G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G G Euronext refers to Euronext NV and any company which is at least a 50% owned subsidiary of Euronext NV. All proprietary rights and interest in this publication shall be vested in Euronext and all other rights including, but without limitation, patent, registered design, copyright, trademark, service mark, connected with this publication shall also be vested in Euronext.LIFFE CONNECT® is a trademark of LIFFE Administration and Management ("LIFFE") and is registered in Australia, Hong Kong, Singapore, the United States, Japan, the United Kingdom and as a European Community Trade Mark. No part of this publication may be redistributed or reproduced in any form or by any means or used to make any derivative work (such as translation, transformation, or adaptation) without written permission from Euronext. Euronext shall not be liable (except to the extent required by law) for the use of the information contained herein however arising in any circumstances connected with actual trading or otherwise. Neither Euronext, nor its servants nor agents, is responsible for any errors or omissions contained in this publication.This publication is for information only and does not constitute an offer, solicitation or recommendation to acquire or dispose of any investment or to engage in any other transaction.All information, descriptions, examples and calculations contained in this publication are for guidance purposes only, and should not be treated as definitive. Those wishing either to trade futures and options contracts on Exchanges within the Euronext Group, or to offer and sell them to others should establish the regulatory position in the relevant jurisdiction before doing so. Euronext.liffe refers to the combined derivatives operations of Euronext and LIFFE. It comprises: Euronext Amsterdam Derivative Markets, which is a regulated market under Dutch Law; G Euronext Brussels Derivatives Market, which is a regulated market under Belgian Law; G G Euronext Lisbon Futures and Options Market, which is a regulated market under Portuguese Law; G LIFFE Administration and Management, which is a Recognised Investment Exchange under English Law; G MATIF and MONEP, which are regulated markets under French Law. All are regulated markets under the European Union’s Investment Services Directive. Euronext NV PO Box 19163 1000 GD Amsterdam The Netherlands Tel +31 (0)20 550 4444 .
ContentsG G 1 Introduction G 1 G Euronext, LIFFE and Euronext.liffe 2 G 2 Introduction to understanding Short Term Interest Rate (STIR) G futures 3G G Definitions 3G G 3 The wholesale cash money markets G 4 G Introduction 4 G Understanding money market risk management 4G G 4 The Inter-bank (or “Depo”) market G 7 G Domestic and Eurocurrencies 8 G The importance of LIBOR and EURIBOR benchmark fixings 8 G Calculating simple interest on loans and deposits 10 G Conclusion – The inter-bank market 12G G 5 STIR futures G 13 G What defines a futures contract? 13 G Why trade STIR futures contracts on Euronext.liffe 13 G What has made STIR futures so successful? 14 G What is a STIR future? 14 G STIRs as “Contracts for difference” 19G G 6 Price movements of STIR futures contracts G 20 G Buying, or selling, STIR futures? 20 G The pricing mechanism of STIR futures 22 G The basis 24 G Conclusion 25Contents continued overleaf
G G 7 Trading with STIR futures G 26 G Using STIR futures contracts as a hedge 26 G Hedging where dates don’t match i.e. to non-Euronext.liffe settlement dates 28 G Trading the futures curve using ‘calendar spreads’ 31G G 8 Pricing swaps using STIR futures -Interest Rate Swaps G 33 G Interest Rate Swaps 33 G The relationship between STIR futures and short dated IRS’s 34 G Using the STIR futures strip to determine the price of a one year swap rate 34G G 9 STIR options – an introduction G 38 G What is an option? 38 G The advantages of buying and selling options 39 G De-coding the market jargon 40G G 10 Trading with STIR options G 43 G Trading examples 43 G Exercising an option 44 G Limitations of using options – the calculation of the break-even rate 45 G Option valuation 45G G 11 One year Mid-Curve options G 52G G G Contacts Inside back cover
Introduction to trading STIRs 1G G G Introduction 1 In today’s financial markets, uncertainty and volatility are ever present, especially in the interest rate markets. Increasingly, treasurers, fund managers and others active in the world’s financial markets are advised to consider cost effective methods of managing their exposure Additionally, and not to be overlooked, bank to sharp moves in those financial markets. treasury managers and fund managers can benefit from less restrictive regulatory Managing risk constraints pertaining to capital requirements Treasurers, fund managers and other market when trading exchange-traded futures and participants have a number of choices available options contracts. to them to help them manage their interest rate exposure. Either by using exchange-traded Comprehensive portfolio products, like futures and options contracts, or Euronext.liffe offers one of the most over-the-counter (OTC) products, such as comprehensive portfolios of Short Term Interest swaps, Forward Rate Agreements (FRAs), caps Rate (STIR) futures contracts in the world and floors together with the underlying cash covering the European market. Indeed, markets themselves. Indeed, successful players in Euronext.liffe, with its flagship contract, the today’s volatile markets will employ the full range Three Month Euro (EURIBOR) Futures of available risk management and trading Contract, has over 99% market share in the strategies. trading of Euro denominated STIR contracts. Exchange traded futures and options contracts Trading STIRs offer market participants not only a high degree This brochure has been developed by of versatility in their use, but also significant Euronext.liffe in conjunction with Resource City, advantages as strategic instruments, especially a leading provider of educational material to when complemented by OTC derivative and capital market participants.The brochure has cash market financial instruments. Indeed, when been designed to provide an overview of the use used effectively, exchange-traded futures and and application of Short Term Interest Rate options contracts, in conjunction with cash futures and options contracts, as well as giving market and OTC derivative instruments can specific worked trading examples. enhance returns, reduce risks and manage interest rate risks with greater certainty, This publication has been written to be precision and economy. accessible to all levels of market participant, and as such assumes no prior financial knowledge on behalf of the readers.Therefore, the publication can either be read through progressively in order to gain an overview of today’s STIR market, or used selectively in order to gain specific insights into certain aspects of the use of STIRs or the actual trading of STIRs. This publication does not offer advice on how or whether to trade STIR futures and options contracts on the LIFFE market and is provided for informational purposes only.
2 Introduction to trading STIRs G Euronext, LIFFE and Euronext.liffe Euronext was formed by the merger of the Amsterdam, Brussels and Paris cash and derivatives exchanges in September 2000.The Euronext Group has since grown further, adding BVLP (the Portuguese cash and derivatives exchange) and LIFFE (The London International Financial Futures and Options Exchange).The derivatives business of Euronext and LIFFE have been being combined under the Euronext.liffe umbrella with the migration of all of Euronext’s derivatives markets to LIFFE CONNECT®, the most sophisticated electronic derivatives trading platform in the world. In this brochure: “Euronext.liffe” refers to the combined derivatives operations of Euronext and G LIFFE, comprising the Euronext derivatives markets in Amsterdam, Brussels, Paris and Lisbon, and the LIFFE market in London; and the “LIFFE market” refers to the UK Recognised Investment Exchange which is G administered by LIFFE Administration and Management (a UK company), and which forms part of Euronext.liffe. For further information about Euronext.liffe’s STIR products, please email firstname.lastname@example.org.
