Understanding Interest Rate Futures

[One2Go]

I'd be grateful if someone could let me know if what i'm thinking is right...

With Interest Rate Futures, if an investor has a long position then they effectively agree to lend money and so receive interest payments based on an agreed rate.

In the meantime, if interest rates go up, then the payoff from the long position isn't as big as it was and the long investor would have to pay more margin. This would be financed at higher interest rates than previously.

If it was a forward, there'd be no margin and hence a forward is more attractive and the price of the forward is greater than the price of the future.

Is this right? I was getting confused by the long position buying the contract but lending the money, together with the fact that interest rates going up should be good for a lender - but not if you've locked in to a rate.

Thanks

 

[vikas.sharan]

Its a bit confusing! You are correct. See Answer to Question 11.4
(You discussed only what happens when the int rates go up, you also need to consider what happens when they go down)
--------------------------------------------------------------------
If you buy an interest rate future today with a settlement date in Dec 2009 (say) then you agree to receive payments based on the 90-day rate prevailing in Dec. At the time of purchase, the price will be based on what you expect the interest rate to be in december i.e. using forward rates.

So suppose that the forward implied 90-day future now is 5% but when you got in december, the rate bacame 6%. You are making a loss since the market rate is 6% but you are receiving payments based on 5%.

So to remember this: buy an interest rate future (ie hold a long position) ---> agree to receive money at a fixed rate -----> hope for market to fall.
---------------------------------------------------------------------
If you want to think of the future as buying or selling an asset, you can think of a long position in interest rate future as an agreement to buy a 90-day treasury bill at a fixed price K. So when interest rates go up, the actual price of bill goes down and at the settlement date you end up buying it at K which is higher than market price.
---------------------------------------------------------------------
There is another related concept in chapter 22, where you can hedge interest rate changes by buying call or put on interest rate futures. (Sec 3.2)

Hope this helps.

 

[Alpha9]

I've struggled with interest rate futures myself! - see http://www.acted.co.uk/forums/showthread.php?t=2563

Think of it in terms of entering into a contract to buy/sell the underlying "synthetic" asset, whose price is quoted at (100 - interest rate), rather than "agreeing to lend" (in fact you're not agreeing to lend at all by entering into the contract: you might do that separately, and you might be buying the interest rate future in order that you can lend at at a pre-fixed rate of interest, but you don't have to).

Going long (buying the future) means being contracted to buy that asset at the strike price. Of course, the asset itself doesn't actually exist: so essentially going long means that the contract will either give you a gain (price goes up, i.e. interest rates fall) or a loss at maturity. Ignoring margin for the moment, the amount of the gain/loss would be the price of the future at maturity less the strike price.

If you buy the future, you have to deposit initial margin. You will have to finance this at the prevailing interest rate at the time you enter into the contract. If interest rates were to stay constant throughout the term of the contract, there would be no gain or loss, and no variation margin to pay or receive: you would get back your initial margin (plus interest at the rate prevailing at the outset of the contract - the core reading doesn't explain this explicitly, but I don't think the sums work without it!). With a forward rate agreement, no money would have changed hands: you'd be in the same position.

However, if you buy the future and interest rates vary, then you will also have to pay or receive amounts of variation margin. If interest rates rise, you will have to pay more margin: you will have to finance this at a higher rate, since interest rates have risen. And if interest rates fall, you will get back variation margin, but you will only be able to invest it at a lower interest rate (since interest rates have fallen). On average, you will be financing at a higher rate than you will be investing.

With a forward rate agreement, none of these cash flows over the term of the contract take place, so you will not be making this financing loss.

Therefore a forward rate agreement is more attractive than an interest rate future in terms of cost. And it doesn't matter whether the final price of the future is higher, lower or the same: it's the variation in rates over the period that causes the prices to be different.

Which is why the difference in prices is proportional to the variance of the interest rate: if it didn't vary, the prices would be the same.