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Interest rate risk

3.3 Interest rate futures (IRFs)

Aim of an interest rate future:

 like an FRA in that they fix the interest rate and are binding

 like currency futures in that they are standardised by date and value

Operation for a loan:

 if you know you will need a loan in the future, sell futures contracts now

 when the borrowing is needed, enter into the loan in the normal way (separate
contract to the futures contract)

 also at this point, close out the futures contract by buying it back

 the loan and the buying back of the futures contracts effectively cancel each
other out (meaning that interest rate changes since the point at which the
futures contracts were initially sold have no effect)

 perform the opposite futures transactions for a deposit (buy up front and sell on
close out)
Basis risk

Because futures are standardised by date, the exact interest rate exposure may not
be covered exactly – the gain or loss on the futures contract may not exactly offset
the movement in interest rates for the underlying loan or deposit. This gives an
imperfect hedge.

It arises because the futures price only matches the spot interest rate on the exact
date of close out. The difference on any other date is the basis.

Imperfect hedges also occur because the contracts are standardised in value and
therefore may not cover the exact deposit or loan value.

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