Introduction to trading STIRs 3G G G Introduction to understanding Short Term Interest Rate 2 (STIR) futures Introduced in 1982, the LIFFE market’s STIR contracts have seen strong and steady growth ever since, maturing into one of the leading derivative product portfolios of any exchange. Indeed, such has been the success of these contracts, Euronext.liffe has captured over 99% It is also appropriate at this point, to define what market share of short term euro derivatives with a futures contract is: its flagship contract, the Three Month Euro (EURIBOR) futures contract. Definition of a futures contract A futures contract is a legally binding G Please see Euronext.liffe’s Short Term Interest agreement, concerned with the buying, or Rate Brochure for further details on selling, of a standardised product, at a fixed Euronext.liffe’s STIR product portfolio. price, for cash settlement (or physical delivery1) on a given future date G Definitions In order to understand STIRs fully, it is important In the case of STIR futures, the “standardised to understand some initial definitions, specifically, product” is short-term interest rates, (which what a derivative is and from where it derives. will also be expanded on further in the futures section of this text). Definition of a derivative As the name suggests, a derivative product is Therefore, having defined STIRs as both G the term applied to any product that derives “derivatives” of the underlying cash money from another product, usually (but not markets, and more specifically “futures always) the underlying cash markets. contracts” on short-term interest rates, we can now turn our attention to understanding what a STIRs, as derivative products, derive from the money market product actually is.This will aid underlying cash money markets, which will be your understanding of STIR futures contracts examined in more detail shortly. and help put them into context. 1 STIR contracts are all cash-settled, there is no physical delivery, unlike the bond futures contracts.
4 Introduction to trading STIRs G G G The wholesale cash money markets 3 G Introduction Each country’s own domestic money market is an “OTC” (over-the-counter2) wholesale market, trading in two main areas: 1. Unsecured cash – the so-called Investment Houses, Fund Managers, large/medium “inter-bank”, or “Depo”, market (we will sized Corporations and Governments3. focus more closely on the “depo” market in the next section, as it is closely related to A “Wholesale” market is distinct from a “Retail” the STIR market), and; market, in that the wholesale markets are usually concerned with transactions for large sums of 2. Secured cash – the so-called cash-based money, i.e. in excess of say £500,000 (or the securities, or “tradeable paper” market e.g. foreign currency equivalent).Whereas “Retail” Treasury Bills, Certificates of Deposit (CDs), generally refers to the day-to-day transactions Commercial Paper (CP), Bankers of the general public, in the form of deposits, acceptances (BAs), Floating Rate Notes personal loans, mortgages etc. (FRNs) and of increasing importance, the so-called “repo” (sale and repurchase Although there is no official definition of what agreement) market. constitutes a “money market” product: All of the above OTC deals are done largely over The majority of all financial instruments traded the telephone (either directly between the two in the money markets will have ‘a maturity’ counterparties concerned, or via money of one year, or less. brokers) or, increasingly, via computerised electronic broking systems. Although some money market instruments can have longer maturities, (CDs for example can Collectively these markets are referred to as the have maturities of up to 5 years), this length of “cash” markets, because real sums of money term is normally the area where the so-called will actually be debited and credited to “Capital Markets”, which specialise in medium respective accounts. However, the most and long term transactions, take over. important thing to remember about them is that, because they trade OTC (rather than trading as G Understanding money market risk a standardised contract, on a regulated exchange, management such as the LIFFE market), there is real All money market products are concerned with counterparty risk to consider. two of the three main types of risk: “Counterparty risk” refers to the risk that Interest rate risk; and either counterparty could actually default on the Counterparty (or credit) risk. G deal and thereby leave the other counterparty G exposed. (The third main type of risk is Foreign Exchange (FX), or Currency Risk.) The main market “players” in these wholesale cash money markets are: International and Domestic Banks, Building Societies (UK), 2 An over-the-counter or OTC market is where the two counterparties concerned strike a deal where all aspects are negotiable.The two parties will therefore agree such things as currency, amount, period and price. 3 Only tradeable paper, not Inter-bank, as Governments will not deal “unsecured”.
Introduction to trading STIRs 5Interest rate riskWhat can interest rates do? Well, they can go up,go down, or stay the same. Nobody knows forcertain what is going to happen next, which iswhy this risk has to be managed. For example, assume that a dealer lends moneyThe level of interest rates in any domestic at say, 5% for a three-month period.Then, themarket is determined by numerous factors. following day, interest rates for the three-monthFor example, supply and demand, government period move up to say, 5.25%. If the dealer hadmonetary policy4, the current economic climate, waited one more day, he could have lent at thisthe strength or weakness of the currency etc. higher rate, ie received more interest on the loan.The markets can be volatile and therefore, alterquite frequently.Any action taken based upon Therefore, as a lender, one always wants toactual, or possible, interest rate movement is lend as expensively as possible. (In bankingknown as managing interest rate risk.The terminology, lending funds is also known asmanagement of interest rate risk in the short- ‘creating an asset’, ie it is your assets that youterm cash money markets is dependent upon are lending).whether one is a borrower, or a lender, of funds. Counterparty, or credit risk However, a lender of funds in the cash money markets also incurs another major risk –The borrowerIf you are a borrower of funds (i.e. createliabilities), then your risk is that if interest rates counterparty, or credit risk.This is the risk thatsubsequently come down, you could have waited the funds that have been lent, will not be re-paidand borrowed at a lower (ie cheaper) rate! by the borrower. It is for this reason that all banks (and other financial institutions thatFor example, assume that a dealer borrows participate in the wholesale money markets),money at say, 5% for a three-month period.Then, have very strict lending guidelines set in place.the following day, interest rates for the three- These include:month period move down to say, 4.75%. If the to whom they can lend money;dealer had waited one more day, he could have the amount they can lend; and Gborrowed at this lower rate, ie paid less interest the period of the loan. Gon the loan. G These guidelines are normally known as “creditTherefore, a borrower of funds always wants limits”. Such limits will be set up by a bank’sto borrow as cheaply as possible. (In banking credit department, whose sole purpose it isterminology, borrowing funds is also known as to assess and monitor the ability of existingcreating a liability, ie you are liable to pay the (and potential) counterparties, to repay moneymoney back). borrowed from the bank.The lenderIf you are a lender of funds, (ie create assets), Money market products as “On balancethen your risk is that if interest rates sheet” transactions A bank will account for all such transactionssubsequently go up, you could have waited and mentioned above, on what is known as itslent at a higher (ie more expensive) rate. balance sheet, which is split into assets and liabilities.4 Monetary policy in the Euro-in region is managed by the ECB (European Central Bank), rather than being the responsibility of each individual government.
