CHAPTER
FIFTY-NINE
INTRODUCTION TO INTEREST-RATE FUTURES AND OPTIONS CONTRACTS

FRANK J. FABOZZI, PH.D., CFA, CPA

Professor of Finance
EDHEC Business School

STEVEN V. MANN, PH.D.

Professor of Finance
Moore School of Business
University of South Carolina

MARK PITTS, PH.D.

ROBIN GRIEVES, PH.D.

Clinical Professor
Moore School of Business
University of South Carolina

With the advent of options, futures, and forwards on interest-rate instruments, proactive fixed income risk management, in its broadest sense, assumes a new dimension. Investment managers and traders can achieve new degrees of freedom. It is now possible to alter the interest-rate sensitivity of a fixed income portfolio economically and quickly. Derivative contracts, known as such because they derive their value from an underlying instrument, offer investment managers and traders risk and return patterns that were previously either unavailable or too costly. Futures contracts can be used to control risk exposure with hedging being a special case of eliminating risk. In addition, futures contracts can be used to build synthetic positions in the underlying assets.

The purpose of this chapter is twofold. First, we explain the basic characteristics of options, futures, and forward contracts. Second, we review the most actively traded and most representative over-the-counter (OTC) and listed contracts. We omit from our discussion the use of futures for controlling interest rate risk; this topic will be explained in more detail in Chapter 61.

BASIC CHARACTERISTICS OF DERIVATIVE CONTRACTS

Futures Contracts

A futures contract is an agreement between a buyer (seller) and an established futures exchange or its clearinghouse in which the buyer (seller) agrees to take (make) delivery of a specific amount of a valued item such as a commodity, stock, or bond at a specified price during a designated time. For some futures contracts, settlement at expiration is in cash rather than actual delivery.

When an investor takes a position in the market by buying a futures contract, the investor is said to be long the futures or have a long position in the futures. If, instead, the investor’s opening position is the sale of a futures contract, the investor is said to be short the futures or have a short position in the futures.

Futures contracts based on a financial instrument or a financial index are known as financial futures. Financial futures can be classified as interest-rate futures, stock index futures, or currency futures. This chapter focuses on interest-rate futures and includes a description of the most important interest-rate futures contracts currently traded.

To illustrate how financial futures work, suppose that X buys a futures contract and Y sells a futures contract on a 6% five-year Treasury note for settlement one year from now. Suppose also that the price at which X and Y agree to transact one year from now is $100. This is the futures price. This means that one year from now Y must deliver a 6% five-year Treasury note and will receive $100. X will take delivery of a 6% five-year Treasury note and will pay $100.

The profit or loss realized by the buyer or seller of a futures contract depends on the price and interest rate on the delivery date. For example, if the market price of a 6% five-year Treasury note at the settlement date is $110, because rates have declined, the buyer profits, paying $100 for a security that is worth $110. In contrast, the seller loses, because an instrument worth $110 must be delivered in exchange for $100. If interest rates rise on 6% five-year Treasury notes so that the market price is $90, the seller of the futures contract profits and the buyer loses.

When the investor first takes a position in a futures contract, he must deposit a minimum dollar amount per contract as specified by the exchange. As the price of the futures contract fluctuates, the value of the investor’s equity in the position changes. At the close of each trading day, any market gain results in an increase in the investor’s equity, whereas any market loss results in a decrease. This process is referred to as marking to market. Should an investor’s equity position fall below an amount determined by the exchange, he must provide additional margin. On the other hand, if an investor’s equity increases, he may withdraw funds. Consequently, a futures position may require substantial cash-flows before the delivery date. Margin is described in more detail later in this chapter.

Forward Contracts

A forward contract is much like a futures contract. A forward contract is an agreement for the future delivery of some amount of a valued item at a specified price at a designated time. Futures contracts are standardized agreements that define the delivery date (or month) and quality and quantity of the deliverable. Futures contracts are traded on organized exchanges. A forward contract is, in contrast, usually nonstandardized and is traded over the counter by direct contact between buyer and seller.

Although both futures and forward contracts set forth terms of delivery, futures contracts are not intended to be settled by delivery. In fact, generally only a small percentage of outstanding futures contracts are delivered or go to final settlement. However, forward contracts are intended to be held to final settlement. Many of the most popular forward contracts, however, settle in cash rather than actual delivery.

Forward contracts may or may not be marked to market. Consequently, there is no interim cash-flow on forwards that are not marked to market.

Finally, both parties in a forward contract are exposed to credit risk because either party may default on its obligation. In contrast, credit risk for futures contracts is minimal because the clearing corporation associated with the exchange guarantees the other side of each transaction.

Options

An option is a contract in which the seller of the option grants the buyer of the option the right to purchase from, or sell to, the contract seller a designated instrument at a specified price within a specified period of time. The seller (or writer) grants this right to the buyer in exchange for a certain sum of money, called the option price or option premium.

The price at which the instrument may be bought or sold is called the exercise or strike price. The date after which an option is void is called the expiration date. An American option may be exercised any time up to and including the expiration date. A European option may be exercised only on the expiration date.

When an option writer grants the buyer the right to purchase the designated instrument, it is called a call option. When the option buyer has the right to sell the designated instrument to the writer, the option is called a put option. The buyer of an option is said to be long the option; the writer is said to be short the option.

Consider, for example, an option on a 6% five-year Treasury note with one year to expiration and an exercise price of $100. Suppose that the option price is $2 and the current price of the Treasury note is $100 with a yield of 6%. If the option is a call option, then the buyer of the option has the right to purchase a 6% five-year Treasury note for $100 within one year. The writer of the option must sell the Treasury note for $100 to the buyer if he or she exercises the option. Suppose that the interest rate on the Treasury note declines and its price rises to $110. By exercising the call option, the buyer realizes a profit, paying $100 for a Treasury note that is worth $110. After considering the cost of buying the option, $2, the net profit is $8. The writer of the option loses $8. If, instead, the market interest rate rises and the price of the Treasury note falls below $100, the call option buyer will not exercise the option, losing the option price of $2. The writer will realize a profit of $2. Thus the buyer of a call option benefits from a decline in interest rates (a rise in the price of the underlying fixed income instrument) and the writer loses.

If the option is a put rather than a call and the interest rate on Treasury notes declines and the price rises above $100, the option buyer will not exercise the option. The buyer will lose the entire option price. If, on the other hand, the interest rate on Treasury notes rises and the note’s price falls below $100, the option buyer will profit by exercising the put option. In the case of a put option, the option buyer benefits from a rise in interest rates (a decline in the price of the underlying fixed income instrument) and the option seller loses.

The maximum amount that an option buyer can lose is the option price. The maximum profit that the option writer (seller) can realize is the option price. The option buyer has substantial potential upside return, whereas the option writer has substantial downside risk. The risk/reward relationships for option positions are investigated in Chapter 64.

