tick size ($31.25) This is the smallest amount The profit on the contract = 15 x £12.50 x 2
and value) a contract can change = £375.00
value and the ‘tick’ size
Trading 07.20 – 14.00
hours Chicago time Exchange trading hours –
open outcry
Project A 14.30 – 16.60
Trading hours 22.30 – 06.00 Computer-based trading
system hours
75
Interest Rate futures
Financial press – Short-term Interest Rate futures Financial press – Long-term Interest Rate futures
LIFFE 3 month Sterling Futures £500,000 points of 100% CBOT Treasury Bonds $100,000 points 32nds of 100%
Reuters 3000 – LIFFE Short and Long-term Interest Rate futures Reuters 3000 – CBOT Short and Long-term Interest Rate futures
76
Interest Rate futures
■ Who uses Interest Rate futures? As in any futures market place for commodities, hedgers can hold $ $
long or short positions and in order to hedge their positions market
Hedgers and speculators players need to take an opposite position to the ones they hold. Derivative
Originally futures contracts were devised so that holders
of an asset could hedge or insure its price today for It is important to understand that the principle of hedging is to
sometime in the future. Hedgers seek to transfer the risk maintain a neutral position. As prices in the cash market for the asset
of future price fluctuations by selling future contracts which move one way, the move is compensated by an equal and opposite
guarantee them a future price for their asset. If the future cash price move in the futures’ price. You can imagine the situation similar to
of their asset falls then they have protected themselves. However, if the movement of the pans on a pair of scales.
the future cash price rises then they have lost the opportunity to
profit. Hedging offers some degree of certainty for future prices and
therefore allows market players to fix prices, interest rate payments or
receipts etc.
❑ Hedgers already holding positions who need to offset their A borrower, who intends to hold cash, needs to protect against the
positions possibility that spot prices fall with a corresponding rise in interest
rates. A short hedge will therefore lock in a selling price.
❑ Speculators with market views on likely price changes who
provide the futures markets with extra liquidity Going long futures
If a market player is short, or intends to go short, in the cash market,
then the opposite position in the futures markets means he must go
long or buy futures.
77
Interest Rate futures
$ $ Another way of considering market players using Interest Rate futures Sellers of Interest Rate futures
contracts is to look at whether they are buyers or sellers of the
Derivative contracts. ❑ Agree to deliver the underlying instrument and
therefore go short.
Buyers of Interest Rate futures
❑ Are borrowers and are hedging against any rise in interest
❑ Agree to take delivery of the underlying instrument and rates. If interest rates do rise, then any losses in selling the
therefore go long. underlying in the future are offset by gains from the futures
contracts on delivery.
❑ Are lenders and are hedging against any fall in interest
rates. If interest rates do fall, then any losses in buying the The diagrams below show how the losses in the underlying
underlying in the future are offset by gains from the futures instrument are offset by gains in the futures market.
contracts on delivery.
Underlying market Futures market
The diagrams below show how the losses in the underlying
Profit
Profit
instrument are offset by gains in the futures market. Futures price
Cash price
falling falling
+
rising
Underlying market Futures market rising
–
Profit
Profit
Loss
Loss
Cash price Futures price
falling
+
rising
Net cash loss Net futures gain
falling rising
–
Loss
Loss
In summary:
Net cash loss Net futures gain Short hedge Long hedge
As interest rates So futures prices • Protects against rise • Protects against fall
in interest rates in interest rates
Rise Fall
• Locks in selling price • Locks in buying price
Fall Rise
• Used by borrowers • Used by lenders
78
Interest Rate futures
Number of = £1,000,000 = 2
For most short-term Interest Rate futures this equation reduces to: contracts required £500,000
It is 11th September and the loan is rolled over and interest rates
Number of = Sum to be hedged
have risen to 6.75%. What is the result of the Treasurer’s hedge?
contracts required Unit of trading
Money markets Futures market
In the examples that follow the sums to be hedged have been 12th June
selected to match unit of trading amounts to simplify the Fears of interest rate will rise from Sell 2 x Sept contracts at 93.50
calculations. 6% (implied interest rate of 6.5%)
30th April
Roll over loan at 6.75%% Buy 2 x Sept contracts for 92.75
(implied interest rate of 7.25%)
to close position
79
Interest Rate futures
$ $ So by selling the futures contracts the Corporate Treasurer has Suppose the following:
hedged the expected rise in interest rates. He has to borrow at a 1st July 31st July
Derivative more expensive rate in the Money Markets but this is compensated by
the gain in buying the futures cheaper than they were sold originally. 30-Day Fed Funds futures price 94.56 95.16
The hedge would also have worked if rates had fallen. The Corporate Implied 30-Day interest rate 5.44% 4.84%
Treasurer would have borrowed at a lower rate in the Money Markets
thus making a gain which would have been offset by a loss on the
futures because they would have risen in price from the original sale
On 1st July the rates have fallen, as expected by the Treasurer to
price.
4.80%. What is the result of the Treasurer’s hedge?
Long hedge – buying futures
Money markets Futures market
A long hedge is typically used by lenders of cash market funds who
need to fix an interest rate for a future date and are worried that
1st July
interest rates might fall.
Deposits $50 million at 4.80% Buy 10 futures at 94.56
Example
31st July
It is 12th June and a Corporate Treasurer has USD funds to lend in
Receive back $50 million plus Sell 10 futures at 95.16
July. The Treasurer is worried that rates may fall during June thus
interest at 4.80% for 1 month.
affecting the interest he is likely to receive.
Interest = $206,666.66 Gain on long position =
60 ticks x $41.67 x 10 =
The Corporate Treasurer will have $50 million to lend and decides to
$25,002.00
hedge his position using CBOT 30-Day Fed Funds futures. The unit
of trading is $5 million and the tick size is $41.67 per basis point.
Net gain on position = 206,666.66 + 25,002.00 = $231,668.66
Number of contracts required =
Net % return = 231,668.66 x 360
50,000,000 31 50,000,000 31
x x 12 = 10.33
5,000,000 30 x 12
= 0.0538
This means that the Treasurer has to buy 10 contracts – a perfect = 5.38%
hedge is not possible – and hold the futures until maturity or close
out prior to expiration. The perfect hedge requires a 5.44% return, but as only 10 contracts
could be bought, this compares well with a cash market return on
unhedged funds at 4.80%.
80
Interest Rate futures
▼
FRA Rate
A trader is expecting that the June balance of trade figures will be futures
better than expected causing short-term interest rates to fall and
therefore futures prices to rise. Based on this view the trader buys one The two instruments are compared in the table below.
3-month June LIFFE Short sterling contract at 93.55. This implies a 3-
month GBP interest rate of 6.45%. FRA Interest rate future
The next day the trader is viewing the news on his RT and is proven • Flexible • Standard contract
correct – interest rates have fallen by 0.5%. The trader therefore sells terms
his contract at the new market price of 94.05 and gains 50 ticks. • OTC market
• Exchange traded
His profit is 50 x £12.50 x 1 = £625.00. • No margin required
• Margin required
Suppose, however, that the trade figures had been worse than • Credit risk between
expected and interest rates had risen by 0.5%? The trader would have counterparties • No credit risk as
closed out the contract at 93.05 and made a loss of 50 ticks which is clearing house stands
£625.00. • No right of offset as counterparty
The chart below compares the relative ways in which the two
instruments are used to hedge interest rate price movements.
To hedge an
Fall Rise
interest rate ..
81
Interest Rate futures
$ $ ■ Interest Rate futures in the market place The process is illustrated as follows:
On the contract date
Derivative This section deals with a number of important matters
The Seller sells a contract to the Buyer and both deposit initial
concerning Interest Rate futures which you will need to
7 8 9
margin with the Clearing house.
,,
4 5 6
1 2 3
understand.