6 Introduction to trading STIRs Operations such as cash loans (assets) and deposits (liabilities) that actually involve a physical payment (and consequent risk) are therefore termed “On-balance sheet” exposures. Having “On balance sheet” exposures dictates that a Bank is required, by the Bank for International Settlements (BIS), via its Capital Adequacy Directive (CAD), and local regulatory authorities, to set aside, for no return, a proportion of its capital, in case of non-repayment and doubtful debts. This is an important aspect of all money market trading, as it can make “On balance sheet” trading expensive to conduct. This major drawback is one of the main reasons why the use of STIR futures (which are termed “Off balance sheet,”) have grown rapidly as an alternative and more cost effective, interest rate risk management tool. In the section “STIR Futures”, the reason as to why STIR Futures are termed as “Off balance sheet” products and the benefits thereof will be explained in detail.
Introduction to trading STIRs 7G G G The Inter-bank (or “Depo”) market 4 The significance of the so-called “inter-bank” or “Depo” market is that it is the underlying cash market from which STIR futures derive. It is therefore necessary to look at the inter-bank market in greater detail.The inter-bank market Trading periods (in market jargon terms, often referred to as the Figure 1 (above) illustrates Sterling (£) inter-bank “Deposit” or ‘Depo’ market), is a wholesale OTC cash rates for certain fixed periods of time. For market. It is the part of the money markets that illustration purposes, assume that it is published is concerned with the borrowing, or lending, of by a London bank that is active in the sterling large sums of cash (ie at least £500,000 or foreign inter-bank cash market.The fixed periods are currency equivalent), totally unsecured, for marked in bold. certain ﬁxed periods of time. O/N: “Overnight” ie cash lent/borrowed for As the name suggests, the interest rates quoted a one-day period, from today until are known as “inter-bank” rates, simply because tomorrow6 they represent the best rates at which the major T/N: “Tom/Next” ie cash lent/borrowed for a banks, and other large financial institutions (but one-day period, but from tomorrow until not Governments5), are prepared to deal. the next day7 All currencies that trade in the international 1 wk “One week” ie cash lent/borrowed for a money markets have an inter-bank cash market: 7-day period 2 wk “Two weeks” ie cash lent/borrowed for Example a 14-day period A typical set of rates, as given below, illustrates 1 mth “One month” ie cash lent/borrowed for the Sterling (GBP) inter-bank cash rates one calendar month applicable, for the various periods concerned: 2 mth etc. Figure 1: Sterling inter-bank rates You will note that there are two interest rates quoted for each period.This style of quote is known as a “two-way” price, representing the Period Offer Bid O/N 4.70 4.60 interest rates at which a market maker (ie the 4.65 4.55 bank making the price) is prepared to lend, or borrow, money in the inter-bank market. T/N 1 wk 5.00 4.75 2 wk 5.00 4.75 The highest rate in an inter-bank two-way quote, 5.00 4.75 is always the rate at which a market-maker (bank) would be prepared to lend cash for the period 1 mth 5.00 4.75 concerned.This rate is known as the “offer”. 2 mth 3 mth 5.00* 4.75 6 mth 5.25 5.00 Similarly: 5.50 5.25 The lowest rate in an Inter-bank two-way quote, 9mth 12mth 5.75 5.50 is always the rate at which a market-maker (bank) * the significance of the three-month offered rate will be would be prepared to borrow cash for the explained shortly period concerned.This rate is known as the “bid.” 5 Governments do not normally deal “unsecured”. 6 If today was a Friday, then “Overnight” would actually mean from today until Monday ie a three-day period. 7 Similarly, if today was a Friday, then “Tom/Next” would mean from Monday until Tuesday.The markets do not trade on weekends, or Bank Holidays.
8 Introduction to trading STIRs A market-maker’s offer is naturally at a higher rate of interest than his bid, as lending high and borrowing low is how a market-maker in the inter-bank market expects to make a profit! Example: Eurocurrencies Assume a market-maker quotes the three-month The definition of a eurocurrency is any G Inter-bank price on the rates given above.This currency that is held outside its country of means he would be willing to: origin. LEND cash (unsecured) for three months For example, USD deposits traded in the UK at 5%, (LIBOR)8 ie his offer, and, money markets are known as “eurodollar” G BORROW cash (unsecured) at 4.75%, deposits, Similarly, sterling traded outside of the ie his bid. UK would be referred to as “eurosterling” etc. G The difference between the market-maker’s offer It is therefore very important not to confuse the and his bid, is known as the “dealing spread”. term “eurocurrency” with the term “euro.” Note: Since this is an inter-bank market, any The “euro” is the name given to the unit of other non-bank participants, e.g. large currency created in January 1999 by the Corporates, may well have to pay a “margin European Central Bank.Whereas, over” to borrow funds. For example, for three “eurocurrency” is the generic term given to any months say 5.00% plus 1⁄4 % margin = 5.25%. currency that is held (or being traded) outside The size of the margin added to the offered rate, its country of origin. for non-bank players, depends on the credit worthiness of the institution concerned. Technically therefore, the euro would not be Similarly, a Corporate wishing to place money on termed a eurocurrency, unless it is being traded deposit may only be quoted, say 4.50% (ie bid outside the euro zone. side minus 1⁄4 %). G The importance of LIBOR and EURIBOR G Domestic and Eurocurrencies benchmark fixings The inter-bank markets for the various currencies that trade in the international money LIBOR markets come in two forms: Referring to the Sterling Inter-bank rate sheet illustrated (Figure 1), you will note that there is Domestic an asterisk* by the three-month offered rate, The definition of a domestic currency is one which is also printed in bold.This is to alert you G that is held in its country of origin. to the importance of this rate, with regard the STIR futures markets. In order to understand the For example, sterling (GBP) is the domestic concept of STIR futures, it is important to currency of the UK money markets.Whereas, understand the significance of this three-month the euro is the domestic currency of the offered rate. (currently) 12 countries which collectively make up the eurozone (ie Germany, France, Italy, Austria, Spain, Portugal, Belgium, Netherlands, Luxembourg, Finland, Ireland and Greece). 8 The concept of LIBOR will be covered shortly.