Options can be written on cash instruments or futures. The latter are called futures options and are traded only on exchanges. Options on cash instruments are also traded on exchanges but have been traded much more successfully over the counter. These OTC, or dealer, options are tailor-made options on specific Treasury issues, mortgage securities, or interest-rate indexes. Option contracts are reviewed later in this chapter.

Differences between Option and Futures (or Forward) Contracts

Unlike a futures or forward contract, an option gives the buyer the right but not the obligation to perform. The option seller has the obligation to perform. In the case of a futures or forward contact, both the buyer and seller are obligated to perform. In addition, the buyer of a futures or forward contract does not pay the seller to accept the obligation, whereas in the case of an option, the buyer pays the seller an option premium.

Consequently, the risk/reward characteristics of the two contracts also differ. In a futures or forward contract, the long position realizes a dollar-for-dollar gain when the price of the futures or forward increases and suffers a dollar-for-dollar loss when the price of the futures or forward decreases. The opposite holds for a short position. Options do not provide such a symmetric risk/reward relationship. The most a long position may lose is the option premium, yet the long retains all the upside potential. However, the gain is always reduced by the price of the option. The maximum profit the short position may realize is the option price, but the short position has substantial downside risk.

REPRESENTATIVE EXCHANGE-TRADED INTEREST-RATE FUTURES CONTRACTS

Interest-rate futures contracts can be classified by the maturity of their underlying security. Short-term interest-rate futures contracts have an underlying security that matures in less than one year or a short-term reference interest rate. The maturity of the underlying security of long-term futures exceed one year. Exhibit 59–1 displays most interest rate futures contracts traded in the United States. The contracts are arranged along the yield-curve from short-term interest rates through the Ultra Long Bond contract. Notice that some of the contracts have physical settlement. Other contracts are cash settled. The success of cash settled contracts depends on having the price or yield in the calculation not be subject to manipulation. Below we describe the specifications of the long-term futures contracts (Treasury bond futures and Treasury notes futures) and short-term futures contracts (Treasury bill futures, Eurodollar futures, interest-rate swap futures, and federal funds futures).

EXHIBIT 59–1
Representative Exchange-Traded Interest-Rate Futures Contracts

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The Treasury Bond Futures Contract

The Treasury bond (T-bond) futures contract is the most successful interest-rate (or commodity) futures contract. Prices and yields on the T-bond futures contract are quoted in terms of a (fictitious) 20-year 6% Treasury bond, but the exchange where the contract is traded, the Chicago Mercantile Exchange (CME), allows many different bonds to be delivered in satisfaction of a short position in the contract. Specifically, any Treasury bond with a remaining maturity of at least 15 years, but less than 25 years, from the first day of the delivery month is acceptable for delivery. There is an Ultra Long Treasury futures contract that differs only in that it is based on Treasury bonds with at least 25 years to maturity.

The T-bond futures contract calls for the short (i.e., the seller) to deliver $100,000 face value of any one of the qualifying Treasury bonds. However, because the coupons and maturities vary widely, the price that the buyer pays the seller depends on which bond the seller chooses to deliver. The rule used by the CME is one that adjusts the futures price by a conversion factor that reflects the price the bond would sell for at the beginning of the delivery month if it were yielding 6%. Using such a rule, the conversion factor for a given bond and a given delivery month is constant through time and is not affected by changes in the price of the bond or the price of the futures contract.

The seller has the right to choose which qualifying bond to deliver and when during the delivery month delivery will take place. When the bond is delivered, the buyer is obligated to pay the seller the futures price multiplied by the appropriate conversion factor, plus accrued interest on the delivered bond. It is important to emphasize that while the underlying Treasury bond for this contract is a hypothetical issue and therefore cannot itself be delivered into the futures contract, the bond futures contract is not a cash settlement contract. To close out a Treasury bond futures contract, one can either initiate an offsetting futures position or deliver a qualifying issue.

Paradoxically, the success of the CME Treasury bond contract can in part be attributed to the fact that the delivery mechanism is not as simple as it may first appear. There are several options implicit in a position in bond futures. First, the seller chooses which bond to deliver. Thus, the seller has an option to swap between bonds. If the seller is holding bond A for delivery, but bond B becomes cheaper to deliver, she can swap bond B for bond A and make a more profitable delivery. Second, within some guidelines set by the CME, the seller decides when during the delivery month delivery will take place. She thus has a timing option that can be used to her advantage. Finally, the short retains the possibility of making the wildcard play. This potentially profitable situation arises from the fact that the seller can give notice of intent to deliver for several hours after the exchange has closed and the futures settlement price has been fixed. In a falling market, the seller can use the wildcard option to profit from the fixed delivery price.

The seller’s options tend to make a contract a bit more difficult to understand, but at the same time they make the contract more attractive to speculators, arbitrageurs, dealers, and anyone else who understands the contract better than other market participants. Thus, in the case of the Treasury bond futures contract, complexity has helped provide liquidity.

Treasury Note Futures

There are three Treasury note futures contracts: 10-year, 5-year, and 2-year. All three contracts are modeled after the Treasury bond futures contract and are traded on the CME. The underlying instrument for the 10-year Treasury note futures contract is $100,000 par value of a hypothetical 10-year 6% Treasury note. There are several acceptable Treasury issues that may be delivered by the short. A note is acceptable if the maturity is not less than 6.5 years and not greater than 10 years from the first day of the delivery month. The delivery options granted to the short position are the same as for the Treasury bond futures contract.

For the 5-year Treasury note futures contract, the underlying is $100,000 par value of a U.S. Treasury note that satisfies the following conditions: an original maturity of not more than five years and three months and a remaining maturity of not less than four years and two months as of the first day of the delivery month.

The underlying for the 2-year Treasury note futures contract is $200,000 par value of a U.S. Treasury note with a remaining maturity of not more than two years and not less than one year and nine months. Moreover, the original maturity of the note delivered to satisfy the two-year futures cannot be more than five years and three months.

Treasury Bill Futures Contract

The IMM’s futures contract on Treasury bills was the first contract on a short-term debt instrument, and has been the model for most subsequent contracts on short-term debt. The contract is based on three-month Treasury bills with a face value of $1 million. As of the third quarter of 2011, there was very little open interest in this contract.

The contract is quoted and traded in terms of a futures “price,” but the futures price is, in fact, just a different way of quoting the futures interest rate. Specifically, the futures price is the annualized futures rate subtracted from 100. For example, a futures price of 97.50 means that Treasury bills are trading in the futures market at a rate of 2.50%. The actual price that the buyer pays the seller is calculated using the usual formula for Treasury bills:

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where the rate is expressed in decimal form. As this formula shows, each basis point change in the interest rate (or each 0.01 change in the futures price) leads to a $25 change in the invoice price for a 90-day bill. Consequently, the value of a 0.01 change in the futures contract is always $25.