0
▼
▼
which acts as the counterparty to both sides. The initial margin is only
a small percentage of the contract price and it is used to cover daily
price movements of the futures’ price in relation to the agreed price.
Clearing house
Each day the futures’ position is marked-to-market which means it is
revalued at the current market price. Any profits and losses are paid Buyer Seller
over daily. By marking-to-market and settling all positions daily the
Clearing house effectively rewrites all futures contracts at the
prevailing market price. During the contract
The Seller’s and the Buyer’s profit and loss accounts are adjusted
If the initial margin is depleted then extra margin – variation margin daily.
,,
– is required. If a profit is made the account will receive it and it may
,,
be withdrawn. The system of maintaining the correct margin ensures
that the loser can bear any losses and the winner is credited with
,,
gains.
▼
variation variation
Dealing on margin is an example of gearing or leverage. Gearing margin margin
allows investors to make a larger investment than could otherwise be payment payment
▼
afforded. Small investments are used to generate large profits,
however, losses can be correspondingly large! For example, a £1000 Clearing house
investment in a futures contract is equivalent to buying a basic
investment of £10,000 – 20,000. Buyer Seller
As the expiry date of the contract approaches the futures price will
equal the current instrument price and so the differential is not very
large. This is why the vast majority, over 98%, of futures contracts are
closed out before the contract reaches the agreed expiry date.
82
Interest Rate futures
On the delivery date or contract closure Advantages and disadvantages of Interest Rate futures $ $
The Seller’s and the Buyer’s profit and loss accounts are settled for The following chart summarises the advantages and disadvantages of
the last time. Interest Rate futures: Derivative
,,
,,
Advantages Disadvantages
,,
▼ • Markets in the major • Only a limited number of
▼
variation variation contracts for Eurodollars, contracts available
margin margin US T-Bonds and UK Gilts are
payment payment large and very liquid • It can be difficult to hedge
positions exactly – matching
▼
▼
Clearing house • The use of margin payments exact amounts and required
allows highly leveraged dates is not always easy
Buyer Seller positions
• When hedging long-term
• Contracts can be bought and futures, the price/yield
sold without having to own relationship varies
the underlying continuously with time and
therefore the hedge ratio
• Most contracts are offset and varies continuously
only a very small percentage
expire resulting in delivery • The mark-to-market
settlement system can lead
to large cash outflows for
adverse price movements
• Trading is usually
concentrated in near month
contracts
83
Interest Rate futures
$ $ Trading strategies for Interest Rate futures Have a look at the prevailing futures prices that the Treasurer sells
There are a number of strategies that traders adopt in order to hedge the contracts:
Derivative positions which do not have ‘perfect’ matches in the futures markets.
The simplest strategies used are: Sell 10 Sept contracts at 94.29 Implied rate 5.71%
Sell 10 Dec contracts at 94.27 Implied rate 5.73%
❑ Futures strips Sell 10 Mar contracts at 93.95 Implied rate 6.05%
Sell 10 Jun contracts at 93.56 Implied rate 6.44%
❑ Stacking futures
Using a strip of futures has effectively locked in the interest rate for
❑ Spread trading the forward 12 month period but what is the rate. The average of the
four interest rates is 5.98% but unfortunately the calculation is not
Futures strips that simple!
These are used to hedge interest rate exposures which span several
futures expiry dates, or span dates which do not exactly match The general equation to calculate a forward-forward rate is given
futures expiry dates. below:
Example
F a x b = Forward starting in a days and ending in b days
It is early June and a Corporate Treasurer calls a bank to ask for the
price of a one year deposit loan for £5 million starting in September
La = Long period interest rate as a decimal
– a 3 x 15 forward price. The Treasurer is worried that rates will rise
in the next three months and wishes to hedge the current loan
Lb = Short period interest rate as a decimal
interest rates. The period required for the hedge spans four
consecutive, futures expiry dates and the Treasurer can sell a strip of
da = Long period in days
four futures. The number of contracts required to sell ( borrow
effectively) is 10 per contract – the unit of trading for the contract is
db = Short period in days
£500,000.
84
Interest Rate futures
The rate is in fact a compound of the notional quarterly interest rate Stacking futures $ $
payments given by the following equation: Suppose in the previous example that the September futures contract
was the only one available. There is still a risk that interest rate will Derivative
rise over the next year but the Treasurer has only one contract
F = 1 –
[( 1 +
4)(
R1 R
)
x 1 + 2 x...
4 ( 1 +
Rn
4 )] available.
Suppose in September, the one year LIBOR is 6.75%. If the Treasurer Futures stack Sell 10
had accepted a quote of 6.12% then the loss covering the cash loan
would have been 5,000,000 x 0.0063 = £31,500. Sell 10
However, if the Treasurer closes out 10 contracts for each period by Sell 10
buying, then the gains are as follows. For each contract subtract the
buy from the previous sell price and to calculate the profit multiply Sell 10
the number of ticks by £12.50 and by 10 for the number of contracts.
The hedge is not perfect but a large loss which could have resulted
from not hedging the deposit has been averted.
The use of strips is restricted to prices for the far months required,
but what happens if this is not the case?
85
Interest Rate futures
Market players need to monitor basis and basis risk to hedge futures
to maximise profitability. It is also important to remember that
futures are marked-to-market daily which means that the underlying
Money Market exposure being hedged must be revalued daily.
86
Interest Rate futures
87
Interest Rate futures
88
Interest Rate futures
$ $
RT You may also find the Exchange Traded Interest 3000 The Futures folder, IR Watch page, IFW, is useful Derivative
Rate Futures Speed Guide useful. These pages list for any particular currency to compare short and
all the contracts and easy access to chains of prices. long-term futures contracts. In the Contract 1 and 2
Type in FUT/IR1 and press Enter. Use the F12 and fields enter the details you require. In the example
F11 keys to page up and down respectively. here LIFFE Short sterling and Long Gilt information is displayed.
89
Interest Rate futures
$ $
Derivative 3000 The IFW page can also be used to display one of the 3000 Finally the IFW page can be used to display details
most important futures contracts – the IMM 3- of similar futures contracts offered by different
month Eurodollar contract. The example here exchanges. In the example here you can compare
shows details for the IMM 3-month Eurodollar prices of Euroyen contracts from LIFFE and SIMEX.
contracts and the long-term CBOT US T-Bonds contracts.
90
Interest Rate futures
■ End check 5. A trader at XYZ Bank thinks that trade figures will be better than $ $
expected resulting in a short-term interest rate fall. He buys 5
June LIFFE 3-month Short sterling contracts at 93.72. The Derivative
1. Which of the following interest rates is implied for a LIFFE 3- contract’s minimum price movement is 0.01 and the tick value is
month Short sterling futures contract with a price of 93.18? £12.50.
❑ a) 5.82% a) What is the implied interest rate for the contract?
❑ b) 6.72% b) If the trader is correct and interest rates fall and he sells the
❑ c) 6.82% contract at 93.17, how much profit does the dealer make?
❑ d) 7.82% c) If the trader is wrong and he has to close the contract at 94.03,
what is his loss?
2. If you place an order for a futures contract, when will you be
required to pay initial margin? Answer a)
❑ a) At expiry of the contract
❑ b) Only if you buy a contract
❑ c) At the time of trading the contract
❑ d) Only if you sell a contract Answer b)
3. When trading in futures, credit risk lies with which of the
following?
91
Interest Rate futures
Derivative ✔ or ✖
1. c) ❑
2. c) ❑
3. a) ❑
4. b) ❑
5. a) 6.28% ❑
Implied interest rate = 100 – 93.72
= 6.28
b) £3437.50 ❑
Contract moves 93.72 – 93.17 = 0.55 = 55 ticks
Therefore profit = 55 x £12.50 x 5 = £3437.50
c) £1937.50 ❑
Contract moves 94.03 – 93.72 = 0.55 = 31 ticks
Therefore profit = 31 x £12.50 x 5 = £1937.50
How well did you score? You should have managed to get most of
these questions correct.
