Chapter 39. Interest Rate Futures and Forward Rate Agreements

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

STEVEN V. MANN, PhD

Professor of Finance, Moore School of Business, University of South Carolina

Abstract: Interest rate derivatives include interest rate futures, forward rate agreements, interest rate swaps, interest rate options, and interest rate caps and floors. Interest rate derivatives can be used to control the interest rate risk of a portfolio or financial institution, to speculate on the future level of interest rates or the change in the shape of the yield curve, or to hedge future borrowing costs. These instruments can be either exchange traded or traded in the over-the-counter market. Interest rate futures are exchange-traded; options can be exchange traded or traded in the over-the-counter market, so-called dealer options. The other interest rate derivatives are traded in the over-the-counter market. Exchange-traded futures on interest rates are classified by the maturity of the underlying interest rate: short-term contracts (Eurodollar futures, Fed funds futures) and long-term contracts (Treasury bond and note futures, swap futures, and municipal bond futures). A forward rate agreement is an over-the-counter derivative instrument which is essentially a forward-starting loan, but with no exchange of principal, so the cash exchanged between the counterparties depend only on the difference in interest rates.

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