The Treasury bill futures contract is considerably simpler than the T-bond and T-note futures contracts. First, because all Treasury bills of the same maturity are economically equivalent, there is effectively only one deliverable issue, namely, Treasury bills with three months to maturity. Three months may have 90, 91 or 92 days depending on the month in which the contract is initiated. The fact that the three-month bills may be either new three-month bills or older bills that currently have three months of remaining life makes little difference because the new and old issues will trade the same in the cash market. Thus, all the subtleties surrounding conversion factors and most deliverable issues are absent from the Treasury bill futures market. Furthermore, there is little uncertainty or choice involved in the delivery date, because delivery must take place during a very narrow time frame, usually a three-day period. The rules of the exchange make clear well in advance the exact dates on which delivery will take place. Finally, because there are no conversion factors, there is no wildcard play in the Treasury bill futures market.

Although the Treasury bill futures contract is simple and thus may not provide as many speculative and arbitrage opportunities as the more complex long-and intermediate-term futures contracts, it does provide a straightforward means of hedging or speculating on the short end of the yield-curve. Because the Treasury bill rate is a benchmark off which other short-term rates may be priced, the bill contract fills a well-defined need of many market participants.

Eurodollar Futures Contract

Eurodollar CDs are U.S. dollar-denominated CDs issued primarily in London by U.S., Canadian, European, and Japanese banks. These CDs earn a fixed-rate of interest related to dollar LIBOR. The term LIBOR comes from the London Interbank Offered Rate and is the interest rate at which one London bank offers funds to another London bank of acceptable credit quality in the form of a cash deposit. The rate is “fixed” by the British Bankers Association every business morning by the average of the rates supplied by member banks.

Three-month LIBOR is the underlying instrument for the Eurodollar futures contract. The contracts are traded on the International Monetary Market of the CME and the Eurex International Financial Futures Exchange (LIFFE). This contract has a $1 million face value and is traded on an index price basis. The index price basis in which the contract is quoted is equal to 100 minus the annualized futures LIBOR. For example, a Eurodollar futures price of 97.50 means a futures 3-month LIBOR of 2.50%.

The minimum price fluctuation or tick for this contract is 0.005 or 1/2 basis point. Accordingly, the tick value for this contract is $12.50 as determined by the following expression:

Tick value = $1,000,000 × (0.005 × 90/360) = $12.50

The Eurodollar futures contract is a cash settlement contract. There are Eurodollar futures contracts available to trade with quarterly expiration dates (March, June, September, and December) that extend out 10 years. Accordingly, it is possible for market participants to hedge or speculate on the level of three-month LIBOR for the next decade.

The Eurodollar futures contract is used frequently to trade the short end of the yield-curve and many hedgers believe this is the ideal contract for a wide range of hedging situations. Moreover, the Eurodollar futures market and interest rate swaps are intensely interconnected. When valuing swaps at their inception, the future path of floating rates are derived from positions in Eurodollar futures contracts.

The 90-day sterling LIBOR interest rate futures contract trades on the main London Futures Exchange, LIFFE. The contract is structured similarly to the Eurodollar futures contract described above. Prices are quoted as 100 minus the interest rate and the expiration months are March, June, September, and December. The contract size is £500,000. A tick is 0.01 or one basis point and the tick value is £12.5.

The LIFFE also trades short-term interest rate futures for other major currencies including euros, yen, and Swiss francs. Short-term interest rate futures contracts in other currencies are similar to the 90-day sterling LIBOR contract and trade on exchanges such as Deutsche Terminbourse in Frankfurt and MATIF (Marché à Terme International de France) in Paris.

Swap Futures Contracts

Interest-rate swaps are discussed in Chapter 62. The CME introduced a swap futures contract in 2001. The underlying instrument is the notional price of the fixed-rate side of a 10-year interest-rate swap that has a notional principal equal to $100,000 and that exchanges semiannual interest payments at a fixed annual rate of 6% for floating interest-rate payments based on three-month LIBOR.

This swap futures contract is cash-settled, with a settlement price determined by the International Swap and Derivatives Association (ISDA) benchmark 10-year swap rate on the last day of trading before the contract expires. This benchmark rate is published with a one-day lag in the Federal Reserve Board’s statistical release H.15. Contracts have settlement months of March, June, September, and December, just like the other CME interest-rate futures contracts that we have discussed.

The London International Financial Futures Exchange (LIFFE) introduced the first swap futures contract called Swapnote, which is referenced to the euro interest-rate swap curve. Swapnotes are available in 2-, 5-, and 10-year maturities.

Fed Funds Futures Contracts

The 30-day federal funds futures contract is designed for financial institutions and businesses who want to control their exposure to movements in the federal funds rate. These contracts have a notional amount of $5 million, and the contract can be written for the current month up to 24 months in the future. Underlying this contract is the simple average overnight federal funds rate (i.e., the effective rate) for the delivery month. As such, this contract is settled in cash on the last business day of the month. Just as the other short-term interest-rate futures contracts discussed earlier, prices are quoted on the basis of 100 minus the overnight federal funds rate for the delivery month. These contracts are marked to market using the effective daily federal funds rate as reported by the Federal Reserve Bank of New York.

Other Futures Contracts

If the yield-curve were flat and moved in parallel shifts, a single futures contract would be sufficient for all fixed income hedging and speculative purposes. Different note or bond positions would differ only in the number of contracts needed for a hedge. For example, with perfectly correlated interest rate changes, one could hedge long bonds with Treasury bill futures. It would require many multiples of the bond’s par value in Treasury bills futures for the hedge, but it would work perfectly. The only challenge would be to get the scale of the hedges right.

Historically, the yield-curve shifts parallel to itself, steepens or flattens, and becomes more or less curved. Consequently, multiple kinds of contracts are needed to hedge bonds of varying maturity. In addition, because credit-spreads widen and narrow, at least one contract with credit risk embedded is needed to allow complete hedging.

The on-the-run (OTR) U.S. Treasury futures contracts are based on prices derived from the yields of on-the-run (most recently auctioned) 2-year, 5-year, and 10-year Treasury notes. These contracts are designed to give users synthetic exposure to the most liquid benchmark maturities on the U.S. Treasury yield curve. Unlike traditional Treasury futures, OTR Treasury futures have cash settlement. The notional underlying is a U.S. Treasury note with a face value of $100,000 paying a 4% coupon rate per annum on a semiannual basis.

As noted above, credit-spreads widen and narrow and are not perfectly correlated to shifts in the yield-curve. This fact suggests there should be a futures contract derived from bonds with exposure to credit risk. Consider the Barclays Capital U.S. Aggregate Bond Index futures contract that trades on the CME. The underlying instrument is the index value multiplied by $100. The index includes all of the sectors of the bond market: Treasury, agency, corporate, agency mortgage-backed, asset-backed, and commercial mortgage-backed.

