1) What is the Time Value of Money ?
One pound today is worth more than one pound tomorrow, assuming interest rates are positive.
2) What is Compounding Interest ?
This is interest calculated on the initial amount plus the previous accumulated interest.
Also known as interest on interest.
3) What is the current Libor rate ?
Overnight was 0.472%
4) Can you describe the different types of Interest Rate Derivatives ?
Exchange - Interest Rate Futures (Government Bonds, STIR)
Exchange - Interest Rate Options (options on Interest Rate Futures)
Exchange - Interest Rate Swaps
Exchange - Interest Rate Swap Futures (futures on Interest Rate Swaps)
OTC - Interest Rate Forwards (Forward Rate Agreements)
OTC - Interest Rate Options (caplet, caps, floorlet, floors, swaptions)
OTC - Interest Rate Swaps
OTC - Interest Rate Swap Futures (futures on Interest Rate Swaps)
5) What exchanges are Interest Rate Derivatives traded on ?
CME Group - Chicago Mercantile Exchange
ICE Futures Group (previously LIFFE) -
BM&F Bovespa - (Brazil Mercantile and Futures Exchange)
6) What is the Short Rate ?
This is the continuously compounded annualized instantaneous short term interest rate.
This is the interest rate earned in a small time period.
7) What is LIBOR ?
LIBOR is the name given to a group of interest rates used in the money markets
These are key reference rates for 10 different currencies including (USD, GBP, CHF, JPY, EUR).
They are fixed every day in London at 11:00am and the rates are set for all maturities less than 1 year.
18 banks submit rates. The highest 25% (4) are discarded. The lowest 25% (4) are discarded. The remaining 10 are averaged.
Maturities (7) - overnight, 1w, 1m, 2m, 3m, 6m, 12m
Libor rates are quoted to the nearest 1/16th = 0.0625
8) What is USD LIBOR ?
This is a key reference rate used for inter-bank transactions that are made in Dollars.
9) What is EURIBOR ?
This is the key reference rate used for inter-bank transactions that are made in Euros.
This is fixed every day in Brussels at 11:00am and the rates are set for all maturities less than 1 year.
23 banks submit rates. The highest 15% are discarded. The lowest 15% are discarded. The rest are averaged.
Maturities (8) - 1w, 2w, 1m, 2m, 3m, 6m, 9m, 12m
10) What do the following abbreviations mean ?
LIBOR - London InterBank Offered Rate
SONIA - Sterling OverNight Index Average (similar to LIBOR but is an end of day average of unsecured overnight borrowings)
EURIBOR - EURopean InterBank Offered Rate
EONIA - Euro OverNight Index Average
STIR - Short Term Interest Rate (less than 1 year)
OIS - Overnight Index Swap
11) What is an Interest Rate Forward ?
Also known as a forward rate agreement (FRA).
This is an agreement to borrow (or lend) a notional amount of cash for a period of up to 12 months, starting at any point in the next 12 months.
The fixed rate is the agreed Forward Rate or FRA rate.
The floating rate (or reference rate) is the fluctuating interest rate.
The 2 most common floating rates are LIBOR and Euribor.
They allow us to lock in a fixed interest rate for borrowing (or lending) cash.
There is no exchange of principal just the interest differential which is paid on the settlement date.
These are cash settled and discounted at the beginning.
This is an off the balance sheet product.
This instrument is different to all the other money market instruments for the following reason:
The buyer of the FRA is borrowing the notional amount at a fixed rate
The seller of the FRA is lending the notional amount at ?
Example is 0R3 (3 month forward rate for today)
Example is 3R6 (3 month forward rate starting in 3 months)
Example is 3R9 (6 month forward rate starting in 3 months)
12) Why would someone buy an Interest Rate Forward ?
13) How is the price of an Interest Rate Forward calculated ?
3R6 is priced at todays implied 3 month forward, 3 month interest rate.
14) What is an Interest Rate Future ?
This is an agreement to buy (or sell) a cash amount on a date in the future based on the rate ?
This type of instrument is often divided into two categories, those that are long-term and those that are short-term (less than one year).
These are settled daily using a margin mechanism.
Examples of long-term interest rate futures are government bond futures
Examples of short-term interest rate futures are EuroDollar futures
15) Why would someone buy an Interest Rate Future ?
It lets you lock in a forward borrowing (or lending) interest rate for a given amount for a period of 3 months.
These are used to hedge against the risk that interest rates will move in an adverse direction.
This is in contrast with spot borrowing (or lending) which would be fully funded and unsecured for a period of 3 months.
A sequence (or strip) of interest rate futures can be used to hedge a bond that match as close as possible to the expiry date.
16) How is the price of an Interest Rate Future calculated ?
17) What is the difference between an Interest Rate Forward and an Interest Rate Future ?
Both are agreements to borrow (or lend) a notional amount for a period of time with a fixed interest rate starting on the contract settlement date.
Buying an Interest Rate Future is equivalent to lending money.
Buying an Interest Rate Forward is equivalent to borrowing money.
18) Can you describe a Government Bond Future ?
