FORWARD INTEREST RATES,

FRAs and,

Intro. to FUTURES

FORWARD-

FORWARDS

S. AISHAH SADRUDDIN

Forward-Forward Contract

■A customized contract between two parties that guarantees a certain interest rate on an investment or a loan for a specified time interval in the future, i.e. begins on one forward date and ends later.

Notion

■Forward-forwards have a special notation to designate the future term.

For instance, a term that begins in 6 months and ends 1 year later, would be designated as 6 v 18.

How is the Forward Rate Determined?

■The interest rate for the shorter period is the market yield with the term equal to the number of days from the agreement date until the contract begins.

The longer period is determined using the market yield with the term equal to the number of days from the agreement date until the contract ends.

FORWARD

RATE

AGREEMENT

FRAs(Introduction)

NAWAL MERAJ

Defining the FORWARD RATE AGREEMENT■Similar to forward contracts

■Two parties involved

BORROWER (Long)

LENDER (Short)

EXAMPLE

Two parties can enter into an agreement

to borrow $1 million after 60 days for a

period of 90 days, at say 5%.

CHARACTERISTICS OF FRAs■Usually cash-settled■Net amount is settled (difference between the current

LIBOR and the agreed FRA rate)■Payment made only at maturity■How a Long Position will Benefit? ■How a Short Position will benefit?■Deposit amount is known as Notional Amount■Determined on Short-term Interest rates (Reference

Rates)

MECHANISM OF AN FRA AGREEMENT■ A bank and a company are agreeing to the company being able

to borrow Rs. 50 million for six months in two months’ (2v8)

time at 6.4167% interest. Current IR is 6%.

■Effects, if Interest Rates Move up from 6% to 8% in two months?

■Effects, if Interest Rates Move down to from 6% to 5% in two

months?

FORWARD

RATE

AGREEMENT

FRAs(Settlements)

SEHRISH GHAFOOR

FRA SETTLEMENTS

The settlement on an FRA is settled net rather

than gross.

The difference is paid or received at the

beginning of the forward period to which it

related.

FOR EXAMPLE

In a 2v5 FRA agreement, the difference is paid after

2 months, that is the beginning of the forward

period.

The buyer of the FRA pays the seller if LIBOR is fixed lower than the FRA rate.

The seller pays the buyer if LIBOR is fixed higher than the FRA rate.

The formula for the settlement amount is:

EXAMPLE # 01

Consider a 3v6 FRA on a notional principal amount of $1 million. The FRA rate is 6% . The FRA settlement date is after 3 months (90 days) and settlement is based on a 90 day LIBOR. Assume that on the settlement date, the actual 90 day LIBOR is 8%. Calculate the FRA settlement amount.

EXAMPLE # 02

Consider a 2v4 FRA on a notional principal amount of $1 million. The FRA rate is 6% . The FRA settlement date is after 2 months (60 days) and settlement is based on a 60 day LIBOR. Assume that on the settlement date, the actual 60 day LIBOR is 5%. Calculate the FRA settlement amount.

FRA PERIODS LONGER THAN 1 YEAR

If the period of the FRA is longer than 1 year, the

corresponding LIBOR rates is used for settlement relates to a

period where interest is conventionally paid at the end of each

year as well as at maturity.

FOR EXAMPLE:

■A 6v24 FRA covers a period from 6 months to 24 months and will be settled against an 18 month LIBOR rate at the beginning of the FRA period.

■An 18 month deposit would, typically pay interest at the end of one year and again after 18 months.

FORMULA FOR PERIOD LONGER THAN A YEAR BUT LESS THAN 2 YEARS

FUTURES

CONTRACT

MARIJ ZAFAR

DEFINTION

• A contractual agreement, generally made on the trading floor of a futures exchange to buy or sell a particular commodity or financial instrument at a pre-determined price in the future.

• Futures contracts detail the quality and quantity of the underlying asset.

• They are standardized to facilitate trading on a futures exchange.

• Some futures contracts may call for physical delivery of the asset.

• While others are settled in cash.

INTRODUCTION■ The future contract is traded on a particular exchange.

■ Future contracts are generally standardized.

■ The specifications of each future contracts are laid down precisely by the relevant exchange

■ vary from instrument to instrument and exchange to exchange.

■The theory underlying the pricing of a future contract depends on the underlying instrument on which the contract is based.

■For a future contract based on 3-month interest rates, the pricing is therefore based on the same forward-forward pricing theory.

Example3-month EURIBOR futures contract traded on LIFFE.

Exchanges: LIFFE (London International Financial Futures and Options Exchange)

Underlying: The basis of the contract is a 3-month deposit of EUR 1 million based on ACT/360 year.

