Ways of expressing forward rates

In addition to the direct or indirect quotation, forward exchange rates can be expressed in one of three ways. First, the forward rate can be quoted as an outright rate — i.e. the actual forward rate of exchange.

Secondly, it can be quoted as forward exchange margins or points (also called swap rates). These latter are either discounts or premiums depending on the interest differentials between the home and foreign currency. If the foreign currency interest rate is higher than the home currency interest rate, the foreign currency will be at a forward discount to its spot rate. If, on the other hand, the foreign interest rate is below the home currency interest rate, the foreign currency will be at a forward premium to its spot value. The magnitude of the discount or premium is dependent upon the size of the differential in home and foreign interest rates and the time to maturity of the forward contract. Read more »

Posted: June 24th, 2008 under Currency Futures, Foreign Exchange Futures, Futures Market.
Comments: 5

As with all other forms of futures contract, the fair price of short-term interest rate futures should preclude any arbitrage possibilities between the futures market and the underlying cash market. In the case of bank deposit interest rate futures, there should be no arbitrage possibilities between the forward interest rate implied by the future and the forward interest rate available on the appropriate type of bank deposit. For example, a three-month eurodollar futures contract that has 135 days to maturity should not provide any arbitrage possibility with the 135-day forward rate on a three-month eurodollar deposit. Read more »

Posted: June 20th, 2008 under Future Trading, Futures Contracts, Futures Market, Futures Prices, Interest Rate Futures.
Comments: 5

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. Read more »

Posted: June 20th, 2008 under Future Exchange, Futures Contracts, Futures Market, Futures Prices, Interest Rate Futures.
Comments: 6

As the name implies, an FRA is an agreement to buy or sell a forward rate of interest on a notional principal amount. Remembering that interbank deposit rate futures also relate to forward rates of interest, the similarity between the two instruments will be obvious. Conceptually, the seller of the FRA undertakes to provide an agreed rate of interest on a notional deposit of a specified size at a previously agreed future date. Thus the FRA locks in the rate of interest on a forward deposit, the forward rate of interest.

An FRA relating to the interest rate on a six-month deposit starting in three months time is referred to in FRA market parlance as a 3 against 9 (or a 3 vs 9) FRA. This clearly indicates that, in this example, the appropriate interest rate is the six- month forward rate three months hence. Read more »

Posted: June 18th, 2008 under Futures Contracts, Futures Prices.
Comments: 3

The valuation of interest rate options is currently the most contested area of option- pricing theory. The problem stems from the fact that although there is a reasonable consensus about the nature of the stochastic process of share prices, equity indices and currencies, the movements in interest rates and interest rate dependent instruments are not fully understood and full agreement on the underlying process has yet to be reached.

The stochastic process of interest rates, and therefore the prices of interest rate dependent claims, has proved to be very difficult to model for a number of reasons. Read more »

Posted: June 17th, 2008 under Equity Futures, Future Broker, Futures Contracts, Futures Quotes, Managed Futures, Stock Market Futures, Swap Futures.
Comments: 4

Bonds are frequently purchased to fund future liabilities because of the relative certainty of the cash flows which are set contractually. However, the certainty as to the value of the terminal value of those future cash flows depends upon two factors:

the rate at which the future coupons can be reinvested remaining unchanged;

if the bond has a maturity longer than the desired holding period, the level of interest rates is the same at the beginning and end of the holding period. Read more »

Posted: June 17th, 2008 under Crude Oil Futures, Futures Options, Futures Prices, Futures Spreads, Short Futures, Silver Futures.
Comments: 6

A detailed analysis of the empirical testing of the term structure is beyond the scope of this post; however, in summary it should be stated that the empirical tests give a substantial role to expectations. However, forward rates are not unbiased estimators of future spot rates, and the bias is consistent with a liquidity premium. There is also some evidence that the premium increases with the term to maturity, but at a decreasing rate. There is less support for the segmentation hypothesis.

The dynamics of the term structure

Clearly the term structure is dynamic, but exactly what is the nature of this dynamic process? It has long been observed that long rates are less volatile than short rates; for further discussion see Kessel (1965), Malkiel (1966) and Brooks and Livingston (1990). Current long-rate volatilities are linked to current short-rate volatilities by the concept of mean reversion — i.e. where short rates have a tendency to be pulled back towards some long-term average value following a movement up or down. Read more »

Posted: June 15th, 2008 under Currency Futures, Future Exchange, Futures Contracts, Managed Futures, Swap Futures.
Comments: 4

However, this theory of the development of the swaps market assumes that the financial markets remain informationally inefficient and that the benefits of comparative advantage are not arbitraged away. There is no doubt that in the early days of the interest rate and currency swaps markets it was possible to locate such inefficiencies that resulted in generous benefits to both parties, but in the years since the market’s inception the benefits have to some extent been reduced by arbitrage, yet the market still grows dramatically.

Thus there must be some other reason, or reasons, for the existence of the swaps market as the comparative advantage theory assumes that some markets persistently underprice credit risk relative to other markets. Three alternative reasons for the market’s existence can be postulated. Read more »

Posted: June 14th, 2008 under Currency Futures, Foreign Exchange Futures, Future Exchange, Future Investing, Future Management, Future Trading, Interest Rate Futures, Managed Futures, Stock Futures, Stock Market Futures, Swap Futures.
Comments: 4

Currency swaps, which were developed before interest rate swaps, were derivations of the 1970s practice of establishing parallel loans between two parties whereby, for example, company A would lend its domestic currency to company B, in return for a loan of company B’s domestic currency. These parallel loans were often used to manage exchange risk or to circumvent exchange control regulations.

This system of mutual lending had two serious drawbacks. First, there was no automatic off-set of the cash flows between parties. Thus, if company A defaulted on its loan from B, company B would still have to honour its commitment to A. Secondly, although the two loans effectively cancelled each other out, they were still shown on the balance sheets of each company. Read more »

Posted: June 14th, 2008 under Commodities Futures, Crude Oil Futures, Equity Futures, Future Exchange, Future Fund, Future Investing, Future Management, Future Trading, Futures Contracts, Managed Futures, Swap Futures.
Comments: 3

The valuation of equity swaps may, at first sight, seem more complex than the pricing of interest rate swaps because the total return to the index is not known at the outset. However, as the equity index is a carryable asset, it is possible to develop an arbitrage-free value of the equity side of the swap in a manner analogous to the pricing a long-term futures contract.

For example, if a party were to pay the equity returns, it is effectively going short the equity market. This position could be hedged by buying the underlying index with the proceeds of a floating rate loan. The interest costs of the loan will be serviced from the LIBOR receipts under the swap. Read more »

Posted: June 8th, 2008 under Future Exchange, Future Fund, Future Investing, Future Management, Future Trading, Futures Contracts, Futures Market, Futures Quotes, Futures Trader, Managed Futures, Swap Futures.
Comments: 4