¶ … risk management tools: interest rate futures, interest rate options, forward rate agreement and interest rate swaps.
Interest Rate Futures
An interest rate futures contract is a financial derivative. It allows the buyer of the contract to lock in a future investment rate. Like all derivatives, interest rate futures are based on an underlying security, which is a debt obligation that moves in value as interest rates change (Ord, 2011).
The interest rate future is a contract between the buyer and the seller in which they agree to the future delivery of any interest-bearing asset. The interest rate future allows the buyer and seller to lock in the price of the interest-bearing asset for a future date.
Some examples of underlying instruments of interest rate futures include:
Treasury bills in the case of Treasury bill futures traded on the Chicago Mercantile Exchange (CME)
Treasury bonds in the case of Treasury bond futures traded on the Chicago Board of Trade (CBT)
Other products such as CDs, treasury notes and Ginnie Mae's are also available to be traded as underlying assets in an interest rate future
Given how large in size interest rate futures are -- for example, $1 million for treasury bills -- they are not considered a product for the less sophisticated trader (Investopedia, 2011).
When interest rates move higher, the buyer of the futures contract pays the seller an amount equal to the benefit received by investing at a higher rate vs. that of the rate specified in the futures contract. Conversely, when interest rates move lower, the seller of the futures contract will compensate the buyer for the lower interest rate at the time of expiration. (Ord, 2011).
Interest rate options are both exchange traded and over-the-counter instruments. Interest rate options from exchanges in the U.S. are offered on Treasury bond futures, Treasury note futures, and Eurodollar futures. An investor who takes a long position in interest rate call options believes that interest rates will rise; and investor who takes a position in interest rate put options believes that interest rates will fall (Investopedia, 2011).
An interest rate option is an option contract that gives the holder the right to buy, for a call, or sell, for a put, a security with a certain interest rate at a given strike price on or before the expiration date. An interest option is useful to hedge the interest risk inherent to portfolios consisting mainly of bonds (Farlex, 2009).
With interest rate options the underlying is not an asset, it is an interest rate. The underlying can be thought of as an interest payment. Interest rate options are by definition cash settled (Chance, 2008).
Forward Rate Agreements
A forward rate agreement (FRA) is a cash-settled forward contract on a short-term loan. For example, a 3x9 FRA is a 3-month forward on a 6-month loan; the loan commences in three months and matures in 9. The interest rate on the loan is called the FRA rate and is set when the contract is first entered into. Because they are cash settled, no loan is ever extended; instead, the contracts settle with a single cash payment linked to LIBOR or EURIBOR (Holton, 2007). FRAs are used as hedging vehicles and are similar to Eurodollar futures; but because they trade OTC, they have…