Introduction to trading STIRs 9At 11am each day, in London, an “official fixing”of a whole range of “LIBOR” rates, for a varietyof currencies, takes place under British BankersAssociation (BBA) rules, for any currency “fixing”in London. For example, for the major currencies“fixing” in London, the BBA will publish an based financial transactions (such as STIR futuresovernight, one week and two week fixing as well contracts), can be made).as 12 monthly fixings out to one year. It is important to realise therefore, that theLIBOR stands for “London Inter-bank word ‘LIBOR’ actually refers to the fixing of anyOffered Rate”. currencies traded in London and agreeing to abide by a BBA LIBOR fixing.The fixings are determined as follows: It is also possible to have an official USD LIBORAt just before 11am, a group of 16 London banks fixing (ie US Dollar inter-bank rates “fixed” insubmit their offered rates for a variety of the Inter- London), or a CHF LIBOR fixing (ie Swiss francbank periods mentioned above, in order to allow rates “fixed” in London). Similarly, it is possible toan official “ﬁxing” of this period to take place. have a Yen LIBOR fixing (ie Yen rates fixed in London), or even a “euro-LIBOR” fixing (ie euroFor example, when setting the official three- rates fixed in London – see notes below onmonth Sterling (or currency code GBP, or “EURIBOR”).symbol £) LIBOR rate, the four highest and thefour lowest rates submitted are discarded. The importance of the three monthSubsequently, the official three-month GBP LIBOR rateLIBOR rate is then ‘fixed’ at 11am, by establishing It is the three month fixing that has mostthe mean average of the remaining eight banks’ significance for the STIR market, as this isoffered quotes. essentially the “underlying cash product” that the STIR futures contracts derive from.It is this official three-month LIBOR (orEURIBOR – see below) “fixing” that is the For example with regard to Euronext.liffe’s STIRmost significant to us here, as this is also the futures contracts, LIBOR is the reference rate“underlying product” that the STIR futures used for the Three Month Sterling (Short Sterling)contracts are based on. Interest Rate futures contract (£ LIBOR), and the Three Month Euro Swiss Franc (Euroswiss)For example, when someone trades a STIR Interest Rate futures contract (CHF LIBOR).futures contract, they are trading what they thinkthis official three month LIBOR (or EURIBOR – Other countries have their own official interestsee below) fixing rate will be for the currency rate fixings for domestic and eurocurrencies, andconcerned, on a given future date. (However, this these are used in similar circumstances, fordoes not mean that the “offered side” of the example:three-month inter-bank rate will remain at thislevel for the rest of the day’s trading. Rather, this SIBOR: Singapore Inter-bank Offered Rateofficial fixing rate at 11am is merely used as a G TIBOR:Tokyo Inter-bank Offered Rate9“reference rate” or “benchmark”, against which Gthe pricing, or settlement, of a variety of LIBOR-9 With reference to the STIR contracts, the yen denominated futures contract is settled against the TIBOR fixing.
10 Introduction to trading STIRs EURIBOR The initial struggle for supremacy concerning a “euro reference rate” needs to be mentioned here.When the euro was first introduced as a single currency, in January 1999, it was assumed that the main “fixing” centre would be in Simple interest = London, ie a LIBOR rate for the euro (the “euro- Actual No. of days in period Principal Amount x % Rate x LIBOR rate” as mentioned above). However, this Actual No. of days in year has not been the case. Using the data in Figure 1, on a market-maker’s three month quote of “5.25 – 5.00” for the three For a variety of reasons, the main centre for the month period, on a principal amount of say fixing of euro benchmark interest rates has now £500,000, the amount of interest to be paid established itself in Brussels, where a panel of 49 (or received), at the end of the period (ie at banks, calculate their own official benchmark maturity), can be calculated as follows: interest rates for the euro.The majority of the panel are from Euro-in countries, but also include, for example, the UK, which is a member of the European Union, but is not a participant in the euro itself. This reference rate is known as the European Bankers Federation (EBF) “EURIBOR” rate. *See notes below on Value Dates & Day Basis. Strictly speaking it should be referred to as the ‘euro-EURIBOR rate’, but because the euro is Hence, in a) above, as a market user: the only currency being fixed under this new If you were a borrower of funds and dealt at EBF benchmark reference rate, it is only ever the market maker’s offer of 5.001%, you would referred to as the “EURIBOR” rate. borrow (“go long”) £500,000 at the outset. You would also repay the principal plus interest EURIBOR stands for “Euro Inter-bank (ie £500,000.00 + £6,232.88) at the end of the Offered Rate”. fixed period (in this case 91 days later). In b) above, as a market user: If you were a lender of funds and dealt at the G Calculating simple interest on loans market maker’s bid of 4.75%, you would lend and deposits In order to fully understand where “minimum tick size movements” on Euronext.liffe’s STIR (“go short”) £500,000 at the outset.You would futures contracts come from, it is important to also receive principal plus interest (ie £500,000 + understand the calculation of interest paid, or £5,921.23) at the end of the fixed period (in this received, in the inter-bank markets.The amount case also 91 days later). of interest to be paid, or received, on a loan or deposit, is calculated at the start of the fixed A dealer making a two-way price and dealing on period to which it relates, but is paid at the end both sides simultaneously would therefore make (known as “in arrears”). It is calculated using the a profit of £311.64. following simple interest formula:
Introduction to trading STIRs 11Value dates & day basisSterling (GBP), as the UK’s Domestic currency,normally deals ‘value today’, ie out of today,calculating the Actual number of days in thedeposit period and dividing by a 365 day basis(known as Bond basis).This would be written This would be referred to as “T (trade) + 2 (twoas “Actual/365”. business days forward)”, ie out of Wednesday 11th May, (also known as “out of spot”) and withWhereas: an end date, or maturity date, of 11th August (ie same date but exactly three calendar monthsMost eurocurrencies deal ‘value spot’ (ie two later, providing it is a good business day). Hence,business days forward), calculating the Actual in this case the trade date (9th May) and thenumber of days in the deposit period, but value date (11th May) are clearly not the same!dividing by a 360 day basis (known as MoneyMarket basis).This would be written as This is because most eurocurrencies trade “out“Actual/360”. of spot”, not “out of today”.Example actual/365 (£) The actual number of days in the deposit periodIf today is Monday, 9th May, 2005, then a would then be calculated (in this case 11th May –calculation for a Sterling deposit, for say a 11th August 2005 = 92 days) and would then bethree