C# for Financial Markets

14

Short Term Interest Rate (STIR) Futures and Options

14.1 INTRODUCTION AND OBJECTIVES

As a general rule market operators may act in the market to protect themselves from market movements (hedgers), to take some risk making bets on market direction (speculators) or to gain from pricing anomalies (arbitragers). To manage market exposure to interest rate risk, operators can use different financial instruments:

• Cash instruments.
• Over the counter (OTC) derivatives products: swap, Forward Rate Agreements (FRA), caps, floor and swaption.
• Futures and options listed on exchanges: Short-Term Interest Rate futures, option and bond futures.

Each of the above categories has different characteristics in terms of liquidity, counterparty risk, effectiveness and standardisation. The players' choice depends on many factors, specific needs and situations in which these instruments are used.

In this chapter we discuss the third class of the above list of instruments, the so-called STIR (Short-Term Interest Rate) futures and options. They can be seen as derivatives on the underlying cash money market rate and contracts on short-term interest rates. Since STIR products derive their value from a cash money market rate we give a short overview of the main trading areas of cash money markets and the related sources of risk.

We discuss why STIRs are popular and what their advantages are. In particular, we examine STIR futures and STIR options features, how to price them and in the latter case we provide ...