MECHANICS OF FUTURES TRADING

Types of Orders

When a trader wants to buy or sell a futures contract, the price and conditions under which the order is to be executed must be communicated to a futures broker. The simplest type of order, yet potentially the most perilous from the trader’s perspective, is the market order. When a market order is placed, it is executed at the best price available as soon as the order reaches the trading pit, the area on the floor of a futures exchange where all transactions for a specific contract are made. The danger of market orders is that an adverse move may take place between the time the trader places the order and the time the order reaches the trading pit.

To avoid the dangers associated with market orders, the trader can place a limit order (or resting order) that designates a price limit for the execution of the transaction. A buy limit order indicates that the futures contract may be purchased only at the designated price or lower. A sell limit order indicates that the futures contract may be sold only at the designated price or higher.

The danger of a limit order is that there is no guarantee that it will be executed at all. The designated price may simply not be obtainable. Even if the contract trades at the specified price, the order may not be filled because the market does not trade long enough at the specified price (or better) to fill all outstanding orders. Nevertheless, a limit order may be less risky than a market order. The trader has more control with a limit order, because the price designated in the limit order can be revised based on prevailing market prices as long as the order has not already been filled.

The limit order is a conditional order: It is executed only if the limit price or a better price can be obtained. Another type of conditional order is the stop order. A stop order specifies that the order is not to be executed until the market reaches a designated price, at which time it becomes a market order. A buy stop order specifies that the order is not to be executed until the market rises to a designated price (i.e., trades at or above, or is bid at or above, the designated price). A sell stop order specifies that the order is not to be executed until the market price falls below a designated price (i.e., trades at or below, or is offered at or below, the designated price). A stop order is useful when a futures trader already has a position on but cannot watch the market constantly. Traders can preserve profits or minimize losses on open positions by allowing market movements to trigger a closing trade. In a sell (buy) stop order, the designated price is less (greater) than the current market price of the futures contract. In a sell (buy) limit order the designated price is greater (less) than the current market price of the futures contract.

There are two dangers associated with stop orders. Because futures markets sometimes exhibit abrupt price changes, the direction of the change in the futures price may be very temporary, resulting in the premature closing of a position. Also, once the designated price is reached, the stop order becomes a market order and is subject to the uncertainty of the execution price noted earlier for market orders.

A stop-limit order, a hybrid of a stop order and a limit order, is a stop order that designates a price limit. Thus, in contrast to the stop order, which becomes a market order if the stop is reached, the stop-limit order becomes a limit order if the stop is reached. The order can be used to cushion the market impact of a stop order. The trader may limit the possible execution price after the activation of a stop. As with a limit order, the limit price might never be reached after the order is activated, and therefore the order might not be executed. This, of course, defeats one purpose of the stop order—to protect a profit or limit a loss.

A trader also may enter a market-if-touched order. A market-if-touched is like a stop order in that it becomes a market order if a designated price is reached. However, a market-if-touched order to buy would become a market order if the market falls to a given price, whereas a stop order to buy becomes a market order if the market rises to a given price. Similarly, a market-if-touched order to sell becomes a market order if the market rises to a specified price, whereas the stop order to sell becomes a market order if the market falls to a given price. One may think of the stop order as an order designed to exit an existing position at an acceptable price (without specifying the exact price), and the market-if-touched order as an order designed to enter a position at an acceptable price (also without specifying the exact price).

Orders may be placed to buy or sell at the open or the close of trading for the day. An opening order indicates that a trade is to be executed only in the opening range for the day, and a closing order indicates that the trade is to be executed only within the closing range for the day.

Futures brokers may be allowed to try to get the best possible price for their clients. The discretionary order gives the broker a specified price range in which to fill the order. For example, a discretionary order might be a limit order that gives the broker a one-tick (i.e., one basis point or 1/32) discretion to try to do better than the limit price. Thus, even if the limit price is reached and the order could be filled at that limit, the broker can wait for a better price. However, if it turns out that the market goes in the wrong direction, the broker must fill the order but at no worse than one tick from the limit price. A not held order gives the broker virtually full discretion over the order. The not held order may be placed as any of the orders mentioned so far (market, stop, limit, etc.), but if the broker believes that filling the orders is not advisable, he or she need not fill them.

A client may enter orders that contain order cancellation provisions. A fill-or-kill order must be executed as soon as it reaches the trading floor, or it is canceled immediately. A one-cancels-other order is a pair of orders that are worked simultaneously, but as soon as one order is filled, the other is canceled automatically.

Orders may designate the time period for which the order is effective—a day, week, or month, or perhaps by a given time within the day. An open order, or good-til-canceled order is good until the order is specifically canceled. If the time period is not specified, it is usually assumed to be good only until the end of the day. For some orders, like the market order, a specific time period is not relevant, because they are executed immediately.

On execution of an order, the futures broker is required to provide confirmation of the trade. The confirmation indicates all the essential information about the trade. When the order involves the liquidation of a position, the confirmation shows the profit or loss on the position and the commission costs.

Taking and Liquidating a Position

Once an account has been opened with a broker, the futures trader may take a position in the market. If the trader buys a futures contract, she is said to have a long position. If the trader’s opening position is the sale of the futures contract, she is said to have a short position.

The futures trader has two ways to liquidate a position. To liquidate a position before the delivery date, she must take an offsetting position in the same contract. For a long position, this means selling an identical number of contracts; for a short position, this means buying an identical number of contracts.

The alternative is to wait until the delivery date. At that time, the investor liquidates a long position by accepting the delivery of the underlying instrument at the agreed-on price or liquidates a short position by delivering the instrument at the agreed-on price. For interest-rate futures contracts that do not call for actual delivery (e.g., Eurodollar futures), settlement is in cash at the settlement price on the delivery date.

The Role of the Clearing Corporation

When an investor takes a position in the futures market, there is always another party taking the opposite position and agreeing to satisfy the terms set forth in the contract. Because of the clearing corporation associated with each exchange, the investor need not worry about the financial strength and integrity of the party taking the opposite side of the contract. After an order is executed, the relationship between the two parties is severed. The clearing corporation interposes itself as the buyer for every sale and the seller for every purchase. Thus the investor is free to liquidate a position without involving the other party to the original transaction and without worry that the other party may default. However, the investor is exposed to default on the part of the futures broker through which the trade is placed. Thus, each institution should make sure that the futures broker (and specifically the subsidiary that trades futures) has adequate capital to ensure that there is little danger of default.