month period, would have a value date of divided by the Day Basis applicable to euros ie6th May ie the same day on which the trade 360 days.was enacted. The actual number of days in a depositThis is referred to as “T (trade) + 0 (no days)” periodand an end date, or maturity date, of 9th August It is important to realise that, in the inter-bank(ie same date, but exactly three calendar months markets, the actual number of days in any givenlater, providing it is a good business day). Hence deposit period can vary, according to the actualin this case, the trade date and value date are the dates in question.same, and Sterling is said to trade “out of today”or “value today”. Hence a three month run will not always be exactly a quarter of a year ie 91, or 90 days,The actual number of days in the deposit period but is normally somewhere between say 89 – 93would then be calculated (in this case 9th May – days. Shorter, or longer, periods are likely to9th August, 2005 = 92 days) and would then be occur where a weekend, or Bank holiday perioddivided by the Day Basis applicable to Sterling ie is concerned.This is because the start date365 days. (value date) and end date (maturity date) can only be on ‘good’ business days.However, this is not the case witheurocurrencies (ie euros, Swiss Francs,Yen etc. For example, assume a Sterling three monthtrading in London). transaction where the actual dates are 2nd Feb – 2nd May 2005. Using a calendar, you will see thatExample actual/360 (€,CHF,Yen) 2nd Feb is a Wednesday. However, 2nd May was aIf one were doing the same calculation as given Bank Holiday in the UK, therefore standardabove, but for say euros, then the value date market practice is to go forward to the nextwould be two business days forward from the good business day ie Tuesday 3rd. (The onlytrade date of Monday, 9th May. exception to this would be if, by going forward, it
12 Introduction to trading STIRs put you into the next calendar month. In that case you would go backwards, to the previous good business day).The actual number of days would therefore be 2nd Feb – 3rd May = 90 days. G Conclusion – The inter-bank market By contrast, a euro three month transaction The inter-bank market is the most basic of all where the actual dates are say 5th April – 5th money market products. It is concerned with the July, 2005, would give rise to an actual number borrowing or lending of cash, totally unsecured, of days of 91 days. for fixed periods of time. Moreover, because money actually changes hands, there is real Using the correct day base counterparty risk to consider. Having established the actual number of days, one must also remember that the Day Base can Banks, and other financial institutions, that deal in vary, according to the currency being used. the Wholesale Cash Money Markets, thereby Hence, in the Sterling example given above, the create what are known as “On Balance Sheet” 93 (Actual) days, would then be divided by the exposures, having to set aside a proportion of Sterling Day Base of 365.Whereas, with the euro their exposure, as provision for bad and doubtful calculation, this would be 91 (Actual) days, debt.This makes On Balance Sheet transactions divided by the euro Day Base of 360. expensive to conduct. Hence in summary, with regard the currencies The main users of the inter-bank markets, are that have a Euronext.liffe STIR futures contract therefore those with a physical cash requirement. based upon them: For example, Banks, Building Societies (UK), Fund Managers or large Corporations, who ﬁnd Currency Value Date Day themselves with excess funds, either overnight Basis (O/N) or for a “ﬁxed” term (ie up to 12 months), or in need of such funds. Sterling Same as Trade date, hence 365 “T + 0” They can use the wholesale cash money markets, €, CHF,Yen Trade date + two business 360 in order to gain access to other participants, and days, hence “T + 2” so match their funding requirements. However, those with a desire only to manage interest rate risk (ie without a physical cash requirement) can access a more prudent and cost effective route: Futures!
Introduction to trading STIRs 13G G G STIR futures 5 G What defines a futures contract? Unlike the OTC Inter-bank markets, from which they derive, all of Euronext.liffe’s STIR futures contracts are traded electronically (via LIFFE CONNECT®) on a regulated exchange. Central Marketplace STIR future contracts are defined as: With exchange traded futures (and options), G A legally binding agreement, concerned with the buyers and sellers enjoy immediate access to buying, or selling, of a standardised amount of a a central marketplace, where a large number given short term interest rate product, at a fixed of competing buyers and sellers can transact price, for cash settlement on a given future date. their business, via the LIFFE CONNECT® electronic trading system. STIR futures contracts derive from the cash inter-bank markets, previously mentioned, since Price transparency they are concerned with the trading of the Euronext.liffe’s electronic trading platform, G implied value of three month LIBOR (£ and LIFFE CONNECT®, provides continuous and CHF) EURIBOR (€) or TIBOR (Yen), but from competitive price discovery and global a given future date. dissemination of price information. In essence “price discovery” means that the G Why trade STIR futures contracts on best bid and best offer in any given contract, Euronext.liffe? is always displayed on the trading screen and Trading interest rate risk using Euronext.liffe’s “global dissemination of price information” STIRs has many advantages, including: means that computer terminals are distributed to a world-wide audience! Liquidity Exchange traded futures (and options) are Together, these two aspects make it possible G standardised contracts.They provide a for traders (no matter how big, or how uniformity of specification and quality, which small) to compete on equal terms and enhances market liquidity and efficiency. In facilitate the timing of trading decisions, as theory, it is possible to have a futures quickly and accurately as possible. contract on any product, but strong user demand is what produces liquidity. Central Clearing Unlike the OTC markets, the LIFFE market’s G “Liquidity” refers to the depth of the futures and options contracts benefit from a market, ie a large number of buyers central clearing counterparty, known as and sellers creating substance to the LCH.Clearnet.This means that counterparty marketplace, allowing for a free flow risk is considerably reduced. of transactions at any given price. Upon matching and registration of purchases Liquidity is therefore the essential factor for and sales, LCH.Clearnet, (which is the survival of any futures contract. independent of the Exchange), becomes the Euronext.liffe is dominant in STIR futures effective buyer to every seller, and seller to contracts, as well as having strong bond, every buyer. Hence LCH.Clearnet becomes swap and equity product portfolios, with its the guarantor of all futures (and options) biggest, and most liquid contract, being the trades to so-called Clearing Member firms. Three Month Euro (EURIBOR) Interest Rate futures contract.
