Hi, Please could someone explain to me how a short interest rate future works and why someone would choose to buy one? An example with explicit cashflows would be much appreciated! Thanks
Short interest rate futures contracts are indexed so that as interest rates fall, their price rises, and as rates rise, their price falls. Their price is 100 minus the annual rate of interest convertable quaterly (so thats the three month efective rate times 4, so for example if i have an effective annual rate of 7% pa eff, i would need to find the nominal rate of interest convertable quaterly which is 4[(1.07)^.25 - 1]=6.82%. The future would then be priced at 93.17. When the contract is due to mature, one party will make a loss, and the other a gain. For example if i agree to buy a short interest rate future off you, and it is currently priced at 93.17 (so interest rates are currently at 6.82% per annum convertable quaterly) and it matures in exactly 1 year, say interest rates go up (for simplicity) to 10 percent per annum convertable quaterly, then the future is now worth 100-10 = 90. So now i must pay you 3.17 to settle the contract (loss for me) and you gain 3.17. They are used as a hedge against adverse interest rate movements, for example if i lent 100 dollars to someone at a variable interest rate, then i would receive less interest if interest rates go down. Interest rate futures are set up so that there is an inverse relation between interest rates and their price. So in the example, i would protect my position with our contract, because if interest rates go up, i lose on the future because im paying you 3.17, but im receiving more interest, and if interest rates go down, then i will gain off you but i will lose to my debtor because i will receive less interest. All you really need to know for CT2 is that they are used to protect against upside and downside risks, (because i can no longer benefit from favourable movements, but am protected against adverse movements).