Also known as long term interest rate futures.
These allow traders to gain exposure to the underlying asset as well as allowing them to hedge the risks associated with these assets.
These require actual physical delivery when settled.
US Treasury Bond 30 year - contract size is $100,000, coupon 6%
US Treasury Note 10 year
US Treasury Note 5 year
US Treasury Note 2 year
US Treasury Bill 90 day
Euro/German Bund - contract size EUR100,000
Euro/German BOBL - contract size EUR100,000
Euro/German Schatz - contract size EUR100,000
19) Can you describe a Short-Term Interest Rate Future ?
These are exchange-traded time deposit contracts where the instrument is a Short Term Interest Rate.
These are cash settled, traded on margin on an exchange.
These are forward contracts on the implied 3 month interest rate.
Most of these contracts have delivery dates: March, June, September, December
They can be listed on a 10 year cycle.
Serial months do exist for the nearest months although liquidity is low.
This contract derives its value from the interest rate at maturity.
Often used to price and hedge interest rate swaps.
The minimum price fluctuation reduces when close to expiry.
20) Can you give some examples of the different types of STIR Futures ?
EuroDollar 1 month - $3,000,000 (12 sequential months)
EuroDollar 3 month - $1,000,000 (launched in 1981)
EURIBOR 3 month - EUR 1,000,000 (launched in 1999)
Short Sterling 3 month - £500,000
EuroSwiss 3 month - CHF 1,000,000
EuroYen 3 month - Y 100,000,000
30 day Fed Funds - $5,000,000
21) How is the price of a STIR future calculated ?
The price is calculated as 100 minus the implied interest rate on the expiry date.
The price is determined by the appropriate 3 month LIBOR reference rate.
During the life of a contract the price will be closely related to the implied forward rate for the date of expiry.
STIR Future contracts move like bonds.
When rates go up their price goes down. When rates go down their price goes down.
These prices/interest rates are often called the money-market rates.
22) Can you describe a EuroDollar Future ?
Unless otherwise specified this has a 3 month maturity.
23) How is the price of a EuroDollar Future calculated ?
The prices are determined by the markets forecast of the 3 month USD LIBOR interest rate.
The prices are determined by subtracting the forecasted interest rate from 100.
For example, if on a particular day an investor buys a single three-month contract at 95.00 (implied settlement LIBOR of 5.00%):
if at the close of business on that day, the contract price has risen to 95.01 (implying a LIBOR decrease to 4.99%), US$25 will be paid into the investor's margin account; or
if at the close of business on that day, the contract price has fallen to 94.99 (implying a LIBOR increase to 5.01%), US$25 will be deducted from the investor's margin account.
On the settlement date, the settlement price is determined by the actual LIBOR fixing for that day rather than a market-determined contract price.
24) How is the price of a Euribor Future calculated ?
Minimum price movement is 0.005 (EUR 12.50)
Delivery months are March, June, September, December
28 delivery months are available
The nearest 6 months are consecutive serial calendar months.
25) How is the price of Short Sterling Future calculated ?
Delivery months are March (H), June (M), September (U), December (Z).
26) What does the term Basis mean ?
This is the gap between the cash price and the futures price.
27) What is the TED spread ?
This is the Treasury Bill Future and the EuroDollar Future spread.
The difference between the rates on 3-month future contracts with the same expiry date.
This is often used as an indicator of credit risk.
28) What is an Interest Rate Option ?
Also known as Options on Interest Rate Futures.
This is an interest rate derivative where the underlying asset is directly related to an interest rate.
They are traded on Exchanges and OTC.
All options on STIR Futures are American
Similar to an interest rate forward except it has an exercise rate instead of an exercise price.
Options on Interest Rate Futures (STIR Futures)
Options on Certificates of Deposit
US Treasury Bond 30 year -
US Treasury Bond 5 year -
EuroDollar options - (american)
Euribor options - (american)
29) What is the difference between an Interest Rate Option and a Bond Option ?
Interest Rate Option - the right to borrow a pre-determined notional amount at a fixed rate starting a few days after the option expiry.
Bond Option - the right to buy a bond at a particular strike price when the option expires.
30) Can you draw the payoff for buying an Interest Rate Option ?
Similar to other options except the "days to maturity" is taken into account.
The payoff is not made until the end of the number of days attached to the rate.
For example if an interest rate option expires in 60 days and is based on 180-day LIBOR, the holder will not be paid for 180 days.
payoff = max (0, underlying asset - exercise price) * (days in rate / 360) * notional
31) Can you describe some different types of Interest Rate Options ?
Caplet - This is a European call option on an interest rate, typically LIBOR or EURIBOR
Cap - This is a portfolio of caplets having the same strike price.
Floorlet - This is a European put option on an interest rate.
Floor - This is a portfolio of floorlets having the same strike price.
Swaption - This is an interest rate derivative.
*) short term options on short-term interest rates
*) medium term options on short-term interest rates
*) short term options on bonds (bond options)
*) medium term options on bonds (bond warrants)
These are traded on both exchanges and OTC.
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