Week3_Interest_Currency_ Futures - Derivatives and Risk...

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Derivatives and Risk Weeks 2-4 Forwards and Futures (Week 3- Interest Rate and Currency Futures)
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Types of Interest Rates Benchmark rates- Base rate as determined by the MPC, Bank of England LIBOR rates- London Inter-Bank Offer Rate. The interest rate that the banks charge each other for Inter-bank lending Repo rates- The discounting rate at which a central bank repurchases government securities from the commercial banks
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Interest rate risk Uncertainty to borrowers or depositors Funding costs for borrowers Yield for investors Liquidity concern on cash/money markets is less than the liquidity concern on equity market Interest rate derivatives can be used to hedge (risk manage), or to take risk (speculate). Scope of operation of interest rate derivatives 0-3 years Short-term exposures: Financial futures, FRAs, interest rate options caps, collars, floors, swaps, swap options 3-5 years Medium-term exposures: Caps, collars, floors, swaps 5-75 years Medium-Long term exposures: Swaps
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Interest-Rate Futures An Interest Rate Futures is a futures contract with an interest-bearing instrument as the underlying asset. The price of this contract rises and falls inversely to changes in interest rates. Examples include Sterling futures, Federal fund futures and Eurodollar futures.
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Interest-Rate Futures Short-term Interest rate Futures (STIRs) The underlying item is a notional money-market deposit of a standard amount and specified term, typically a 3- month deposit or a standard quantity of money-market instruments e.g. £1m of 91-day T-bills The futures market price reflect an interest rate for the deposit or the money-market instruments and selling or buying STIRs at an agreed price locks in an interest rate for the notional amount of funds. Long-term Interest rate Futures (Bond Futures) The underlying item is a standard quantity of notional govt. bonds. £100,000 of notional 7% Treasury 2025. The futures market price reflects the prices in the underlying bond markets that in turn reflect interest yields on long term government bond investments. Bond futures are traded on LIFFE (now Euronext.Liffe)
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A few more characteristics: First, all futures contracts are 3-month time deposits. On delivery, the buyer receives the deposit at an eligible bank of the amount specified in the title. E.g. Three Month Euro Swiss Franc Futures is a contract for a deposit of SFr1m. Secondly, that prices are quoted in a rather strange way – as points of 100%. The price of the contract is quoted as a subtraction from 100%. E.g. a price of 97.95 represents an annual rate of interest of 2.05%. Thirdly, the minimum price change (‘tick size’) on these contracts is one basis point or 0.01%. This is equivalent to $25 for a $1m 3-month Eurodollar deposit (0.01% annual interest rate on $1m for 3-months).
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Reading the Financial Times The listed months denote the expiry month of the contract. E.g.
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