Margin Requirements

When first taking a position in a futures contract, an investor must deposit a minimum dollar amount per contract as specified by the exchange. (A broker may ask for more than the exchange minimum, but may not require less than the exchange minimum.) This amount is called the initial margin, and constitutes a good faith deposit. The initial margin may be in the form of Treasury bills. As the price of the futures contract fluctuates, the value of equity in the position changes. At the close of each trading day, the position is marked to market, so that any gain or loss from the position is reflected in the equity of the account. The price used to mark the position to market is the settlement price for the day.

Maintenance margin is the minimum level to which an equity position may fall as a result of an unfavorable price movement before additional margin is required. The additional margin deposited, also called variation margin, is simply the amount that will bring the equity in the account back to its initial margin level. Unlike original margin, variation margin must be in cash. If there is excess margin in the account, that amount may be withdrawn.1

If a variation margin is required, the party is contacted by the brokerage firm and informed of the additional amount that must be deposited. A margin notice is sent as well. Even if futures prices subsequently move in favor of the institution such that the equity increases above the maintenance margin, the variation margin must still be supplied. Failure to meet a request for variation margin within a reasonable time will result in the closing out of a position.

Margin requirements vary by futures contract and by the type of transaction; that is, whether the position is an outright long or short or a spread (a long together with a short), and whether the trade is put on as a speculative position or as a hedge. Margins are higher for speculative positions than for hedging positions and higher for outright positions than for spreads. Margin requirements also vary between futures brokers. Exchanges and brokerage firms change their margin requirements as contracts are deemed to be more or less risky, or as it is felt that certain types of positions (usually speculative positions) should be discouraged.

REPRESENTATIVE EXCHANGE-TRADED FUTURES OPTIONS CONTRACTS

Although futures contracts are relatively straightforward financial instruments, options on futures (or futures options, as they are commonly called) deserve extra explanation. Options on futures are very similar to other options contracts. Like options on cash (or spot) fixed income securities, both put and call options are traded on fixed income futures. The buyer of a call has the right to buy the underlying futures contract at a specific price. The buyer of a put has the right to sell the underlying futures contract at a specific price. If the buyer chooses to exercise the option, the option seller is obligated to sell the futures in the case of the call, or buy the futures in the case of the put.

An option on the futures contract differs from more traditional options in only one essential way: The underlying instrument is not a spot security, but a futures contract on a security. Thus, for instance, if a call option buyer exercises her option, she acquires a long position in futures instead of a long position in a cash security. The seller of the call will be assigned the corresponding short position in the same futures contract. For put options the situation is reversed. A put option buyer exercising the option acquires a short position in futures, and the seller of the put is assigned a long position in the same futures contract. The resulting long and short futures positions are like any other futures positions and are subject to daily marking to market.

An investor acquiring a position in futures does so at the current futures price. However, if the strike price on the option does not equal the futures price at the time of exercise, the option seller must compensate the option buyer for the discrepancy. Thus, when a call option is exercised, the seller of the call must pay the buyer of the call the current futures price minus the strike price. On the other hand, the seller of the put must pay the buyer of the put the strike price minus the current futures price. (These transactions are actually accomplished by establishing the futures positions at the strike price, then immediately marking to market.) Note that, unlike options on spot securities, the amount of money that changes hands at exercise is only the difference between the strike price and the current futures price, not the whole strike price. Of course, an option need not be exercised for the owner to take her gains; she can simply sell the option instead of exercising it.

We now turn to the options contracts themselves. We describe two of the most important contracts, the CME’s options on the long-term bond futures contract and on the Eurodollar contract. There are also options on the 5- and 10-year note futures contracts, but because they are both very similar in structure to options on Treasury bond futures, they are not included in this section.

Options on Treasury Bond Futures

Options on CME Treasury bond futures are in many respects simpler than the underlying futures contracts. Usually, conversion factors, most deliverables, wildcard plays, and other subtleties of the Treasury bond futures contract need not concern the buyer or seller of options on Treasury bond futures. Although these factors affect the fair price of the futures contract, their impact is already reflected in the futures price. Consequently, they need not be reconsidered when buying or selling an option on the futures.

The option on the Treasury bond futures contract is in many respects an option on an index; the “index” is the futures price itself, that is, the price of the fictitious 20-year 6% Treasury bond. As for the futures contract, the nominal size of the contract is $100,000. Thus, for example, with futures prices at 95, a call option struck at 94 has an intrinsic value of $1,000 and a put struck at 100 has an intrinsic value of $5,000.

In an attempt to compete with the OTC option market, flexible Treasury futures options were introduced. These futures options allow counterparties to customize options within certain limits. Specifically, the strike price, expiration date, and type of exercise (American or European) can be customized subject to CME constraints. One key constraint is that the expiration date of a flexible contract cannot exceed that of the longest standard option traded on the CME. Unlike an OTC option, where the option buyer is exposed to counterparty risk, a flexible Treasury futures option is guaranteed by the clearinghouse. The minimum size requirement for the launching of a flexible futures option is 100 contracts.

The premiums for options on Treasury bond futures are quoted in terms of points and 64ths of a point. Thus an option premium of 1-10 implies a price of 1 10/64% of face value, or $1,156.25 (from $100,000 × 1.15625%). Minimum price fluctuations are also 1/64 of 1%.

Although an option on the Treasury bond futures contract is hardly identical to an option on a Treasury bond, it serves much the same purpose. Because spot and futures prices for Treasury bonds are highly correlated, hedgers and speculators frequently find that options on bond futures provide the essential characteristics needed in an options contract on a long-term fixed income instrument.

Options on Eurodollar Futures

Options on Eurodollar futures fill a unique place among exchange-traded hedging products. These options are currently the only liquid listed option contracts based on a short-term interest rate.

Options on Eurodollar futures (traded on the CME) are based on the quoted Eurodollar futures price (i.e., 100 minus the annualized yield). Like the underlying futures, the size of the contract is $1 million and each 0.01 change in price carries a value of $25. Likewise, the option premium is quoted in terms of basis points. Thus, for example, an option premium quoted as 20 (or 0.20) implies an option price of $500; a premium of 125 or (1.25) implies an option price of $3,125.

Like other debt options, buyers of puts on Eurodollar futures profit as rates move up and buyers of calls profit as rates move down. Consequently, institutions with liabilities or assets that float off short-term rates can use Eurodollar futures options to hedge their exposure to fluctuations in short-term rates. Consider institutions that have liabilities that float off short-term rates. These include banks and thrifts that issue CDs and/or take deposits based on money market rates. Also included are industrial and financial corporations that issue commercial paper, floating-rate notes, or preferred stock that floats off money market rates. Likewise, those who make payments on adjustable-rate mortgages face similar risks.2 In each instance, as short-term rates increase, the liability becomes more onerous for the borrower. Consequently, the issuers of these liabilities may need a means of capping their interest-rate expense. Although options on Eurodollar futures do not extend as far into the future as many issuers would like, they are effective tools for hedging many short-term rates over the near term. Consequently, an institution with floating-rate liabilities can buy an interest-rate cap by buying puts on Eurodollar futures. As rates move up, profits on the put position will tend to offset some or all of the incremental interest expense.

