It was shown that it is possible to lock in a forward rate of interest. However, depositors will only lock in a forward deposit if the rate that results is at least as favourable as the rate that they expect to prevail at the future point in time. If the forward rate implied by the current rates was above investors’ expectations, theinvestors would increase their borrowing for 90 days, causing upward pressure on that rate, and increase their deposits for 180 days, causing downward pressure on that rate, thereby bringing the 90-day forward rate down to current expected levels.

Conversely, if the implied forward rate were below expectations, investors would borrow for the longer term, raising that rate, and deposit for the shorter term, lowering that rate, until the implied forward rate matched expectations.

From this analysis it is clear that forward rates, in an informationally efficient, competitive market free of restriction on the inflow and outflow of funds, will reflect the market’s consensus expectations of future interest rates. This does not imply that forward rates are good forecasters of future spot rates. In the intervening period new information will affect the market and the rates will change.

Futures on short-term interest rates

Futures on short-term interest rates are based upon the rates applicable to bank deposits, Treasury bills, certificates of deposit or the differential between eurocurrency interest rates. The CD futures have declined in popularity in recent years and, at the time of writing, the CD future traded on the IMM of the Chicago Mercantile Exchange is moribund.

It should be noted that the price quotations of the short-term interest-rate futures are not in terms of interest rates. They are actually similar to those traditionally seen in the secondary market for debt, and the movements in these quotations are similar. When interest rates rise, the futures price falls, similar to the price response of a Treasury bill, a Certificate of Deposit or indeed a bond. This price reaction is created by quoting the futures price as an index of 100 minus the market yield.

Futures contracts on interbank interest rates

A number of futures exchanges trade futures on short-term bank deposit interest rates. For example, LIFFE trades futures on three-month Sterling LIBOR, three- month eurodollar, euromark and euro Swiss Franc LIBOR and three-month ECU interest rates. The IMM of the Chicago Mercantile Exchange trades futures on one- month and three-month eurodollar LIBOR. The Singapore International Monetary Exchange also trades a three-month eurodollar LIBOR future and it is fungible with the Chicago contract. The MATIF trades a three-month PIBOR futures contract.

The contract specifications and delivery system

This section describes, by way of example, the specifications and delivery system of the IMM and LIFFE three-month eurodollar interest rate contracts. Many other futures markets trade futures on short-term interest rates, and the number of such contracts is growing rapidly. Readers should familiarize themselves with the specifications of any contracts that may be of interest to them.

Both the IMM and LIFFE contracts relate to the interest rate on a $1 000 000, eurocurrency deposit, and have a minimum price movement of 0.01% or one basis point. This translates into a tick size of $25 (1 000 000 x 0.01 x

The delivery months are March, June, September and December. The last trading day is the second London business day before the third Wednesday of the delivery month. The delivery day for the IMM contract is the last day of trading, but for the LIFFE contract, it is the first business day after the last trading day.

The delivery system for both contracts is a cash settlement system. On the last trading day all positions are marked to market for the last time, and the clearinghouse settles with the long and short positions. Thus there is no physical delivery of bank deposits, thereby avoiding the risk that some of the banks whose deposits would be delivered would not be acceptable credit risks.

The final marking to market is executed at the exchange delivery settlement price. With both the IMM and LIFFE, this price is an arithmetic mean, calculated from a random sample of rate quotations from a specified number of prime banks on the last trading day. From the June 1992 contract onwards, the exchange delivery settlement price will be the relevant British Bankers Association interest settlement rate. This change has been brought about so the futures settlement rate is the same as the FRA settlement rate. This is particularly important because many FRA positions are hedged in the futures market.

As the futures contract relates to the interest rate on a three-month deposit, account must be taken of the fact that the day count will differ between quarters, depending upon whether the constituent months have 30, 31, 28 or even 29 days. Thus the interest rate upon which the future is based could be related to a 90-day, 91-day or 92-day deposit, depending upon which quarter is relevant and whether or not it is a leap year. Accordingly, different sections of the short end of the term structure will be relevant for pricing depending upon which contract is being valued. The influence of the day count upon the return to bank deposits is made all the more important by the market convention of calculating the yield on an actual over 360-day basis.

The differing day count in various months is relevant to all short-term interest rate futures, and is increasingly important in the calculation of hedge ratios, the shorter the term of the underlying instrument. Thus it is even more crucial on one-month LIBOR futures than it is on three-month LIBOR futures.

Possibly related posts: (automatically generated)
Forward interest rates and expectations

• Pricing futures on interbank interest rates
• Inside of the foreign exchange market continue...
• Forward rate agreements (FRAs)
• Key Points and bottom lines in Currency Forward Rates
• Principles of Futures Contract Pricing (T1)
• Inside of the foreign exchange market
• Empirical evidence of the term structure
• Are interest rate options different to other options?
• Valuing American options on futures contracts
• Using currency options to manage risk