92
Interest Rate Swap (IRS)
■ What is it? The growth of IRSs can be traced to the early 1980s. But why have $ $
these long term OTC derivatives become so important? IRSs are
An Interest Rate Swap is an agreement between characterised by the following: Derivative
counterparties in which each party agrees to make a
series of payments to the other on agreed future dates ❑ The interest amounts for both sides of the agreement are
until maturity of the agreement. Each party’s interest calculated from the same notional principal amount. This
payments are calculated using different formulas by means that there is no physical exchange of the principal.
applying the agreement terms to the notional principal Therefore the risk involved in the swap is reduced to that of
amount of the swap. assessing the credit risk that the other side may default on
their interest rate payments.
If you need an overview of swap derivatives or you need to
❑ The two rates of interest are calculated for the same
remind yourself about derivatives in general, then you Derivatives
currency.
may find it useful to refer to the Introduction to Derivatives Section 4
workbook, Section 4 at this stage.
❑ The interest payments between both parties are usually
netted so it is only the difference in payments which is paid
IRSs are the most important of the OTC swap derivatives currently
to one side or the other. It is for this reason that IRSs are
traded in the global markets. An IRS is in effect an agreement which
sometimes known as contracts for difference.
allows both parties access to better interest rates than they would
normally receive in the markets.
The OTC nature of IRSs means that their terms and conditions can
be very flexible. However, in practice, most agreements are for plain
In other words Party A and Party B both borrow the same amount, at
vanilla – fixed-for-floating – swaps. One side pays a fixed rate whilst
the best interest rates they can and then swap the interest rate
the other pays a floating rate – the situation illustrated in the original
payments to the benefit of both parties. The cost of borrowing for
diagram opposite.
both parties is reduced without altering the underlying principal
loans. The interest rates bases for the loans are therefore separated
Floating-for-floating swaps are available but terms and conditions
from the underlying instruments.
involved with these can be quite complex.
,,
▼
Party A Party B
93
Interest Rate Swap (IRS)
Derivative International Swaps and Derivatives Association (ISDA) issue Date: July 1, 1997
To: OkiBank
standard terms and conditions relating to a range of swap derivatives. Attention: Swaps Group Leader
From: MegaBank
Once an agreement is made, most confirmation notes include the
relevant information. For example, a plain vanilla IRS confirmation We are pleased to confirm our mutually binding agreement to enter into a Rate Swap Transaction with
you in accordance with our telephone conversation with Mr. Deal on July 1, 1997, pursuant to the Master
note typically includes: Interest Rate Exchange Agreement between us dated as of July 1, 1997.
date. These are the same conventions as used MMI:DEP MegaBank Calculation Periods for Payments:
for Money Market deposits. First period: Effective Date to but excluding January 5, 1998.
Last period and End Dates: Each July 1 and January 1 after the first Period End Date,
subject to the Modified Following Banking Day convention, and
finally the Termination Date.
❑ Termination date OkiBank Calculation Periods for Payments:
This is the end date of the contract – the date of the final First period: Effective Date to but excluding July 1, 1998.
Last period and End Dates: Each July 1 after the first Period End Date, subject to the
difference in interest payments. Modified Following Banking Day convention, and finally the
Termination Date.
By By
94
Interest Rate Swap (IRS)
IRSs are the most important of the swap derivatives both in terms of The ISDA data also shows that IRSs involving the USD dominate the $ $
the face value of OTC contracts not yet settled – the notional markets. The chart below indicates the top five currencies by
outstanding values, and in terms of the average daily turnover. The percentage market share based on the USD equivalent of notional Derivative
following statistics are taken from the BIS Report 1995: Central Bank principal outstanding.
Survey of Foreign Exchange and Derivatives Market Activity. Currency % Market USD billion
equivalent
Derivative Outstanding notional Average daily turnover
USD billions USD billions USD 34.12 4,371.7
JPY 22.61 2,895.9
Interest Rate Swap 18,283 62 DEM 11.23 1,438.9
FRF 9.52 1,219.9
Currency swap 1,957 7 GBP 6.67 854.0
Other 15.85 2030.6
The latest data from the ISDA Summary of Market Survey Statistics: 1995 Total 100.00 12,811.0
Year End confirm the dominance of the IRS markets as the chart
below shows.
12
9 JPY
Other
6
GBP
3,704
FRF DEM
3
1,197 Source: ISDA
0
Interest Interest Currency
Rate Swaps rate options swaps
Source: ISDA
95
Interest Rate Swap (IRS)
$ $ ■ Who uses IRSs? It is this access to different markets which in effect provides credit
arbitrage in the markets. The difference in organisations‘ credit
Derivative Banks and corporations ratings can result in considerable differences in yield gaps on fixed
The ISDA data below shows that the market players using rate debt such as bonds and floating rates paid on loans. Many bond
IRSs the most are banks and multinational corporations. issues are swap driven because issuers can take advantage
of IRSs to swap the interest payments on the funds raised
Market player % of users based on into a different rate basis. Often these transactions also FXI:CSP
year end outstandings involve a Currency swap which effectively converts a
domestic loan into one for a foreign currency.
Corporations 24
Banks 53 Organisations with good credit ratings usually find it easier to borrow
Institutional investors 7 at fixed rates, whilst those with lower ratings tend to get their best
Government 9 terms on a floating rate basis.
Other 7
Have a look at the following example to see how a plain vanilla IRS
Total 100 works between the XYZ and AYZ Corporations. The original lenders
of the loans on both sides need not even know that the
counterparties have entered into a swap agreement.
IRSs are used increasingly by these market players for two main
reasons:
Example – a plain vanilla IRS
❑ To hedge exposure on interest rates Consider the following situation:
❑ To speculate in the swaps markets in order to make a profit XYZ is a multinational corporation with a credit
from offsetting fixed/floating rate transactions rating of AAA. XYZ needs to borrow $50 millions
for 5 years. XYZ can borrow at a low fixed rate but
IRSs also offer the following benefits to corporations and banks: would prefer to take advantage of a floating rate
basis loan. XYZ would like to take advantage of floating rates in order
❑ Counterparties are able to convert underlying interest rates to maximise any interest rate gaps.
from fixed to floating and vice versa over a long term
period AYZ is a corporation with a lower credit rating of
BBB who also need to raise $50 millions for 5
❑ Usually there are cost savings to both sides years. Because of AYZ‘s lower credit rating
borrowing on a floating rate basis or issuing a
❑ IRSs provide access to markets not normally available to the bond with a high value coupon is easier than obtaining a fixed rate
market players, for example, for reasons relating to credit loan. AYZ would prefer a fixed rate loan in order to predict future
rating interest rate payments.
96
Interest Rate Swap (IRS)
Required basis Fixed Floating Pays fixed rate of Pays floating rate
10% to lender of LIBOR + 1% to
lender
In order to obtain the type of loan both corporations require they
enter into a swap agreement. Both corporations need to assess the
risks involved if the other side defaults on payments – if this does
happen then the party who does not receive an interest payment still
has to pay the interest due on the underlying loan.
97
Interest Rate Swap (IRS)
,,
Thus using the swap there is a net saving of 1.00% which in this case
is split 0.75%/0.25% in favour of XYZ which is the organisation with
the better credit rating.
Fixed rate Fixed rate
,,
,,
▼
Originally swaps were arranged directly between counterparties with
banks merely acting as agents for both sides. Now many banks act as
▼
intermediaries and make a two-way market in swaps by taking one
side of the transaction. Floating rate Floating rate
Market-maker
Party A Party B
Of course, the market-maker does not enter into these swaps for no
reward. The intermediary is paid a fee which is either based on the
principal notional amount involved, a spread between the two-way
prices quoted for swap repayments – the swap rate, or both.