Delivery: It is not permitted for this contract to be delivered: if a trader buys such a contract, he cannot insist that, on the future delivery date, his counterparty makes an arrangement for him to have a deposit for 3-months from then onwards at the interest rate agreed.

Delivery months: The nearest 3-months following the dealing and March, June, September and December thereafter.

Delivery Day: First business day after the last Trading day.Last Trading Day: 10.00 a.m. 2 Business Days prior to the third Wednesday

of the delivery month.

Settlement Prices: On the last day of trading- usually the third Monday of the month-LIFFFE declares an exchange delivery settlement price (EDSP) which is the closing price at which any contracts still outstanding will be automatically reversed.

Price: The price is determined as a free market and is quoted as an index rather than as an interest rate. The index is expressed as 100 minus the implied interest. Thus a price of 94.52 implies an interest rate of 5.48% (100 - 94.52 = 5.42).

Price Movement: Prices are quoted in unit of 0.005. This minimum movement is called the Trek. Profit and Loss value: The P&L is defined as being calculated on exactly 3/12 of

a year regardless of a number of days in a calendar quarter. The profit or loss on a single contract is therefore:Contract amount x price movement x 3/12Therefore the value of a one basis point movement is EUR 25.00 and the value of

a one tick movement (The tick value) is EUR 12.50. 

EUR 1 million x 0.01% x 3/12 = EUR 25.00EUR 1 million x 0.005% x 3/12 = EUR 12.50

There are relatively minor differences between future exchanges and even between different STIR contracts on the same exchange.

■ Underlying: The typical contract specification for short term interest rate futures is for 3-month interest rate. Although 1-month contracts also exist in some currencies on some exchanges.

■ Delivery Date: STIR contracts worldwide are generally based on the delivery month cycle of March, June, September and December.

■ Trading: Trading times vary. Some contracts are traded by open outcry, notably on the IMM (the International Monetary Market, the financial sector of the Chicago Mercantile Exchange (CME)) and some are traded electronically.

■ Price movement: Tick sizes and Tick values, vary. For example, the minimum price moment on Sterling is 1 basis point. The minimum price movement for US dollars varies from ¼ basis point for the nearest dated futures contract, through ½ basis points for the subsequent ones, to 1 basis point for later ones.

■ Settlement price: The settlement price varies according to both currency and exchange.

Example

A dealer expects interest rates to fall (future to rise) and takes a speculative position. He therefore buys 20 EUR 1-month futures contracts at 95.27. He closes them out subsequently at 95.20. What is his profit?

The price has fallen, so he makes a loss of EUR 3,500:

Number of contracts x contract amount x price movement x 1/12

= 20 x EUR 3,000,000 x 0.07% x 1/12 = EUR 3,500  

SHORT-TERM INTEREST RATE FUTURES

Price= 100 – (implied forward-forward interest rate x 100)

Profit on a long position in a 3-month contract

= contract amount x (sale price – purchase price)/100 x 3/12

 

THE

MECHANICS

OF

FUTURES

SHARJEEL MERAJ

THE MECHANICS OF FUTUREMARKET PARTICIPATION: Members Customers Locals Public Order Member

OPEN OUTCRY VERSUS SCREN-TRADING

OPEN OUTCRY:The buyer and seller deal face to face in public in the

exchange’s trading pit.

SCREEN TRADING:Designed to simulate open outcry but with the advantage of

lower costs and wider access.

CLEARING:

The futures exchange is responsible for administering the market, but all transactions are cleared through a clearing house.

Only clearing members of an exchange are entitled to clear their transactions directly with the clearing house.

Non-clearing members have to clear all their transactions through a clearing member.

MARGIN REQUIREMENTS

Initial Margin

Variation Margin

CALCULATION OF VARIATION MARGIN

The variation margin required is the tick value multiplied by the number of ticks price movement since the close

the previous day.

EXAMPLE:

If the tick value is EUR 12.50 on each contract, and the price moves from 94.370 to 94.215 ( a fall of 103 ticks), the loss on a long future contract is EUR (1.250 x 103) = EUR 1287.50

CLOSING OUT:

A futures position can be closed out by means of an exactly offsetting transactions.

LIMIT UP/ DOWN:

Some markets impose limits on trading movements in an attempt to prevent wild price fluctuations and hence limit risk to some extent.

BASIS

Basis is the difference between what the futures price would be based on the current cash interest rate, and the actual futures price.

Value basis = Theoretical futures price – Actual futures price

Basis = Implied cash price – Actual futures price

Basis Risk is the risk arising from the basis.

EXAMPLE:

It is now mid-February and the current 3-month GBP LIBOR is 5.32%; the current June futures price is 94.37 and the theoretical June futures price based on the current cash market is 94.30.