On the other side of the coin, and facing opposite risks, are the purchasers of floating-rate instruments—that is, investors who buy money market deposits, floating-rate notes, floating-rate preferred stock, and adjustable-rate mortgages. Investors who roll over CDs or commercial paper face the same problem. As rates fall, these investors receive less interest income. Consequently, they may feel a need to buy interest-rate floors, which are basically call options. As rates fall, calls on debt securities increase in value and will offset the lower interest income received by the investor.

In conclusion, options on Eurodollar futures can be used to limit the risk associated with fluctuations in short-term rates. This is accomplished by buying puts if the exposure is to rising rates, or by buying calls if the exposure is to falling rates.

Mechanics of Trading Futures Options

To take a position in futures options, one works with a futures broker. The types of orders that are used to buy or sell futures options are generally the same as the orders discussed for futures contracts. The clearinghouse associated with the exchange where the futures option is traded once again stands between the buyer and the seller. Furthermore, the commission costs and related issues that we discussed for futures also generally apply to futures options.

There are no margin requirements for the buyer of futures options, but the option price must be paid in full when the option is purchased. Because the option price is the maximum amount that the buyer can lose regardless of how adverse the price movement of the underlying futures contract, there is no need for margin.

Because the seller has agreed to accept all of the risk (and no reward other than the option premium) of the position in the underlying instrument, the seller generally is required to deposit not only the margin required for the underlying futures contract but also with certain exceptions, the option price as well. Furthermore, subsequent price changes adversely affecting the seller’s position will lead to additional margin requirements.

OTC CONTRACTS

There is a substantial over-the-counter (OTC) market for fixed income options and forwards. (Forward contracts are the OTC equivalent of futures contracts.) For example, in the OTC market, one can easily buy or sell options on LIBOR, commercial paper, T-bill, and prime rates. One can buy and sell options on virtually any Treasury issue. One can buy and sell options on any number of mortgage securities. One can buy and sell options with expirations ranging from as short as one day to as long as 10 years. In the OTC market, one can easily take forward positions in three- and six-month LIBOR going out to about 2 years.

In the options market in particular, a natural division has evolved between the OTC market and the listed market. Given the relatively small number of futures contracts, the exchanges’ need for standardization, and the synergy created by the futures options contract trading side by side with the underlying futures contract, the exchanges have been most successful with options on futures contracts. Because off-exchange options on futures are prohibited, futures options cannot be traded over the counter. On the other hand, because the OTC market is very good at creating flexible structures and handling a diversity of terms, the OTC market has been more successful than the exchanges in trading options on cash securities and on cash market interest rates.

In the following sections, we discuss the structure of the OTC fixed income derivative markets and their advantages and disadvantages relative to the exchange-traded markets. We also discuss the most important contracts traded in the OTC market. These are options on mortgage securities, options on cash Treasuries, caps and floors on LIBOR, and forward rate agreements on LIBOR.

The Structure of the OTC Market

As in other OTC markets, there is no central marketplace for OTC fixed income options and forward contracts. A transaction takes place whenever a buyer and seller agree to a price. Unlike an exchange transaction, the terms, size, and price of the contract generally remain undisclosed to other market participants. Accordingly, the OTC market is much less visible than the exchange markets and it is more difficult to ascertain the current market price for a given option or forward contract. Two groups, however, help to alleviate this problem. First, there are the OTC market makers. Market makers in OTC fixed income options and forwards are typically large investment banks and commercial banks. A market maker, by definition, stands ready to buy or sell a given option or forward contract to accommodate a client’s needs. To be effective, the market maker must be willing and able to handle large orders and must keep the bid/ask spreads reasonably narrow.

The other group that helps bring order to the OTC market is the brokers. The sole job of the brokers is to bring together buyers and sellers; it is not the brokers’ job to take positions in option and forward contracts. The buyers and sellers that the brokers bring together can be market makers or the end users of the contracts. To do their job, the brokers must distribute information about the prices where they see trades taking place and the prices at which they believe further trades can be completed. This information is distributed to potential buyers and sellers over the phone and over publicly available media such as Telerate pages.

Because there is no central market for OTC fixed income options and forwards, there can be no clearinghouse. Consequently, those who position OTC contracts may have to give considerable weight to the creditworthiness of their counterparty. For example, entities that sell options or position forward rate agreements (FRAs) can have potential liabilities equal to several times their net worth. Furthermore, there is no guarantee that these counterparties have effective hedges against their positions or, in fact, that they are hedging at all. Furthermore, financial problems on the part of the counterparty can jeopardize the ability or willingness of the counterparty to make good on the terms of a contract even if it is hedged. Consequently, unlike the exchange-traded markets, where one neither knows nor cares who is on the other side of a trade, in the OTC market it is usually very important to know who is on the other side. Creditworthiness can be one of the most important considerations in the trade.

The potential credit problems associated with OTC trades are mitigated in a number of ways. First, some institutions will not buy options from or take either side of an FRA contract with any party other than a major entity with a sound credit rating. Second, some institutions require their counterparty to post collateral immediately after the transaction is completed. This collateral serves much the same purpose as initial margin in the futures and futures options market. Finally, some institutions reserve the right to call for additional collateral from their counterparties if the market moves against the counterparty. This is analogous to variation margin in the exchange-traded markets. Although these provisions may not be as good as a central clearinghouse, they are apparently good enough for a very large number of institutions and good enough for a very large market to develop.

Liquidity, in terms of being able to easily close out an existing position, can be a constraint in the OTC market. OTC options and forwards generally are not assignable transactions. Thus, for example, if one sells an option, the contingent liability associated with that option cannot be transferred to a third party without the express permission of the option buyer. If an option seller wants to cover a short option position, often the best strategy is to buy a similar option from a third party to offset the risks of the original option. However, if the credit of the offsetting party is in question, or the offsetting option is not identical, risks will remain for the option seller. The option buyer can face similar problems if closing out the option before expiration. Credit considerations and the fact that the option buyer may not be able to sell an identical option to offset the first option make it more difficult to effectively close out the long option position. Because FRAs involve contingent liabilities for both sides of the transaction, similar problems exist for both buyers and sellers of FRAs.

Some of the problems associated with the OTC market arise from the fact that the contracts are not standardized. However, nonstandardization leads to many benefits as well. As indicated earlier, OTC contracts can be specified in virtually any terms that are acceptable to both buyer and seller. A potential buyer or seller thus can approach a market maker with whatever structure is needed and in many (but certainly not all) cases obtain the desired structure at a reasonable price. Compared to the very rigid structure of the exchange-traded markets, this is a remarkable advantage.

