Q Discuss the following questions: How can we use the futures market to hedge against rising interest rates?
What is the difference between using derivatives to hedge against risks and using them to speculate?
Let’s begin this discussion by giving a brief introduction to futures. Then we will move to how we use futures
market to hedge against rising interest rates.
A future is basically a financial contract which obliges the buyer to purchase an asset, such as a physical
commodity or financial instrument, in our case interest rate, at a predetermined future date and price.
Future contracts specify the quality and quantity of the underlying asset. Futures can be used to hedge or
speculate on price movement of interest rates. For example, a person can lock in a certain price and reduce risk.
The main difference between future and options is that options give the holder, the right to buy/sell the
underlying asset, while the holder of a futures contract is obligated to fulfil his contract.
Example 1:Let’s look at interest rate risk. Interest-rate risk can be defined as the uncertainty surrounding
expected returns on a security, brought about by changes in interest rates. For example, a firm needs to borrow
$X for a year, paying interest quarterly. Let’s assume that the firm’s first such bill bears an interest rate R% and
the firm expects this rate to be stable in successive quarters, although it could vary each quarter. However, what
if interest rates were to rise in the subsequent quarters? This would pose a threat to the firm’s. This was an
example of variable interest rate budget
Example 2: Interest-rate risk affects fixed-rate debt, too. For example, if a firm enters into a four-year, fixed-rate
lease, and then interest rates drop unexpectedly, the firm will lose the opportunity to borrow at the lower rate
(because it has entered into a fixed-rate borrowing arrangement).
Investors are also interested in futures. They can also be used by speculators aiming to make profits by
speculating on interest-rate movements. Bond prices are linked to interest rates. Thus, falling prices may be of
special concern to investors.
How to use futures to hedge against interest-rate changes?
As we saw in the previous examples, there was a risk posed by change in interest rates to the firm which paid
quarterly interests. A contract which would help counter this risk is called a future. A futures contract may be
defined as a contract to buy or sell a stated commodity or financial claim at a specified price and specified future
date.
Hedging against rising interest rates
To hedge against rising interest rates, you(firm) must enter into a selling position in the futures market. If rates
do rise, cost of borrowing is saved as the firm can borrow at a price lower than increased price.
Take the example of BAB or Bank-accepted bill. Say, the manager expects the interest rates to rise.
P = 365*V/(365+Rate) [Key idea is to remember that Rate is inversely proportional to price]. In the expression,
P represents present value, V represents face value, Rate = Annual Interest Rate.
Thus when rate increases, value decreases. By entering a selling position at current rate, by selling at a higher
price, we can make a profit.
Hedging against falling interest rates
To hedge against falling interest rates, you (the firm) must enter into a buying position in the futures market. An
investor or potential investor faces the converse problem to that of the borrower illustrated above; the investor
will want to hedge against falling rates. This can be accomplished by taking a buying position in the futures
market (called a long position).
Using the same formula as before, P = 365*V/(365+Rate), as Interest rates fall, price increases. By buying at
lower price(at current interest rates, P is lower than future P), firm is not expected to make a loss.
Limitations of hedging
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Futures are generally traded in standard amounts or quantities. Thus, exact amounts may be hard to
hedge.
Price on the futures refers to a specific commodity. Trying to hedge a different commodity may not
produce an exact hedge. BAB futures and other form of short term debt may not give same results.
Future contracts are settled on specific dates. Thus, there will a gap in the hedging process as the dates
may not coincide with the actual loan dates.
What is the difference between using derivatives to hedge against risks and using them to speculate?
Speculators buy and sell futures with a view to profit rather than hedging. For example, suppose a
speculator believes that interest rates will rise above the level at which futures contracts are currently being
traded. We saw earlier that profit is produced by means of taking a selling position. Since it is customary for the
futures exchange to settle the profit (or loss) with the market player, the speculator can walk away with a
standard amount of profit per standard contract, under the above assumptions.
Speculators do not have to have any actual bills to enter the futures contract nor do they have to pay the
face value. All they have to do is place the required deposit with the exchange and, if their strategy proves apt,
take the eventual profit. For example, suppose the player had taken a short position on one standard contract and
was required to pay a deposit of $500 two months prior to settlement, then emerged with the profit of $946; this
would represent an annual rate of return of over 1,000% on a simple interest basis.
However, if rates were, instead, to fall in the previous paragraph’s example, the player would emerge with a
loss. This would have to be paid to the futures exchange. The exchange protects itself against failure of players
to settle their losses by requiring periodic, additional payments titled margin calls. For example, if rates began to
slide downwards, so exposing the player to potential losses, the exchange could demand that the player pay
these additional calls, reserving the right to close-out the contract and apply the proceeds against accrued losses
if the calls are not paid when due