Derivatives

CHAPTER 12Hedging with Interest Rate Futures

Aims

• To examine how interest rate futures can be used for either hedging the value of fixed income assets (e.g. the dollar value of a portfolio of T-bills), or to ‘lock in’ future borrowing or lending rates (e.g. on existing floating-rate bank loans or deposits).
• To use the ‘price value of a basis point’ (PVBP) and the ‘duration-based hedge ratio’ to determine the optimal number of futures contracts to hedge a cash-market position in a fixed income asset (e.g. T-bills, bank loan, or bank deposit).
• To demonstrate the use of strip, rolling, and stack hedges.

We show how interest rate futures contracts allow investors to hedge spot positions in cash market assets, such as T-bills, bank deposits, and loans. Interest rate futures are a little more complex than futures on, say, stocks or oil. But the key thing to remember is that the price of any interest bearing asset (e.g. spot T-bill prices, interest rate futures prices) always moves in the opposite direction to the change in interest rates (yields). So, for example, when yields fall, the futures price will rise (and vice versa). The futures contracts we consider are the (90-day) T-bill and (90-day) Eurodollar contracts, where the change in futures prices depends on the change in a 90-day (forward) interest rate.

Interest rate futures can be used to lock in a known ‘effective’ interest rate over a specific future time period. Consider the following situations:

• It is 27 June. You have ...