The OTC Contracts
Options on Mortgages

The OTC market for options on fixed income instruments began in the mid-1970s with standby commitments. Standbys were essentially put options on mortgages that allowed the holder (usually a mortgage banker) to sell mortgages at a given price during a given period of time. Although standbys were popularized by the Federal National Mortgage Association, other institutions soon got into the business of selling options. Thrift institutions, in particular, soon became sellers of puts, as well as calls, on mortgages. The thrift would typically sell out-of-the-money puts (struck at a yield that seemed attractive relative to current yields) and out-of-the-money calls (often struck at the thrift’s cost of the underlying securities). Until the early 1980s, there were no real market makers in the OTC mortgage options market. Thus a trade typically did not occur until an end user who wanted to buy an option could be paired with an end user who wanted to sell the very same option. The intermediary who stood in between these two parties was usually not willing to position one side without the other.

Today, the market for options on mortgages includes many more participants, although the original standby commitments no longer exist. Investment banks and commercial banks now play a major role in the mortgage options market. Many of the large investment and commercial banks are now willing to position mortgage options without having the other side of the trade. This makes the market much more liquid and flexible than it would be otherwise. The end users of options on mortgages have not changed greatly, but the number of users has increased greatly. Mortgage bankers continue to buy puts on mortgages. Thrifts continue to sell both puts and calls. As some thrifts now play the role of mortgage banker, they too have become buyers of puts on mortgages. Money managers have also become a part of the market, usually as sellers of call options against mortgages in their portfolios.

The market for mortgage options today is composed almost entirely of options on the standard agency pass-through mortgage securities. Options on CMO tranches, IOs, POs, and the like are not a significant part of the OTC mortgage options market. The majority of the options traded are on 30-year mortgages, but options on 15-year products are also readily available. In terms of expiration, trading in mortgage options tends to be concentrated in the shorter expirations, with most of the options expiring within 60 days, and the vast majority expiring within one year. In terms of strike price, most of the trading is in at-the-money and out-of-the-money options.

Options on Treasury Securities

Although not as old as the OTC options market for mortgages, the OTC options market for Treasury securities is now just as large and liquid. As in the mortgage options market, investment banks and commercial banks play major roles as market makers, frequently standing ready to buy or sell options on $100 million (or more) of Treasury securities. Most of the action is in options expiring within 60 days, written at the money or out of the money. Options on Treasuries are concentrated in the on-the-run issues, with most of the remaining business being done in the off-the-run issues.

Except for the mortgage bankers, who have considerably less interest in options on Treasuries, the end users of options on Treasuries mirror the market for options on mortgages. Thrifts tend to be writers of out-of-the-money puts and calls, and money managers and mutual funds tend to be covered call writers.

Caps and Floors on LIBOR

The primary OTC options covering the short end of the yield-curve are the caps and floors on three- and six-month LIBOR. A cap on LIBOR is, in essence, a series of puts on LIBOR-based debt, whereas a floor on LIBOR is, in essence, a series of calls on LIBOR-based debt.

The buyer of a cap or floor holds most of the rights in the contract, as with other options. The seller of a cap or floor will of course receive an options premium from the buyer, but is then obligated to perform on the contract.

To see how these contracts work, consider a five-year, $100 million cap on three-month LIBOR struck at 4%. Such a contract will specify reset dates occurring every three months for a total of 20 resets. The first reset will usually occur immediately or within a couple of weeks of the trade date, and the last reset will usually be about three months before the stated maturity of the contract. To determine what the payoff to the cap buyer will be, on every reset date one compares the three-month LIBOR (taken from a predetermined source) with the 4% strike rate. If the three-month LIBOR is at or below 4%, nothing is owed to the cap buyer. However, if the three-month LIBOR is above 4%, the cap seller must pay the cap buyer the monetary value of the amount by which three-month LIBOR exceeds 4%. In this case, for a 90-day interest accrual period, the value of each basis point is $2,500 (from 0.0001 × $100,000,000 × 90/360). Thus, for example, if three-month LIBOR on a particular reset date is 4.50%, the cap seller owes the cap buyer $125,000 for that reset. If, on the next reset date, three-month LIBOR is 6%, the cap seller owes the cap buyer $500,000 for that reset. If, on the next reset date, three-month LIBOR is 3.50%, the cap seller owes nothing to the cap buyer for that reset. In most cases, the cap seller pays the cap buyer the amount of money owed for a particular reset at the end of the interest accrual period-in this case, three months after the reset date.

The mechanics of floors are similar, except that the payoff comes when rates fall below a given level, instead of when they rise above a given level. For example, if one buys a $25 million seven-year 3% floor on six-month LIBOR, there are a total of 14 reset dates. On each of these reset dates, one compares six-month LIBOR to 3%. If six-month LIBOR is above 3%, nothing is owed to the buyer of the floor for that reset. However, if six-month LIBOR is below 3%, for a 180-day interest accrual period the floor seller owes the floor buyer $1,250 for every basis point by which six-month LIBOR is below 3% (from 0.0001 × $25,000,000 × 180/360).

Like other OTC options markets, the cap and floor market is composed of market makers, end users, and brokers. The market makers are once again the large investment banks and commercial banks. However, there are fewer market makers and generally wider spreads in the cap and floor market than there are in the options market for mortgages or Treasury securities. Nonetheless, there is an active market out to 10 years, particularly for out-of-the-money caps and, to a lesser degree, out-of-the-money floors.

The end-user buyers of caps and floors are primarily institutions with risks that they need to cover. For example, institutions that fund short and lend long will tend to have losses as short-term rates rise. Similarly, businesses that fund by rolling over short-term obligations such as commercial paper or by bank borrowings tied to LIBOR or the prime rate will tend to have losses as short-term rates rise. These institutions, which include many thrifts, banks, and finance companies, as well as industrial and construction companies, can protect themselves against rising short-term rates by buying caps. End-user buyers of floors tend to be firms that face losses if rates fall. Such a case might occur, for example, if an institution borrows at a floating rate with a built-in floor. Such an institution may be structured so that floating rates, per se, pose no problem; the problem arises when the floating rate at which they borrow is no longer really floating because the floor has been hit. This institution may buy a floor so that it will receive monetary compensation from the floor seller whenever the floating rate falls below the floor rate, thus covering the risks of lower rates.

The sellers of caps and floors, other than the market makers, are quite varied. In some cases, sellers sell caps or floors outright to bring in premium income. Others sell caps and/or floors to smooth out the cash-flows on other fixed income instruments, such as certain derivative mortgage products. In other cases, sellers only implicitly sell the caps or floors. The following example illustrates both kinds of sellers.