In the US and to a lesser extent in the UK, swap rates are quoted over
the yield on a Treasury note with comparable maturity.
98
Interest Rate Swap (IRS)
Savings – 0.25%
99
Interest Rate Swap (IRS)
$ $ The convention of quoting a swap rate as described separates the Your notes
credit risk element from the general interest rate in the market.
Derivative However not all currencies have well developed government Treasury
instruments across a range of maturity dates. In these cases swap
dealers will quote all-in prices as a total rate.
100
Interest Rate Swap (IRS)
[( )]
2
101
Interest Rate Swap (IRS)
102
Interest Rate Swap (IRS)
Swap valuation The interest payments are netted between XYZ and AYZ based on the $ $
Consider a plain vanilla IRS in which XYZ Corporation borrow $100 following calculation:
millions for 5 years at a floating rate but enter into an IRS agreement Derivative
with AYZ Bank to make fixed rate payments at 9.00% every 6 months. LIBOR – 9 x $100 millions x No. of days in 6 month period
In return the swap dealer, AYZ, will pay a floating rate of LIBOR every 360 x 100
6 months.
9.00% Fixed Depending on the value, either XYZ or AYZ receive the net payment.
At the start of the plain vanilla swap the derivative has no value to
either party. The interest rates that have been agreed for both sides
are determined so that the present value – the value the swap will
LIBOR Floating have at a future date – of the fixed side equals the present value of
XYZ AYZ
Both payments are the floating side taking into account the conditions of the agreement.
made every 6 months
If the terms of the agreement remain constant then neither side gain
The spot rate for the transaction is 1st June so the first payment is or lose at the expense of the other.
due on 1st December. The amount of interest due on the 1st
December is already known on the 1st June. How can this be the However, suppose interest rates rise and LIBOR increases. In this case
case? The answer is that LIBOR for the first payment is fixed on the XYZ will gain at the expense of AYZ because XYZ pays a fixed rate
1st June as the floating rate to be paid in 6 months time. In a similar and receives a floating rate which has just increased. So the swap now
manner the 1st December LIBOR fixing determines the rate to be has a positive value to XYZ which can be considered to be an asset.
paid for the second payment on the following 1st June and so on The actual value of the asset can be calculated from the difference in
until the final payment in 5 years. present values. Unfortunately in the case of AYZ the swap has a
negative value and is considered to be a liability.
1st June 1st Dec. 1st June
There are two basic ways that swaps can be valued:
1st June Use LIBOR Use LIBOR
from from
1st June 1st Dec. ❑ Pricing from swap curve
LIBOR Net LIBOR Net LIBOR Using the spot curve method produces a more accurate figure than
➝ ➝
➝ ➝
fixed fixed fixed
payment payment the swap curve method, but the calculations involved can be quite
made made complex. Both methods of pricing involve calculations for bonds
which are dealt with in more detail in the Debt Instruments workbook.
Why Debt Market instruments? Read on...
103
Interest Rate Swap (IRS)
$ $ Pricing from the swap curve Example – Fixed side – Straight bond: Floating side – FRN
Yield curves are an essential part of valuing future cash flows and Suppose a plain vanilla swap has been arranged between XYZ
Derivative calculating forward interest rates. Plain vanilla swap rates are priced Corporation and AYZ Bank for a $100 millions notional principal
from benchmark bond yield prices as has already been mentioned. amount for a 3 year period. On the fixed side the payments are
The benchmark Yield To Maturity (YTM) curves are used for pricing 9.30% on an annual basis; on the floating side the payments are 12
over a range of maturities. months LIBOR.
The cash flows over the 3 year period would look something like
those shown in the chart below.
104
Interest Rate Swap (IRS)
XYZ and AYZ enter into the swap on the stated conditions. On the The present value for the floating side can be calculated using the $ $
spot date LIBOR is fixed at 7.50% for the first payment. As has been more direct relationship between the present and future value of an
mentioned the swap has no value at the start of the agreement. On instrument, Equation 2. Derivative
the first payment date the 3 year swap rate is now quoted at 9.00% on
the fixed side and 12 months LIBOR is fixed at 7.79%. What is the
Future Value
value of the swap now? Is the swap an asset or a liability to the receiver PV =
of the fixed side? (1 + R)
Principal + Interest due
What is the value now of the swap that matures in the future? The =
present value of the fixed side can be calculated using the general (1 + R)
straight bond valuation equation. For a bond with an annual coupon
this is Equation 1. Where: R = Discount or LIBOR rate
as a decimal ...Equation 2
C C (C + 100)
Present Value (PV) = + + ...+
1 + R (1 + R)2 (1 + R)n
In this example then: Principal = 100 millions; Interest = 7.50;
R = 0.0779. Because the floating rate is based on Actual/360 the
Where: C = Coupon rate values used need to be adjusted to a 365 day year.
R = Discount or swap rate as a decimal
n = Number of years to maturity
...Equation 1
[ 100 +
( 7.50 x 365
360 )]
PV =
In this example then: C = 9.30%; R = 0.090; n = 3
= $100.7594 million The net value of the swap is therefore $1.03 millions in favour of the
fixed side. This is because the swap rate quoted by the bank at the
end of the first payment is less than the coupon rate of 9.30% on the
position. The floating side has lost value because LIBOR has
increased.
105
Interest Rate Swap (IRS)
$ $ Treating the value of a swap as the difference between a straight bond Pricing from the spot curve
and a floating rate instrument gives rise to market-makers hedging or The Yield To Maturity (YTM) curve is simply a graph of YTM values
Derivative warehousing a swap position by temporarily buying or selling the of bonds against maturity period. Unfortunately this is a simplistic
underlying bond. view of yields and it is better to use a graph of spot rate against
maturity period. The spot rate is a measure of the YTM on an
The payer of the fixed side buys the underlying which can then be instrument at any moment in time which takes into account a variety
sold to offset the position if the swap rates fall. of market factors. A graph of spot rate against maturity is known as a
spot curve. It is also known as a Zero Coupon yield curve because the
The receiver of the fixed side sells the underlying to offset any losses spot rate for an instrument is equivalent to the yield on an
if swap rates rise. instrument which has no coupon repayment – zero coupon. This
means that spot rates for a series of instruments with zero coupons
The calculations here are quite complicated and time consuming to for a range of maturity periods can be compared directly.
perform. In practice, traders will often use a graphical representation
to assess the relationship of the swap with a benchmark instrument of The curves represent the perceived relationship between the return
the same maturity. The graphical representation used is the spot on an instrument and its maturity – usually measured in years.
curve or Zero Coupon yield curve. Depending on the shape of the curve it is described as either:
❑ Positive
❑ Negative or inverse
106
Interest Rate Swap (IRS)
The shapes of ‘theoretical’ yield curves are shown below – in practice How does the spot curve help in pricing a swap? A more accurate way $ $
they may not appear so clear! of considering an IRS is to consider the instrument as a series of fixed
cash flows on one side combined with a series of notional Derivative
Positive yield curve floating cash flows on the other which are considered as a
MMI:FRA
strip of FRAs or futures contracts.
Maturity
107
Interest Rate Swap (IRS)
❑ Plain vanilla swap ❑ Accreting swaps have notional amounts that increase in
steps over the life of the swap
❑ Forward start swap
This is a fixed-for-floating IRS in which the accrual date of ❑ Amortising swaps have notional amounts that decrease in
the swap for the first interest period starts sometime after steps over the life of the swap
the spot date. This type of swap can still be considered as a
strip of FRAs on the floating side except the near FRAs have These types of swaps are used in real estate markets where developers
been removed. Forward start swaps are often used to hedge seek to lock in the interest cost of future floating rate borrowings
against forward interest rate movements. which either diminish or expand over time. The following charts
illustrate these swaps.