14 Introduction to trading STIRs LCH.Clearnet thereby ensures the integrity of the Exchange’s contracts, by calling on Member Firms, for so-called Initial Margin (ie funds placed with LCH.Clearnet at the time that a new position is taken), and Variation margin (ie additional funds placed with or settlement. By trading STIR futures, a trader withdrawn from LCH.Clearnet, where a will utilise less of a Bank’s capital10 than position is showing an open loss or gain), on would be the case with ‘On-Balance Sheet’ all positions. For further details on the transactions, such as ‘cash’. margining system used by the LIFFE market, London SPAN® version 4, please see 3. Counterparty risk is standardised in www.euronext.com. the Futures markets.This is due to the combination of the margining system unique Regulated market to the Futures Exchange and the role of the The LIFFE market is a Recognised clearing house (LCH), standing as G Investment Exchange (RIE) under the UK counterparty to every trade. Consequently, Financial Services Act.As such the LIFFE ‘counterparty risk’ (which is prevalent in the market is required to ensure that all business cash markets) is all but eliminated. is conducted in an orderly manner and that the Exchange affords proper protection to G What is a STIR future? investors. STIRS are short-term interest rate derivatives, that derive from the underlying three-month G What has made STIR futures so successful? LIBOR,TIBOR or EURIBOR rate traded in the STIR futures contracts have been so successful OTC Cash Money Markets. and have expanded so rapidly, simply because they offer something that the underlying OTC The Short Term Interest Rate (STIR) Futures cash markets alone cannot offer. Chiefly there Contracts currently traded on Euronext.liffe, are are three reasons: as follows: 1. They enable traders to trade for a future Contract Underlying product value date, thereby allowing them the Three Month Euro Three month € opportunity to hedge (ie cover, or protect) a (EURIBOR) Interest EURIBOR fixing rate forward interest rate exposure and hence Rate futures contract remove some of the uncertainty associated Three Month Sterling Three month £ LIBOR with interest rate risk management. (Short Sterling) Interest fixing rate (Speculators on the other hand, are on the Rate futures contract other side of the fence.They are instrumental in providing the liquidity that is needed for Three Month Euro Three month CHF futures exchanges to succeed, by speculating Swiss Franc (Euroswiss) LIBOR fixing rate (ie taking risk) on future price movements!) Interest Rate futures contract 2. They are termed ‘Off-Balance Sheet’ Three Month Euroyen Three month Yen products.They do not involve the physical (TIBOR) Interest Rate TIBOR fixing rate risk of the underlying transaction amount (unlike the Cash Money Markets), but are in the main based on ‘contract for difference’ 10 In fact, Futures do NOT require credit risk weighting for BIS capital adequacy purposes.
Introduction to trading STIRs 15Contract monthsThe STIR futures contracts are standardisedcontracts that trade for specific so-called“quarterly” contract months.These are: March, June, Sep, Dec. However, this does not mean that a trader has to keep a position until expiry. STIR futures areMoreover, the STIR contracts actually expire (ie tradeable, which means they can be bought andstop trading) on the third Wednesday of sold on an on-going basis, right up until the daythe contract month in question at and time of expiry, at which time the contract11.00 a.m. (London or Brussels time depending will cease to exist!on the contract). In practice, this means thatShort Sterling stops trading at 11.00 am (London What is meant by the serial months?time) on the third Wednesday (ie Sterling trades In order to widen the menu of contracts“out of today”). available for trading, so-called “serial months” have also been introduced, such that the frontHowever, the Three Month Euro (EURIBOR) and three calendar months are always available forThree Month Euro Swiss Franc (Euroswiss) trading.futures contracts actually stop trading at 11amBrussels time on two business days prior to the A “serial month” therefore simply refers to athird Wednesday.This is because they trade ‘out contract month other than the standardof spot’ (ie two working days hence.) This has quarterly futures date mentioned above.got nothing to do with whether they are fixedagainst LIBOR, or not – it is just that they are all For example:classified as “eurocurrencies”. For example, the If it is now 1st June, 2005, then the EURIBOREuroswiss contract trades “out of spot”, but has contract months available for trading would bea LIBOR fixing. as follows:Traders of STIRs, are therefore trading June (Quarterly) ‘front’ month (expires Monday preceding 3rd Wednesday. Gwhat they think the official three-monthCash Inter-bank LIBOR (Sterling, of June)Euroswiss), or EURIBOR (Euro) or Tibor July (Serial month) August (Serial month) G(Euroyen TIBOR) fixing rate will be on a Then Sept (Quarterly) and subsequent Ggiven future date. quarterly months. GFor example, September ’05 EURIBORFuture: However, all other aspects of serial monthWhat do I think the official three month trading are the same.EURIBOR (Brussels) fixing rate will be at11.00am (Brussels time) on the Monday For example:preceding the third Wednesday of If you traded the July ’05 EURIBOR (serialSeptember 2005? month) contract you would be trading:Or, Dec ’05 Short Sterling: What do I think the official three monthWhat do I think the official three month LIBOR EURIBOR (Brussels) fixing rate will be at 11am(London) ﬁxing rate will be at 11.00am (London (Brussels time) on the Monday preceding thetime) on the third Wednesday of December 2005? third Wednesday of July 2005?
16 Introduction to trading STIRs Hence it is still a three month EURIBOR-based contract, but for a different calendar month! What are the standard contract sizes on Euronext.liffe? Unlike the OTC Cash Money Markets, where the For example, a dealer trading in say, the size of each trade has to be agreed between the EURIBOR futures contract, is not risking a two counterparties concerned, each STIR futures capital sum of €1,000,000. Rather, the nominal “contract” is based on a nominal standard contract size is merely used to calculate the contract size, as determined by the Exchange. minimum tick size movement that each futures contract represents (see minimum tick size For example: movement calculations below). One Short Sterling contract is worth a nominal £500,000. This is what is then used to calculate the profit, or loss, thereby generated on any given Therefore, if you were to trade in 20 contracts, transaction.This is an important point, because you would be trading a nominal11 value of: it means that STIR futures are therefore termed “Off Balance Sheet” transactions. £500,000 x 20 = £10,000,000 worth of short term interest rate movement. Why are STIR futures termed “Off balance sheet”? The contract sizes for all the STIR contracts One of the most important aspects of trading traded on LIFFE are as follows: STIRs is that (unlike the inter-bank market), they are termed “Off Balance Sheet” products. Contract Unit of trading (Nominal STIR futures are termed “Off Balance Sheet”, contract size) because they do not involve the physical borrowing, or lending, of the nominal underlying Three Month Euro (EURIBOR) contract value. Moreover, since the nominal Interest Rate futures contract €1,000,000 capital sum is never at risk, a Bank, or other Three Month Sterling (Short financial institution, can trade more of them Sterling) Interest Rate futures (as opposed to trading in the Inter-bank market), contract £500,000 without “inflating” the Balance Sheet. Three Month Euro Swiss Franc (Euroswiss) Interest Rate futures Because they are classified as “Off Balance contract CHF 1,000,000 Sheet” instruments, the Capital Adequacy requirement for STIR futures contracts, is also Three Month Euroyen (TIBOR) greatly reduced. Interest Rate futures contract ¥100,000,000 In essence, this means that STIRs are a more Why are futures contracts known as cost effective tool for managing interest rate contracts for difference? risk, than the underlying inter-bank markets, from Futures are known as ‘contracts for difference’, which they derive. simply because the underlying “nominal” value of the contract is not pledged. 11 Trading a ‘nominal’ value in the STIR Futures markets is distinct from the Cash markets, where the actual underlying cash sum is physically borrowed, or lent.