When the cap market was developing, it quickly became obvious that there were many natural buyers of caps, but few natural sellers of caps. One successful effort to create sellers of caps occurred when investment bankers, who had many potential buyers of caps, realized that caps could be created as a derivative of the floating-rate note (FRN) market. Issuers of FRNs routinely issue notes reset off LIBOR. Furthermore, there were known buyers of capped FRNs; but of course, capped FRNs must have a higher coupon than uncapped FRNs to compensate the FRN buyer for the cap risk. If an issuer sells capped floating-rate notes, the issuer, in effect, buys a cap on LIBOR from the buyer of the FRN. This cap can then be sold to the investment banker, who in turn sells it to capbuying clients. The deals that took place took exactly this form. The investment bankers underwrote capped FRNs for certain FRN issuers who agreed to make caplike payments to their investment banker. The banker then sold caps to another client but did not incur any market risks because the two sets of potential payments offset one another. Using part of the proceeds of the sale of the cap, the investment bank agreed to make payments to the issuer to bring the cost of the floating-rate debt down to a level below that of uncapped floating-rate notes. Thus the investment bankers, the issuers of the FRNs, the buyers of the FRNs, and the ultimate cap-buying clients all walked away with a satisfactory transaction.

Such a transaction illustrates how creative financing can be used to create a seller of an instrument when no obvious seller exists. In this example, the issuers of the FRNs are willing to sell caps, given the fact that they, in turn, find someone willing to sell the caps to them. The ultimate seller of caps is the buyer of the capped FRNs. The buyers of the FRNs are, however, only implicit sellers of caps in the sense that they never explicitly have a position in caps on their books.

This example, which is just one of dozens, shows how market makers explicitly and implicitly induce end users of financial products to buy or sell the instruments that allow the market makers to cover their positions in the OTC market. This is not to say that the market makers are taking advantage of the other parties to their trades. As is often the case, all parties to a transaction can come out ahead.

Forward Rate Agreements (FRAs)

The FRA market represents the OTC equivalent of the exchange-traded futures contracts on short-term rates. FRAs are a natural outgrowth of the interbank market for short-term funds. However, unlike the interbank market, virtually any creditworthy entity can buy or sell FRAs.

The liquid and easily accessible sector of the FRA market is for three- and six-month LIBOR. Rates are quoted widely for settlement starting one month forward, and settling once every month thereafter out to about six months forward. Thus, for example, on any given day forward rates are available for both three- and six-month LIBOR one month forward, covering, respectively, the interest period starting in one month and ending in four months, and the interest period starting in one month and ending in seven months. These contracts are referred to as 1 × 4 and 1 × 7 contracts. On the same day, there will be FRAs on three- and six-month LIBOR for settlement two months forward. These are the 2 × 5 and 2 × 8 contracts. Similarly, settlements occur three months, four months, five months, and six months forward for both three- and six-month LIBOR. These contracts are also denoted by the beginning and end of the interest period they cover.

On each subsequent day, contracts with the same type of structures, that is, contracts with one month, two months, and so on, to settlement date, are offered again. Thus, although on any given day a relatively limited number of structures are widely quoted, new contracts with new settlement dates are offered at the beginning of each day. This is quite different from the futures market, where the same contracts with the same delivery dates trade day after day.

As for other OTC debt instruments, there are market makers and brokers who make the market work. However, unlike the other OTC derivative instruments, in the FRA market the commercial banks are clearly the dominant force among the market makers. This dominance is due to the ability of the banks to blend their FRA transactions into their interbank transactions and overall funding operations. Consequently, many banks are willing to quote on a much wider variety of structures than the standard structures explained above. One can choose maturities other than three- and six-month LIBOR, and one can choose many settlement dates other than at an even number of months in the future.

In most cases, FRAs are written so that no money changes hands until the settlement date. To determine the cash-flows on the settlement date, LIBOR taken from some predetermined source is compared to the LIBOR rate specified in the FRA contract. The actual dollar amount that changes hands is the dollar value of the difference between the two rates, present valued for a period equal to the maturity of the underlying LIBOR, either three or six months. The rationale behind present valuing is that if an FRA is used to hedge the rate on a deposit (or other short-term instrument), the loss (gain) due to a change in interest rates will be paid (saved) at the maturity of the deposit, not at the issue date. Thus, because cash payments on the FRA are made on the settlement date (which presumably is the same as the issue date of the deposit) the present value of the interest expense (or saving) on the deposit will equal the amount of money actually received or paid on the FRA.

Finally, one peculiarity of the FRA market deserves note. If one buys an FRA, one profits from an increase in rates, and if one sells an FRA, one profits from a decline in rates.

KEY POINTS

• A forward contract is an agreement for the future delivery of something at a specified price at the end of a designated period of time but differs from a futures contract in that it is nonstandardized and does not trade on an organized exchange.

• Parties to a forward contract are exposed to counterparty risk which is the risk that the counterparty will not satisfy its contractual obligations.

• A futures contract is an agreement between a buyer (seller) and an established exchange or its clearinghouse in which the buyer (seller) agrees to take (make) delivery of something at a specified price during a designated period of time.

• The parties to a futures contract are required to satisfy margin requirements.

• An investor who takes a long futures position realizes a gain when the futures price increases; an investor who takes a short futures position realizes a loss when the futures price decreases.

• For the Treasury bond futures contract, the underlying instrument is $100,000 par value of a hypothetical 20-year, 6% coupon Treasury bond.

• Conversion factors are used to adjust the invoice price of a Treasury bond futures contract to make delivery equitable to both parties.

• The short in a Treasury bond futures contract has several delivery options.

• The 2-year, 5-year, and 10-year Treasury note futures contracts are modeled after the Treasury bond futures contract.

• Three-month LIBOR is the underlying instrument for the Eurodollar futures contract. This futures contract is a cash settlement contract and is one of the most heavily traded futures contracts in the world.

• The federal funds futures contract is a cash settlement contract whose underlying is the average overnight federal funds for the delivery month.

• The underlying instrument for a swap futures contract is the notional price of the fixed-rate side of a 10-year interest rate swap that has a notional principal equal to $100,000 and that exchanges semiannual interest payments at a fixed annual rate of 6% for floating interest rate payments based on 3-month LIBOR.

• Interest rate options include options on fixed income securities and options on interest rate futures called futures options.

• Caps and floors are agreements between two parties whereby one party for an upfront fee agrees to compensate the other if a designated interest rate is different from a predetermined level.

• A forward rate agreement is an over-the-counter derivative instrument which is essentially a forward-starting loan, but with no exchange of principal, so the cash exchanged between the counterparties depend only on the difference in interest rates.

• The elements of an FRA are the FRA rate, reference rate, notional amount, contract period, and settlement date.

• The buyer of an FRA is agreeing to pay the FRA rate and the seller of the FRA is agreeing to receive the FRA rate. The amount that must be exchanged at the settlement date is the present value of the interest differential.

• In contrast to an interest rate futures contract, the buyer of an FRA benefits if the reference rate increases and the seller benefits if the reference rate decreases.

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