❑ Swaption
This is similar to a forward start swap to which has been Accreting swaps
added the option whether or not to start the swap on the
Notional amount
accrual date. Hence the name is derived from the fact it is
an option on a swap. One counterparty buys the option,
whilst the other writes or sells the option.
Notional amount
There are many types of structured swaps available now – some of the
more common types are briefly discussed next.
Maturity
108
Interest Rate Swap (IRS)
109
Interest Rate Swap (IRS)
Derivative
110
Interest Rate Swap (IRS)
Double-clicking on this
price displays this screen
111
Interest Rate Swap (IRS)
$ $
Derivative 3000 Use the Multiple Watch page, SWMW, in the Swaps
folder to view up to three different contributor
quotes for the same currency. Different contributors Fixed/floating terms
may use different swap terms so you may need to
check this in the Basis fields. You can also compare up to three
different currency swap rates in this page.
You may also find it useful to use the Model page, SWM. Enter
the details of the swap you are interested in and the fixed/
floating payments are calculated and displayed in the Cash Flow
Analysis fields.
Fixed/floating
cash flows
112
Interest Rate Swap (IRS)
3. A client asks you to quote for a 2 year GBP IRS. You quote
7.43 – 7.39. The client deals at 7.39. What have you done?
❑ a) 6.750%
❑ b) 6.800%
❑ c) 7.375%
❑ d) 7.425%
113
Interest Rate Swap (IRS)
Derivative ✔ or ✖
1. c) ❑
2. a) ❑
3. c) ❑
4. d) ❑
How well did you score? You should have managed to get most of
these questions correct.
114
Options on Interest Rate futures
■ What is it? The relationship between the rights and obligations for the different $ $
types of options is summarised in the following diagram – you may
An Interest Rate option is an agreement by which the find it useful to refer to when considering some of the examples Derivative
buyer of the option pays the seller a premium for the which follow.
right, but not the obligation –
Options
to buy a call option
at an agreed price Strike price for the Right but not Obligation to: Right but not Obligation to:
interest rate obligation to: obligation to:
• Buy underlying • Sell underlying • Sell underlying • Buy underlying
instrument instrument instrument instrument
If you need an overview of options or you need to remind • At the strike • At the strike • At the strike • At the strike
yourself about derivatives in general, then you may find it Derivatives price price price price
useful to refer to the Introduction to Derivatives workbook, Section 3 • If the call is • If the holder • If the put is • If the holder
Section 3 at this stage. exercised decides to buy exercised decides to sell
115
Options on Interest Rate futures
$ $ Interest Rate options are financial derivatives first introduced in the Exchange traded Interest Rate options
1980s to hedge interest rate exposure. The underlying instrument for Interest Rate options on an exchange
Derivative can either be for cash or for Government bonds. Exchange traded
If the option is Exchange traded, then it is settled using the same options are standardised in terms of :
conditions as for the underlying futures contracts. There are two
types of Exchange traded options on futures contracts: ❑ Underlying instrument and its trading amount
❑ Options on short-term Interest Rate futures contracts which ❑ Strike prices – in general exchanges try to have a range of
are cash settled if the option expires In-The-Money, At-The-Money and Out-of-The-Money strike
prices
❑ Options on long-term Interest Rate futures contracts which
are settled on Government bonds if the option expires ❑ Expiry dates
OTC Interest Rate options are used to control maximum ❑ Style – most exchange options are American
and minimum levels of borrowing and lending money
and are in effect options on Forward Rate Agreements MMI:IRG ❑ Premium quotations – these are percentage rates expressed
(FRAs). These options are described in greater detail in in decimal points for short-term contracts and as fractions
the section Options on FRAs – Interest Rate Guarantees. for long-term contracts
The diagram below indicates the availability of Interest Rate options. ❑ Margin payments are required to be paid to the Clearing
house
Interest Rate options In effect Interest Rate options on futures give the buyer or the seller
of the instrument the right to lend or borrow money. The following
chart indicates these rights from the buyer’s perspective – sellers
would have the opposite views.
116
Options on Interest Rate futures
Exchange contracts $ $
Options on both short-term and long-term Interest Rates are
available on a number of exchanges worldwide. The charts below Derivative
indicate a selection of the Interest Rate options on futures available.
LIFFE CME
Short-term Cash settled based on LIBOR Unit of trading Short-term Cash settled based on interbank rates Unit of trading
Three month Sterling (Short Sterling) GBP 500,000 Three month Eurodollar USD 1,000,000
Three month Eurodeutschemark (Euromark) DEM 1,000,000 One month LIBOR USD 3,000,000
Three month Eurolira ITL 1,000,000,000 One year T-Bills USD 500,000
Three month Euroswiss Franc (Euroswiss) CHF 1,000,000 Three month Euromark DEM 1,000,000
13-week US T-Bills USD 1,000,000
117
Options on Interest Rate futures
Option on 3 month Sterling Interest Rate future Options on US Treasury Bond futures
Underlying contract One 3-month Sterling futures This is the standard contract size. Underlying contract One US Treasury Bond
contract – GBP 500,000 futures contract – $100,000
Quotes as either decimals or
Premium quotations Multiples of 0.01 ( 0.01%) fractions of rate Premium quotations Multiples of 1/64th of a point
Minimum Price 0.01 This is the smallest amount a Minimum Price 1/64
Fluctuation (Tick) (£12.50) contract can change value and Fluctuation (Tick) ( $15.625)
the ‘tick’ size.
Contract expiry March, June, September, Contract expiry March, June, September,
December Option contracts are referred to December
by the trading cycle of the futures
Exercise procedure American contract months. Exercise procedure American
118
Options on Interest Rate futures
■ Who uses Options on Interest Rate futures? If the treasurer had been in the position of a lender of funds and $ $
wanted to guarantee a minimum rate of interest on a deposit then
Buyers/sellers she would have used a put option. Derivative
Interest Rate options are used to hedge interest rate
exposure. The chart below indicates the buyers and Originally these types of option were written on real loans/deposits.
sellers of options and the rights to the respective Now they are settled on a cash compensation basis where the writer
underlying instruments if the options are exercised. or the holder, pays or receives the difference between the interest
rate on the underlying loan or deposit and the strike price of the
Option on futures Buyer/holder has On exercise Seller/ option. This means that options are traded independently and
contract right to: writer has obligation to: separately from the actual instruments.
Call Buy a futures contract Sell a futures contract Another way of looking at the use of Interest Rate options on futures
– – is summarised in the chart below:
Go long Go short
Market player who is a ... wants to...
Put Sell a futures contract Buy a futures contract
– – Money Market buyer of a Call guarantee minimum
Go short Go long fund manager deposit rates on future
deposits – a floor
Example
Corporate seller of a Put guarantee maximum
A Corporate Treasurer has a loan of $1 million with an interest rate
Treasurer borrowing rates on
of LIBOR, reset every 3 months. The current interest rate is 6.25%
future loans – a cap
but she feels that interest rates may rise. If she buys an Interest Rate
futures contract she effectively locks in her borrowing at the futures
contract rate and cannot take advantage of any interest rate falls.
Using the futures contract limits her losses but does not give her the
opportunity to profit. The solution is to use an option contract. In
this case she buys an interest rate call option with a strike price of
93.75 (6.25%) and a maturity to suit the roll-over date of the loan.
On maturity:
119
Options on Interest Rate futures
$ $ ■ Options on Interest Rate futures in the market place The information in the chart allows you to calculate the premium
cost of any option which is quoted.