Introduction to trading STIRs 17As you will see shortly, the nominal contractvalue is never at risk, but is merely used todetermine two important aspects of dealing a)the total number of contracts required and b)the calculation of the “minimum tick size value”for each contract. On a principal amount of say, €1,000,000, it is now possible to calculate the amount of interestHow are the minimum tick size to be paid, or received, at the end of the fixedmovements on STIRs determined? period, ie at maturity. In this case, the differenceThe tick size values for each of the STIR futures between the two amounts should represent thecontracts are based on the simple interest dealer’s profit on the transaction.formula used for calculating interest in theInter-bank market.The minimum tick size movement variesaccording to the contract concerned, but formost contracts is referred to as “a 01”.The value of a “01” actually means a one basis *See notes on value dates and day basispoint move, in interest rate terms, from say 4%(ie 96.00 futures equivalent price) to 3.99% The difference between the two amounts(96.01 futures equivalent price). represents the dealer’s profit. Hence in this example, a dealer in the inter-bank market,In order to understand how the futures market borrowing euros at 3.99% and lending at thecalculates the value of “an 01”, it is therefore higher rate of 4.00%, would make a profit ofimportant to re-visit the way in which the only €25.00.calculation of interest is determined in theinter-bank market, from which STIR futures However, since the inter-bank market isare derived. “On Balance Sheet”, a certain amount of capital would also have to be set aside, for bad andYou will recall that in the inter-bank market, doubtful debt.This means that, in practice, it isinterest is calculated “in arrears”, using the more expensive to transact, when comparedSimple Interest formula: with using “Off Balance Sheet” products, such as STIR interest rate futures. For example, in theSimple interest = above scenario, the cost of capital could more Actual No. of days in periodPrincipal Amount x % Rate x than wipe out this tiny profit. Actual No. of days in yearLet us now assume that a bank dealer is able to The STIR futures market, was therefore devisedborrow euro in the inter-bank market at say as an alternative “Off Balance Sheet” market, for3.99%, for a three month period (say 90 days, trading interest rate risk, without the underlyingusing actual number of days). Similarly, let us capital sum involved actually being pledged.assume that he can also lend the same amount,at a higher rate of interest, say, 4.00% (ie a STIR futures contracts are considered “Offdifference of “.01”) for a similar period. Balance Sheet” because all transactions areBorrowing cheaply and lending expensively is based on a “nominal” contract size, which canhow a dealer hopes to make a profit. then be used to determine a nominal “tick size” movement.This means that no actual capital sum
18 Introduction to trading STIRs changes hands and therefore cannot be at risk. To demonstrate how the STIR futures market works, now let us assume that the bank dealer does not wish to borrow or lend, but simply wishes to take a view on interest rates, and as such, trades one Three Month Euro (EURIBOR) price moves from say 96.00 to 96.005, then Interest Rate futures contract. the half tick value can be similarly identified as follows: Let us assume that he deals simultaneously at 3.99% equivalent (ie futures price of 96.01) and at 4.00% equivalent (ie futures price of 96.00) to lock in a difference of “one tick” or a “01” ie 0.01/100.We will further assume that rather than an actual sum, a nominal €1,000,000 contract value is now applied. Calculating basis point value or tick values To further simplify things, with STIR futures for other STIR futures contracts contracts, the period of time is also standardised, The other STIR futures contracts have their tick in that it is no longer calculated based on the values calculated in a similar fashion. actual number of days in a given three month period, but is simply expressed as: Three Month Sterling (Short Sterling) Interest Rate futures contract “1/4 of a year” For example, for the Short Sterling contract, the only difference is that the nominal contract value (Since no actual physical borrowing or lending is is £500,000.Therefore the tick value of a “01” going to occur, this is not a problem!) can be calculated as follows: Hence the calculation has now been reduced to: Three Month Euro Swiss Franc (Euroswiss) Interest Rate futures contract For the Euroswiss, the tick value is similar to the EURIBOR contract, in that the nominal contract Therefore the value of each “01” or one tick value is of a similar denomination ie is €25.00. CHF1,000,000.Therefore: Hence a one tick move (up or down) in the EURIBOR futures contract, is equivalent to “.01%” interest rate movement in the underlying market, but because no capital sum ever changes hands, it is reduced to a tick value of €25.00 profit, or loss, per contract. Note:The Three Month Euro (EURIBOR) Interest Rate futures contract actually trades in half ticks (.005) as well as full ticks (.01) ie if the
Introduction to trading STIRs 19 Three Month Euroyen (TIBOR) Interest Rate futures contract For the Euroyen, the tick value is larger, because the nominal contract value is greater: ThereforeG STIRs as “contracts for difference” The tick values created above represent a dealer’s actual profit, or loss on the transaction. Consequently, such profit and loss amounts will show up on a balance sheet, as they represent a real ‘cash’ flow. Hence a dealer using STIR futures contracts is trading interest rate risk, however, without the associated risks of On Balance Sheet transactions, such as when trading the underlying cash inter-bank market.The only sum that would appear on a Bank’s balance sheet, when trading futures contracts, is the profit or loss thereby generated. Hence, this is why STIR futures are also known as: “contracts for difference”
20 Introduction to trading STIRs G G G Price movements of STIR futures contracts 6 Now that we have looked at minimum tick movements of STIR futures contracts, it is important to see what a price movement up, or down, actually implies, in interest rate terms. The following diagram portrays, in pictorial style, For example: the relationship between interest rates, and their related STIR futures contract.This will be Step 1: Buy 5 EURIBOR contracts at 97.60, referred to within the text of this section. Step 2: Sell 5 EURIBOR contracts at 97.70 BUYING a Future is like “lending”* at that Calculate Profit/Loss on transaction as follows: equivalent interest rate. 5 (contracts) x 10 ticks x €25.00 per full tick SELLING a Future is like “borrowing” at that =€1,250.00 (profit) equivalent interest rate. *Lending in the cash market would normally be at London Inter- Bought low and sold high, so it is a profit. However, you also need to consider why a trader bank Bid Rate (LIBID) or equivalent. G Buying, or selling, STIR futures? buys, or sells, a STIR contract and what this So far, we have only looked at futures contracts implies in interest rate terms. purely in terms of the value of ‘minimum tick size movements.’ This would enable you to calculate Firstly, it is important to realise that STIR futures profit and loss. contracts trade on a price that is directly ‘inverse’ to interest rates. For example: Figure 2: STIR Futures Diagram Typical futures price Bid Ask (Offer) 97.205 97.210 The interest rate implied from this indirect method of pricing can simply be found by taking the price away from 100. Hence: Bid Ask (offer) 100.000–97.205 100.000–97.210 Implied interest rate: 2.795% 2.790%
