Interest rates fluctuate on a daily basis, depending on monetary policy set by G-7 governments and major banking institutions. The ability to pay back debt and the implied risk of default determine the ratings that are posted on debtors and their instruments by Moody’s, Standard and Poor’s, Fitch, and a number of less famous agencies.
Interest Rate Futures Market
In order for businesses to hedge themselves against interest rate fluctuation risk in the course of managing their budgets and cost of capital, an Interest Rate Futures market developed. This market has also drawn plenty of speculators as well, which adds to the liquidity of interest futures, which, inclusive of forwards and swaps, was over $164 trillion as of 2009 and has only continued to grow to the present.
Price Of Interest Rates Futures Inversely Correlated With Interest Rates
In basic terms, prices of debt derivatives, like interest rate futures (as well as their underlying securities) and interest rates are inversely correlated.
This means that as interest rates rise, prices are depressed. This is because softer demand (as in the case of say, BB or lesser junk rated bonds, which have perceived higher risk) has to be stimulated with a higher return (in the form of a higher coupon) to increase prices. Conversely, prices rise when interest rates drop.
If demand for a particular debt issue is strong, the interest rate can be cut, so that the cost of borrowing is decreased.
A Typical Interest Rates Futures Trade
In a typical interest rate futures transaction, a borrower might sell a future to offset an anticipated rise in interest rates. If the interest rates do, in fact, rise, the price of the future will fall, along with the underlying bond asset price, and the borrower can buy back, or close out the future contract at a lower price, hence making a profit on the difference from the higher sell price.
The majority of interest rate futures contracts trade on the Chicago Mercantile Exchange (CME) and are priced with 1 tick equating to 1 basis point, or .01, although some contracts like Eurodollar futures may price in ticks of half basis points, or .005.
Short Term Interest Rate Futures (STIRS)
These are interest rate futures contracts whose prices are affected primarily by the daily fluctuations of the Fed Rate and LIBOR benchmarks and all have maturities that are short, with the average 30 days or less on the minimum with 90 days or so on the maximum. STIRS include the following examples:
30 Day Fed Funds – these are funds held on account that are above Fed Capital requirements and are lent between Federal Reserve Member banks for overnight loans.
Daily 30 Day Federal Funds (CBOT)
13 Week Treasury Bills – Since the post WW II period, any issue that is associated, explicitly or implicitly, with the U.S. Government, is considered AAA due to the perceived economic stability of the USA. T- Bill futures are sold on the Globex market for March, June, September and December contracts.
90 Day Eurodollars – these are US dollars held outside of the USA. This is the most liquid interest rate futures contract on the market at present. These $1M contracts are priced at 3 month LIBOR (London InterBank Overnight Rate).
30 Day LIBOR – these are also Eurodollar based, but are $3M contracts priced at 30 day LIBOR.
The STIRS category also includes Mexican, EuroYen and other derivatives.
For longer term interest rate hedging and speculation, the Swaps market includes coverage for 5 year, 7 year, 10 year and 30 year maturities. CME Clearing’s guarantee also serves as the ultimate counterparty to all trades, which aids in mitigating much risk.
How To Trade Interest Rate Futures
As the voluminous body of research and analysis on credit risk, yield curves, spreads, et al. continues to grow, the task of monitoring and strategizing interest rate futures trades can be daunting. Economic policy, election cycles, and other factors in the news impact interest rates on a minute to minute basis.
The current fears over a European Credit meltdown has already seen a tremendous rise in Italian Sovereign Debt interest rates for example (going from 2-3% to now north of 7%), so the turbulence will create many lucrative, but risky opportunities.