Derivative This section deals with typical contract quotations and how
7 8 9 options are traded and premiums are calculated for Interest Example
4 5 6
1 2 3
Rate options which are derived from exchange traded futures Suppose you need to hedge a 6.25% interest rate on a 3-month
0
contracts based on: Eurodollar investment starting at the end of September. To hedge
the return on this investment you decide to use an option. You will
❑ Short-term interest rate instruments need to buy a Sep Call option but what strike price should you use?
❑ Long-term interest rate instruments The strike price for 6.25% is simply determined by subtracting 6.25
from 100. So the strike price is 100 – 6.25 = 93.75. Buying a Sep Call
Typical exchange contract quotations
option gives you the right, but not obligation, to buy a 3-month
Interest Rate option quotations are available from the financial press
Eurodollars futures contract on or before the September expiry date
such as the Financial Times and The Wall Street Journal and from
at an interest rate of 6.25%. But how much will you have to pay the
products such as Reuters Money 3000. The information appears in a
seller for this right?
similar style to those in the following examples.
Contract premium price
Financial press – Option on short-term Interest Rate futures contract
This is calculated using the following simple equation:
120
Options on Interest Rate futures
Reuters Money 3000 – Options on short-term Interest Rate futures Financial press – Option on long-term Interest Rate futures contract $ $
Options on short-term Interest Rate futures can be found using the
IR Options folder, Futures Option Watch page IFOW for any Minimum price movement Derivative
US Treasury Bond future = 1/64: Tick price = $15.625
particular currency. The following is a section of a screen dump
showing Bid/Ask prices for the IMM 3-month Eurodollars futures
Call and Put options on the Index and Option Market (IOM) of the T-Bonds (CBOT) $ 100,000; 64ths of 100%
CME.
Strike Calls Puts
price Apr Jun Sep Apr Jun Sep Expiry
dates of
110 1-23 2-15 2-61 0-61 1-53 2-63 futures
111 0-55 - - 1-29 - - contracts
112 0-32 1-21 2-04 2-06 2-58 4-03
63
= 2 /64 x $15.625
1
/64
121
Options on Interest Rate futures
$ $ Reuters Money 3000 – Options on futures contracts How an Exchange traded Interest Rate option contract works
Options on long-term Interest Rate futures can be found also using Exchange traded Interest Rate options on futures are traded in a
Derivative the IFOW page for any particular currency. The following is a section similar way to exchange traded futures contracts in that margin
of a screen dump showing Bid/Ask prices for US T-Bond futures Call payments are required by the Clearing house. Initial margin is
and Put options on CBOT. payable by the appropriate party at the time of the trade.
,,
,,
,,
▼
Profits and Profits and
losses losses
▼
Clearing house
Buyer Seller
122
Options on Interest Rate futures
The option premium was 0.30. This means that the premium cost The most basic buy /sell strategies for puts and calls are
was: illustrated using profit/loss charts in the following Derivatives
examples. You may find it useful to refer to option Section 3
= 30 x £12.50 = £375.00 strategies in general by referring to the Introduction to
derivatives workbook.
The net profit on the option is therefore £937.50 – 375.00 = £562.50.
Depending on whether the market player is a buyer or seller of a call
A simpler way of calculating the option profit is to use the following or put, gains or losses either have ceiling values or are limitless.
equation:
= 45 x £12.50 = £562.50
123
Options on Interest Rate futures
$ $ Buying a Call option – Long Call At expiry the profit/loss chart for the Long Call looks like this:
A fund manager has investments that mature in the future which he
Derivative will need to re-invest. The manager believes that interest rates will be
lower in the future and needs to protect his position. He buys Call
options on futures contracts that correspond to the fund Strike price = 93.00
investments. In other words he buys the right, but not obligation to Profit
make a future Money Market loan at a pre-determined interest rate.
If interest rates decline, then gains made on the options should help
offset the lower interest rate return. However, if interest rates rise,
then the fund manager can still take advantage of the higher rates Futures
and not exercise the options. 9225 9250 9275 9300 9325 price
124
Options on Interest Rate futures
Buying a Put option – Long Put At expiry the profit/loss chart for the Long Put looks like this: $ $
The Treasurer of XYZ Corporation may or may not need to borrow
funds at a specified time in the future depending on the outcome of Derivative
a tender bid but he is worried that interest rates will rise. By buying Strike price = 93.00
Put options the Treasurer can lock in the maximum interest cost in
the event he needs to borrow. In other words the Treasurer buys the Profit
right to sell the underlying futures contract and therefore he is
entitled to borrow money at a future date at a fixed interest rate.
This protects him against a future rise in interest rates.
If interest rates rise, then the option can be exercised at a profit to Futures
offset the increased borrowing costs. If interest rates fall, then the 9275 9300 9325 9350 9375 price
Treasurer can take advantage of lower interest rates and not exercise
the option. If the tender is unsuccessful and no borrowing is
required, then the Treasurer can exercise or sell the option for
whatever value it has but his loss is limited to the option premium Loss
cost.
Maximum loss = premium price
The Treasurer decides to buy Put options on a LIFFE 3-month Short Break-even point = 0.21
sterling futures contract having a strike price corresponding to an = 93.00 – 0.21 = 92.79
interest rate of 7.00%. He buys 9300Sept Puts with a premium of
0.21.
125
Options on Interest Rate futures
$ $ Selling a Call option – Short Call Selling a Put option – Short Put
A fund manager expects interest rates to remain relatively steady for This is more or less the same scenario as for a Short Call except that
Derivative the next few months or possibly fall slightly. The manager would like this time the fund manager believes that interest rates will remain
to earn extra income on his portfolio and decides to sell Call steady or rise slightly.
options on long-term futures contracts.
At expiry the profit/loss chart for the Short Call looks like this:
If interest rates remain steady and the options are not exercised,
then they expire worthless and the fund manager has earned extra
Maximum profit = premium received
income equal to the value of the premium received.
The risk the fund manager takes is that prices on the underlying Profit
bond contracts rise. If the options are exercised then he has the
obligation to deliver the bonds.
Profit
Futures
100 111 112 113 114 price
Loss
If bond prices increase
then the option may be
exercised
126
Options on Interest Rate futures
127
Options on Interest Rate futures
128
Options on Interest Rate futures
$ $
3000 To see premium prices for Interest Rate options Derivative
select the FuOpt Watch page, IFOW, for IR Options
for any particular currency you need. In the screens
shown here LIFFE 3-month Short sterling and IOM
3-month Eurodollar Call and Put premiums are displayed for
various strike prices for the underlying September and December
futures contracts respectively. If it is more convenient, you can
view the information by name rather than the contract RIC.
129
Options on Interest Rate futures
$ $
Derivative 3000 You may also find it useful to use the Interest Rate
History page, IOIR, and FuOpt Model, IFOM page.
The IOIR page displays the deposit rates you select
for up to three currencies simultaneously – you can
choose any combination of currencies and deposit periods as
required from the drop down menus. The IFOM page can be
useful if you need to know the option delta values and whether
an option premium is In-The-Money, At-The-Money or Out-of-
The-Money.
Using this IFOM page you can see that the Call for this 9300 strike
for the September contract which has an underlying value of 92.85
has a delta value of 0.2965 which means it is OTM
130
Options on Interest Rate futures
■ End check 3. What is the maximum interest rate that the buyer of a 9375Sept $ $
Put is guaranteed on a future loan?
Derivative
Using the chart of premium prices for options on Eurodollars answer Answer:
the following:
Eurodollar (CME) $ million; pts of 100%
9325 0.50 0.30 0.29 0.00 0.15 0.42 4. What is the premium cost for a 9350Jun Call?