Introduction to trading STIRs 21Therefore:A price for the September sterling futurescontract, of say 97.00, implies that the market’sperception is that the official three monthLIBOR fixing on the 3rd Wednesday of Hence,September at 11 am will be 3%. A trader buys STIR futures when he thinks interest rates are going to FALL. (ie said to be “bullish” for interest rates.) The Buyer A trader wishing to buy the STIR futures onG LIFFE CONNECT®, ie simply taking the view Whereas, a trader sells STIR futures when that the price will be higher (ie implied he thinks interest rates are going to RISE (ie interest rates lower) is termed a said to be “bearish” for interest rates)13. speculator. Furthermore, rather than simply speculating The trader could therefore either: on future price movements, a dealer could a) specify a price at which they wish to buy be using STIR futures as either a hedge ie to (perhaps join the bid at 97.000), or protect an underlying cash position. (We will b) enter a “market” order to buy (ie take look at an example of a hedger shortly.) the best available offer at say, 97.005). The concept of “Long” and “Short” Buying a STIR is like lending12 at the equivalent G in STIR futures interest rate, (ie in this case 2.995%.) When a dealer first initiates a new STIR position, either to buy or sell, he is said to: The Seller A trader wishing to sell the STIR future onG Go “long” if he buys the contract. LIFFE CONNECT®, ie simply taking the view Or that the price will be lower (ie implied interest rates higher) is also said to be a Go “short” if he sells the contract. speculator. The concept of “going short” can therefore The trader could therefore either: seem strange, ie selling something that one a) specify a price at which they wish to sell does not own, especially since there is no (perhaps join the offer at 97.005) or tangible underlying product here. However, b) simply enter an order to sell (ie “hit the the position can either be closed out, by bid” at 97.000). buying back at a later date, or simply holding until expiry and paying, or receiving, a cash Selling a STIR is like borrowing at the differential based on the official fixing of the equivalent interest rate, (ie in this case 3%.) LIBOR/EURIBOR/TIBOR rate, this final price is known as the EDSP (Exchange Delivery Settlement Price) of the relevant futures contract.12 Beware of the concept of lending at that rate, since STIRS are all based on a LIBOR rate, whereas in the underlying cash market lending would have to be transacted at LIBID, or equivalent rate. For hedging purposes, this would always make a synthetic (ie futures) transaction (where you have bought the future) appear more attractive than lending in the underlying cash market where you would be dealing at the prevailing LIBID rate.13 “Bullish” in most markets means up, but in interest rate markets, it means interest rates lower, similarly “bearish” in most markets means down, but in interest rate markets it means interest rates higher.
22 Introduction to trading STIRs Adding to a position, (ie buying more, if one is long, or selling more, if one is short), simply adds to this “long” or “short” position. It is not until a trader actually takes an equal and opposite position in the contract, that By using a simple mathematical formula, known he is said to be “square” or “flat” (ie has no as the ‘forward/forward formula’, they were able position). to calculate the interest rate they would need to obtain for the forward period, in order to ensure It is important to realise too, that a trader that they did not lose money on the cash does not have to hold a position until expiry transaction as a whole. of the contract, but can trade out of a position at any time up until expiry. He can Furthermore, since futures are concerned with do this by buying (selling) an equal and the implied value of interest rates for a given opposite transaction in the futures market period, this so called ‘forward/forward formula’ to the position already held. can also be applied to the pricing of STIR futures and works in exactly the same way, as shown G The pricing mechanism of STIR futures below: So far we have only looked at the STIR futures contracts with a given price to work from. But The forward/forward formula how is the price actually derived? b c? As one would expect, STIR futures are priced from the underlying cash inter-bank money a markets from which they derive. Where ‘a’ is the long date,‘b’ is the short date and ‘c’ is the forward/forward period. Prior to the introduction of STIRs (and FRAs – Forward Rate Agreements that trade in the OTC The formula for calculating ‘c’ (the unknown) market) a dealer in the cash markets could easily is therefore: ﬁnd himself with so-called ‘mis-matched’ positions. For example, suppose a dealer in the inter-bank market had lent six month cash and then found that he could only borrow for the first three months at an acceptable rate. He thereby created for himself an exposure,‘borrowing NB. *If the contract to be priced is the requirement’, relating to a three month period, Short Sterling contract, you must remember but starting in three months time ie to replace 360* with 365 in the above formula. ‘forward/forward’. (All other STIR contracts are calculated using a 360-day basis.) The term ‘forward/forward’, therefore literally means an exposure starting on a forward date, Since STIR Futures are based on either a for a further period of time. LIBOR/EURIBOR/TIBOR rate, you must now determine which information would be needed It was because of the headaches associated with to create a LIBOR/EURIBOR/TIBOR rate for running these ‘mis-matched’ positions that the future period ‘c’. dealers soon devised a market for dealing ‘forward/forward’.
Introduction to trading STIRs 23The following diagram shows how this wouldbe created: interest rate futures from the Cash rates, is therefore Thursday, 24th). NB: If this were a Short Sterling example, it would trade ‘out of today’ (T + 0), not spot.Explanation: To calculate the implied, or fair value, price forAssume a trader has borrowed cash for six the June ’05 EURIBOR futures contract using themonths (ie ‘the long date’,) and only lent cash for forward/forward formula:say three months (ie ‘the short date’.) By usingthe forward/forward formula, the trader is able Given:to calculate the rate at which he has effectively 6 month cash rates: 2.2735 – 2.1485 (use offeredborrowed for the 3–6 period. side ie “Borrow” long date) three-month cash rates: 2.1486 – 2.0236 (use bidThis so-called forward/forward formula can side ie “Lend” short date)be used to calculate the ‘value’ ofLIBOR/EURIBOR/TIBOR from any given start Although there are various methods of creatingdate and for any given LIBOR/EURIBOR/TIBOR this rate, including creating a trading channel, thisperiod, and since STIR futures are based on the is probably the simplest method to create thevalue of LIBOR/EURIBOR/TIBOR, it can be used implied forward/forward borrowingin this context. (ie EURIBOR) rate.Example: Pricing STIR futures off the cash This is because, if you use the “borrowing rate”money market rates for the long date (here 173 days) and thenAll STIR futures are essentially priced off the use the “lending rate” for the short dateCash Inter-bank Money Market rates (with slight (here 83 days), you thereby create a synthetic‘sentiment’ adjustments, as you shall see).This is implied rate, at which one could “borrow”because the forward/forward formula needs the forward/forward period.Cash rates in the first instance to give a roughapproximation of what the implied forward Since STIRS are based on what the impliedinterest rate should be. borrowing rate should be (either LIBOR/EURIBOR or TIBOR depending on theFor example: contract concerned), it can then be used in this context to create a “fair” futures price. Diagrammatically it would look like this:* = 3rd Wednesday of contract delivery monthAssume today is Tuesday 22nd March 2005 For “c” use 91 days for Short Sterling (ie 1/4 of(Spot date, for calculating implied EURIBOR 365 days), but 90 days for all other STIR futures contracts (ie 1/4 of 360 days).Thus 90 days from