Hedging Using Interest Rate Futures
Contracts
• There are two main interest rate futures contracts
– Eurodollar futures
– US T-bond futures
• Eurodollar futures are the most popular and active
contract
– Open interest in excess of $4 trillion at any one point in
time
– Eurodollars in this case are not Eurodollar currency.
They are US Dollar deposits in banks that are not
subject to US banking regulations.
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Hedging Using Interest Rate Futures
Contracts
• Eurodollar futures contracts are based on the
interest rate payable on a Eurodollar time deposit
• This rate is known as the LIBOR (London
Interbank Offer Rate) and has become the
benchmark short-term interest rate for many US
borrowers and lenders
• Interest rates are typically quoted as LIBOR +
basis points (.0001, so 100 basis points = 1%)
• LIBOR is an annualized rate based on a 360 day
year
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How is LIBOR Interest Calculated?
• LIBOR is calculated on a notional principal
amount of $1M.
• The contract is settled in cash; there is no actual
delivery of the time deposit
• The interest on a 3 month (90-day) contract with
notional principal of $1M and an 8% rate would
be calculated as:
.08 * (90/360) * 1,000,000 = ??
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Other Characteristics of LIBOR
• Prior to expiration, the quoted futures price
“implies” a LIBOR rate. So
Implied LIBOR = 100 – Quoted Futures Price
• At Expiration, the Futures Price is quoted at
100 – LIBOR
So, if the LIBOR rate was 8% at expiration, the
contract would be quoted at 92.
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Other Characteristics of LIBOR
•
•
•
•
Contract is a Eurodollar time deposit
Traded on the Chicago Mercantile Exchange
Notional principal is $1,000,000
Contracts are delivered in
–
–
–
–
March
June
September
December
• Cash settlements based on a 3-month LIBOR
• Minimum Price Movement is $25 or 1 basis point
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An Example
• Assume the following
– On November 15 you purchase one December
Eurodollar Futures contract
– The quoted futures price at the time is 94.86
– What is your profit or loss if the LIBOR rate falls 100
basis points between now and the expiration date of the
contract?
• Remember
– No money changes hands when you buy the contract
• What was the implied LIBOR rate when the
contract was purchased?
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Example (cont)
• What is the LIBOR rate if interest rates fall 100
basis points?
• What is the new futures price?
• What is our gain or loss based on the price?
• What is the overall gain or loss on the contract?
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Hedging Using Interest Rate Futures
• As with any hedge, you are not locking in a rate
per se. You are locking in an effective rate based
on gains and losses on the contract!
• Assume the following
– Suppose a firm knows in February that it will be
required to borrow $1M in March for a period of 3
months (90 days)
– It will pay the loan off at the end of the period
– The firm borrows at LIBOR + 50 basis points
– The firm wants to hedge its interest rate risk
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In Order to Hedge, Do You Buy or Sell?
• If interest rates go up, your company’s borrowing
costs go up.
• So, to hedge your position, you want a strategy
that will allow you to offset borrowing costs if
rates go up!
• So, you would sell a contract, because if interest
rates rise, the cost of the contract goes down, but
you will have an agreement to deliver the contract
at a higher price
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How Does the Hedge Work?
• Assume the following:
– The March Eurodollar futures price is 94.86
– What does that make the implied LIBOR rate?
– If we lock in this effective borrowing rate, what will our
interest expense be?
• Now assume that LIBOR increases to 6.14%. How
does the hedge work?
– What is our borrowing cost now that interest rates have
gone up?
– What was our gain or loss on futures contract?
– What does that make the net expense to the borrower?
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How Does the Hedge Work?
• Now assume that LIBOR falls to 4.14%. How
does the hedge work?
– What is our borrowing cost now that interest rates have
gone up?
– What was our gain or loss on futures contract?
– What does that make the net expense to the borrower?
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