9350 0.26 0.16 0.18 0.01 0.26 0.55
9375 0.05 0.07 0.11 0.05 0.42 0.73 Answer:
Tick size for this contract is 0.01 and the tick value is $25
1. Why are the Calls with higher strikes cheaper than those with
lower strikes, and why are the Puts with higher strikes more
expensive than those with lower strikes?
Answer:
5. You buy an option on LIFFE which can exercised at any time.
Which of the following describes this type of option?
❑ a) European
❑ b) American
❑ c) Asian
❑ d) Average
Answer:
131
Options on Interest Rate futures
Derivative ✔ or ✖
1. The higher the strike the lower the Call prices ❑
because they are further Out-of-The -Money.
The higher the Put prices because they are further
In-The-Money.
5. b) ❑
How well did you score? You should have managed to get most of
these questions correct.
132
Options on FRAs – Interest Rate Guarantees (IRGs)
■ What is it? Interest Rate caps and floors thus provide insurance against interest $ $
rate movements over a consecutive number of roll-over loan dates
An Interest Rate Guarantee is a financial derivative which which are subject to floating rate payments. They can be used by Derivative
can be considered to be an option on a series of Forward borrowers and lenders for the protection they need.
Rate Agreements (FRAs).
Caps and floors are a series of OTC options which coincide with the
An Interest Rate Cap is an agreement between roll-over dates on floating rate loans which can be considered to be a
counterparties in which one party agrees to make series of Forward Rate Agreements (FRAs) with the same strike prices
payments to the other if floating rates exceed an agreed for the loan maturity period.
strike rate.
series of
▼
An Interest Rate Floor is an agreement between FRA IRGs
options
counterparties in which one party agrees to make
payments to the other if floating rates fall below an
agreed strike rate. An OTC call is an option to buy a FRA and is known as a borrower’s
option.
Caps and floors are based on a floating rate such as LIBOR, Prime If floating rates rise, then the option is exercised and the borrower
rates and CPs and are sold for a one-off premium. The most receives a cash settlement. If floating rates fall, then the option is not
commonly quoted caps and floors use 3-month or 6-month LIBOR. exercised but the borrower can take advantage of lower cash market
rates. The borrower pays a premium for this insurance protection to
Exercise for both caps and floors occurs automatically on set dates the option writer or seller.
during the maturity period of the option if this is to the holder’s
advantage.
133
Options on FRAs – Interest Rate Guarantees (IRGs)
If interest rates fall, then the option is exercised and the investor The cost to the buyer is limited to the premium which is paid to the
receives a cash settlement from the option seller. If floating rates rise, seller – the buyer has no further obligations.
then the option is not exercised but the investor can take advantage
of the higher cash market rates. Most caps are based on LIBOR and the following example illustrates
how a cap works.
Some of the advantages offered by these OTC options include:
Example
❑ Flexibility covering a wide range of maturity periods, A Corporate Treasurer has borrowed $10 million on a floating rate
amounts and strike prices basis for 15 months using 3-month LIBOR roll-over dates. The
Treasurer believes that interest rates will rise and wants to cap the
❑ The one-off cost of the option premium is known at the loan at 6.00%. The Treasurer buys a cap option and pays a premium
beginning of the transaction to the seller.
❑ A single agreement may cover a maturity period of several The Treasurer’s loan can therefore be considered to be a series of
years and is therefore less costly in fees FRAs starting in 3 months from the first loan period – 3 x 6, 6 x 9, 9 x
12, 12 x 15.
If on any roll over date LIBOR exceeds the cap rate agreed, the seller
of the option has to pay the Treasurer the difference between LIBOR
and the cap rate as a cash settlement.
134
Options on FRAs – Interest Rate Guarantees (IRGs)
Maturity
3x6 6x9 9 x 12 12 x 15
FRA FRA FRA FRA
135
Options on FRAs – Interest Rate Guarantees (IRGs)
$ $ If the interest rate falls below the floor rate agreed, then the buyer
receives the difference between LIBOR and the floor rate as a cash Summary
Derivative payment.
Caps Floors
If the interest rate is above the floor level, then the buyer receives no
• Protect buyers from rising • Protect buyers from falling
payment. The option is not exercised and the Treasurer receives a
interest rates above an interest rates below an
higher rate of return from the underlying.
agreed level whilst agreed level whilst
allowing the opportunity allowing the opportunity
The overall effect is that the Corporate Treasurer protects the rate of
to benefit from any fall in to benefit from any rise in
return on the investment from falls below a floor level whilst
rates rates
simultaneously taking advantage of any rises in interest rates.
• Establish a maximum • Establish a minimum rate
Collars borrowing cost for buyers of return for buyers over
The collar is the natural combination of a cap and a floor where a over the maturity period the maturity period of the
market player wants to restrict interest rates between guaranteed of the option option
maximum and minimum limits and reduce overall premium costs.
• Do not affect the • Do not affect the
This can be achieved by buying a cap to place a maximum interest underlying loan underlying deposit or
rate limit whilst simultaneously selling a floor to earn premium investment
income or vice versa.
• Provide a flexible • Provide a flexible
alternative to fixed rate alternative to fixed rate
borrowing lending
136
Options on FRAs – Interest Rate Guarantees (IRGs)
Caps Floors
137
Options on FRAs – Interest Rate Guarantees (IRGs)
LIBOR
Collar – margin 2.0%
Buyer of cap receives the
difference between LIBOR and
cap rate
Cap rate 6.0%
Floor rate 5.0%
Buyer of floor receives the
LIBOR
The option guarantees that if LIBOR rises above 6.0%, then the For collars in general, because the option involves a simultaneous
Treasurer receives payment from the seller. If LIBOR falls below purchase and sale, the premium charges involved are partially or fully
4.0%, then the Treasurer will have to make a payment to the floor eliminated. One premium is received whilst the other is paid.
buyer.
138
Options on FRAs – Interest Rate Guarantees (IRGs)
139
Options on FRAs – Interest Rate Guarantees (IRGs)
$ $ The implied volatilities are therefore forecasts of the proportional Cap and floor volatilities are available from individual market-makers
percentage range, up or down, within which the underlying interest on the RT.
Derivative rate is expected to finish at the expiry date of the option.
Example
DEM one year forward interest rates are 4.00% and the one year
volatility is forecast at 10%. So the standard deviation is ±0.04 and two
standard deviations is ±0.08.
The price ranges for the two confidence levels are shown in the table
below:
140
Options on FRAs – Interest Rate Guarantees (IRGs)
➞
➞
Strike price
On Bid side The market-maker will buy Puts or Calls at 11.50%
➞
➞ ➞ ➞
Underlying forward price
per annum
➞ ➞
Expiry date
On Ask side The market-maker will sell Puts or Calls at 13.50%
per annum Volatility
The prices are for At-The-Money options – the strike price is at the
current underlying forward rate. Why not test the summary above by using the RT?
Once the counterparties want to trade, all the factors, including the
volatilities, are entered into each side’s pricing models to calculate
the premium to be paid. If both sides agree then the transaction
proceeds.
Strike price
▼
Expiry date
▼
Premium
▼
Interest rate
▼
Volatility
▼
Pricing model
Each
counterparty
141
Options on FRAs – Interest Rate Guarantees (IRGs)
Derivative
142
Options on FRAs – Interest Rate Guarantees (IRGs)
To see more
information from the
contributor, double-
click on the quote
143
Options on FRAs – Interest Rate Guarantees (IRGs)
$ $ Your notes
144
Options on FRAs – Interest Rate Guarantees (IRGs)
■ End check $ $
Derivative
1. Your company obtained a 3-year rollover credit for $10 million on 2. Your organisation wishes to speculate by placing $10 million in
the basis of 6-month LIBOR from XYZ Bank one year ago. As FRNs for 2 years based on 6-month LIBOR. Although you are
Treasurer you are of the opinion that interest rates are likely to convinced that interest rates will rise from their current rate of
rise in the future. Therefore you want to hedge against an interest 5.00% and you would like to benefit from any rise, you would still
rise of 0.25% above the prevailing interest level of 5.00%. like to protect yourself against an adverse movement of 1% in
interest rates.
a) Do you buy a Cap or Floor?
Answer: a) Do you buy a Cap or Floor?
Answer:
145
Options on FRAs – Interest Rate Guarantees (IRGs)
Derivative ✔ or ✖ ✔ or ✖
1. a) Buy a Cap ❑ 2. a) Buy a Floor ❑
b) ❑ b) ❑
Underlying index 6 month LIBOR Underlying index 6 month LIBOR
Term 2 years Term 2 years
Reset period Every 6 months Reset period Every 6 months
Strike 5.00 + 0.25 = 5.25 Strike 5.00 – 1.00 = 4.00
Notional amount $10,000,000 Notional amount $10,000,000
d) You exercise the option because you have to d) You exercise the option because you have to
borrow at 6.00%. ❑ lend at 3.50%. ❑
You receive compensation You receive compensation
= 10,000,000 x 0.75 x 180 = 10,000,000 x 0.50 x 180
100 x 360 100 x 360
= $37,500 ❑ = $25,000 ❑
e) You do not exercise the option because you can ❑ e) You do not exercise the option because you can ❑
borrow in the market at 5.00% lend in the market at 6.00%
How well did you score? You should have managed to get most of
these questions correct.
146
Options on IRSs – Swaptions
• The buyer has the right to • The buyer has the right to
pay the fixed side to and receive the fixed side
receive the floating side from and pay the floating
from the holder of the side to the holder of the
underlying IRS underlying IRS
147
Options on IRSs – Swaptions
Derivative This section deals with examples of how Call and Put
6.50% ,,
,,
6.00%
7 8
4 5
1 2
0
9
6
3
Swaptions work in the market place.
,,
LIBOR LIBOR
Call Swaptions
Example Swaption Swaption Underlying
XYZ Corporation decides to hedge against falling interest rates using seller buyer IRS
a 1 plus 4 Call Swaption. This means they buy an instrument which
grants the right to exercise the option in one year for an underlying 4
year Fixed pay/Floating receive (Current interest rate/LIBOR) IRS
for a Swaption rate of Fixed pay/Floating receive, 6.5%/LIBOR. Payments XYZ receive XYZ pay Net % position
This means that if XYZ, the Swaption holder, exercises their right in a Fixed 6.50% 6.00% + 0.50
year, they will pay the IRS holder a fixed rate and receive LIBOR, and
at the same time receive 6.5% fixed interest from the option seller Floating LIBOR LIBOR Cancel out
and pay LIBOR.
148
Options on IRSs – Swaptions
$ $
,,
Put Swaptions
,,
Example 6.50% 6.00%
XYZ Corporation needs to hedge against rising interest rates using a Derivative
1 plus 4 Put Swaption. This means they buy an instrument which
grants the right to exercise the option in one year for an underlying 4 ,,
year Fixed receive/Floating pay (Current interest rate/LIBOR) IRS
for a Swaption rate of Fixed receive/Floating pay, 6.5%/LIBOR. LIBOR LIBOR
This means that if XYZ, the Swaption holder, exercises their right in a Swaption Swaption Underlying
year, they will pay the IRS holder LIBOR and receive a fixed rate, and seller buyer IRS
at the same time receive LIBOR from the option seller and pay a
fixed rate of 6.5%.
To justify exercising the swaption, the interest rates of the underlying Payments XYZ receive XYZ pay Net % position
instrument must be greater than the Swaption rates.
Fixed 7.00% 6.00% + 0.50
At expiration the current rate for a 4 year Fixed receive/Floating pay
IRS is 7.0%/LIBOR. XYZ exercise their right on the Swaption and Floating LIBOR LIBOR Cancel out
make a net gain of 0.5% in interest rate payments, so hedging against
rising interest rates.
149
Options on IRSs – Swaptions
Derivative
150
Options on IRSs – Swaptions
151
Options on IRSs – Swaptions
$ $ Your notes
Derivative
152
What’s next?
You have now completed this Level 3 workbook which has Books What’s next?
been designed to give you a better understanding of the The Penguin International Dictionary of Finance
market and product information you may need for your Graham Bannock & William Manser, Penguin, 2nd Edition 1995
job. ISBN 0 14 051279 9
You may have all the knowledge and understanding you Investments
require or you may still need to study further workbooks William F. Sharpe, Gordon J. Alexander & Jeffrey V. Bailey, Prentice
and /or Web materials in the Know your Markets series. Hall, 5th Edition 1995
ISBN 0 13 18 3344 8
In particular you may need to study the Level 3 workbook:
Foreign Exchange Instruments – the companion workbook to A–Z of International Finance
this one. Stephen Mahony, FT/Pitman Publishing, 1997
ISBN 0 273 62552 7
The remaining workbooks in the Know your Markets package cover the
following markets at both Level 2 and Level 3: Financial Derivatives
David Winstone, Chapman & Hall, 1st Edition 1995
❑ Debt ISBN 0 412 62770 1
❑ Equities Booklets
Chicago Mercantile Exchange
❑ Commodities, Energy and Shipping • An Introduction to Futures and Options: Interest Rates
You may also find the Further resources useful for further reference. Swiss Bank Corporation
The order of the materials/information has no significance and • Financial Futures and Options
covers many of the sources used in the preparation of this workbook. • Options: The fundamentals
ISBN 0 9641112 0 9
If you have access to the Internet, then you may find the Web
addresses listed useful.
Chicago Board of Trade
• Financial Instruments Guide
The decision to study further workbooks or use the Web site is yours –
• An Introduction to Options on Financial Futures
Good luck! • Trading in Futures
153
What’s next?
Further resources
What’s next? Reuters Money 3000 – Training Programme Futures - Hedging with Short-term Interest Rate Futures
1. Foreign Exchange & Money Markets • Item code: UKCA0349
2. Futures & Forward Rate Agreements
3. Bonds & Swaps FRAs - Fundamentals
4. Options • Item code: UKCA0306
FRAs - Applications
Intuition Plus: CAT
• Item code: UKCA0364
Call & Fixed Deposits - Fundamentals
• Item code: UKCA0290 Swaps - Interest Rate Swaps - Fundamentals
• Item code: UKCA0385
Fixed Deposits - Dealing
• Item code: UKCA0320 Swaps - Interest Rate Swaps - Applications
• Item code: UKCA0386
Treasury Bills - Fundamentals
• Item code: UKCA0291 Options - Fundamentals
• Item code: UKCA0308
Treasury Bills - Dealing
• Item code: UKCA0323 Options - Transactions
• Item code: UKCA0309
Certificates of Deposit - Fundamentals
• Item code: UKCA0292 Options - OTC Options - Fundamentals
• Item code: UKCA0403
Certificates of Deposit - Dealing
• Item code: UKCA0322 Repurchase Agreements - Fundamentals
• Item code: UKCA0314
Bills of Exchange - Fundamentals
• Item code: UKCA0293 Internet Web sites
Applied Derivatives Trading
Commercial Paper - Fundamentals • http://www.adtrading.com/
• Item code: UKCA0294 Have a look at the ADT Guide
Futures - Fundamentals Derivatives Research Unincorporated
• Item code: UKCA0301 • http://fbox.vt.edu:10021/business/finance/dmc/DRU/contents.html
A good collection of well explained articles
Futures - Hedging with Long-term Interest Rate Futures
• Item code: UKCA0348 AIB: Derivatives in plain English
• http://cgi-bin.iol.ie/aib/derivs-pe/
Futures - Hedging with Long-term Interest Rate Futures
• Item code: UKCA0348
154