INTEREST RATE MARKETS.

INTEREST RATE FUTURES ARE THE MOST

POPULAR AND SUCCESSFUL FINANCIAL
DERIVATIVE INSTRUMENT TODAY IN THE
GLOBAL FIN. MARKETS.BOTH THE BORR-
OWERS AND LENDERS FACE INTEREST
RATE RISK. IF BOTH DISLIKE RISK AND
UNCERTAINITY THEN THEY WILL SEEK
SUCH INSTRUMENTS THROUGH WHICH
THEY CAN REDUCE SUCH RISK.
11 July 2013 PROF. D. GOPINATH 1
 INTEREST RATE FUTURES
INTEREST RATE FUTURES ARE SUCH FINA-
NCIAL DERIVATIVES WHICH ASSIST IN
REDUCING THE INTEREST RATE RISK OF
SUCH PERSONS. INTEREST RATE FUTURE
ARE SUCH FINANCIAL DERIVATIVES
WHICH ARE WRITTEN ON FIXED INCOME
(RETURN) SECURITIES OR INSTRUMENTS
HERE INTEREST AND PRINCIPAL ARE
PAYABLE ON PREDETERMINED DATES.
11 July 2013 PROF. D. GOPINATH 2
 INTEREST RATE FUTURES
IN THE FINANCIAL MARKETS THESE DEBT
OBLIGATIONS ARE OFTEN ARBITRARILY
SEPERATED INTO SHORT TERM(MONEY
MARKET) AND LONG TERM(CAPITAL MKT)
INSTRUMENTS. MONEY MARKET INSTRU-
MENTS ARE THOSE FINANCIAL ASSETS
HAVING INITIAL MATURITY OF ONE YEAR
OR LESS AND CAPITAL MARKET MORE
THAN ONE YEAR.
11 July 2013 PROF. D. GOPINATH 3
 INTEREST RATE FUTURES
AN INTEREST RATE FUTURES CONTRACT IS
A FUTURES CONTRACT ON AN ASSET
WHOSE PRICE IS DEPENDENT SOLELY ON
THE LEVEL OF INTEREST RATES. INTERE-
ST RATE FUTURES ARE MORE COMPLICA-
TED THAN OTHER TYPES OF FUTURES
BECAUSE IT REQUIRES DESCRIPTION OF
BOTH LEVEL OF INTEREST RATES AND
MATURITY OF INTEREST RATES.
11 July 2013 PROF. D. GOPINATH 4
 TYPES OF INTEREST RATES
1. TREASURY RATES:-
IT IS THE RATE OF INTEREST
APPLICABLE TO BORROWING BY A
GOVT IN ITS OWN COUNTRY. EX:-
INDIAN GOVT CAN BORROW IN INDIAN
RUPEES ON TREASURY RATES PRESCRI-
BED.TREASURY RATES ARE ALSO
REGARDED AS RISK FREE RATE OF
INTEREST.

11 July 2013 PROF. D. GOPINATH 5

 TYPES OF INTEREST RATES
2. LIBOR RATE:- LONDON INTER BANK
OFFER RATE IS THE RATE AT WHICH
INTERNATIONAL BANKS ARE WILLING TO
LEND MONEY TO ANOTHER INTERNATIO-
NAL BANK.LIBOR RATES CHANGE AS PER
THE ECONOMIC CONDITIONS, QUANTUM
OF MONEY FLOWS, MARKET POSITION
OF FUNDS REQUIREMENTS ETC. LIBOR IS
HIGHER THAN TREASURY RATES.
11 July 2013 PROF. D. GOPINATH 6
 TYPES OF INTEREST RATES
3. REPO RATE:-IT IS A CONTRACT WHERE
THE OWNER OF THE FUNDS AGREES TO
SELL THE TO A COUNTER PARTY NOW
AND BUY THEM BACK LATER AT A SLIGH-
TLY HIGHER RATE.SO TH COUNTER PAR-
TY IS GIVING A LOAN TO OTHER PARTY.
THE DIFFERENCE BETWEEN THE SELLING
PRICE AND THE REPURCHASE PRICE IS
CALLED AS INTEREST EARNED OR REPO.
11 July 2013 PROF. D. GOPINATH 7
 TYPES OF INTEREST RATE
4. ZERO RATE/ SPOT RATE:-IT IS THE
RATE OF INTEREST EARNED ON AN
INVESTMENT THAT STRATS TODAY AND
LASTS FOR n YEARS. IT IS CALLED AS n
YEAR ZERO RATE, n-YEAR ZERO OR n
SPOT RATE.ALL THE AMOUNTS OF
ACCRUED INTEREST AND PRINCIPAL ARE
REALIZED AT THE END OF n YEARS.
THERE ARE NO INTERMEDIATE
PAYMENTS
11 July 2013 PROF. D. GOPINATH 8
 THE UNDERLYING MARKETS
THERE ARE A NUMBER OF MONEY MARK-
ETS OPERATING IN DIFFERENT
SEGMENT COLLECTIVELY CALLED AS
PARALLEL MARKETS. IT COMPRISES OF
:-
1. THE INTER BANK RATE.
2. THE CD’S AND CP MARKETS.
3. THE LOCAL GOVT SECURITIES MARKET.

11 July 2013 PROF. D. GOPINATH 9

 THE UNDERLYING MARKETS
1. INTER BANK MARKET:- IT INVOLVES THE
BORROWING AND LENDING AMONG
BANKS AND LARGE ENTITIES LIKE CORP,
GOVT BODIES, CENTRAL BANKS, IMF. IT
IS A WHOLESALE MARKET WHERE ONE
SINGLE TRANSACTION IS USUALLY IN
MILLIONS. OFTEN MONEY PASSES
THROUGH MANY BANKS BETWEEN
ORIGINAL LENDER AND THE ULTIMATE
BORROWER.
11 July 2013 PROF. D. GOPINATH 10
 THE UNDERLYING MARKETS
THE INTER BANK INTEREST RATE HAS
BECOME THE BENCHMARK FOR OTHER
INTEREST RATES.BOTH THE BID AND
OFFER RATES ARE AVAILABLE HERE. THE
DIFFERENCE BETWEEN OFFER AND BID
RATE IS KNOWN AS SPREAD WHICH IS
USUALLY 1/8 %.

11 July 2013 PROF. D. GOPINATH 11

 THE UNDERLYING ASSET
2. CD’S AND CP MARKET:-THE CD’S ARE
BEARER CERTIFICATES ACKNOWLEDGING
A DEPOSIT FOR A PERIOD, SUCH AS 3 OR
6 MONTHS.IT IS A NEGOTIABLE INSTRU-
MENT WHICH CAN BE BOUGHT AND
SOLD BETWEEN THE DATE OF ISSUE AND
MATURITY.THE MARKET IS DOMINATED
BY BANKS AND USUALLY THE DISCOUNT
HOUSES OPERATE MARKET MAKERS IN
THIS MARKET.
11 July 2013 PROF. D. GOPINATH 12
 THE UNDERLYING MARKET
THE CP’S ARE ISSUED BY THE CORPORATE
BORROWERS. CORPORATE FIRMS
DIRECTLY APPROACH THE INVESTORS
AND CAN BORROW AT RATES EQUAL TO
OR EVEN PERHAPS LOWER THAN THE
INTEREST RATES CHARGED BY THE
BANKS FROM THEM.

11 July 2013 PROF. D. GOPINATH 13

 THE UNDERLYING ASSET.
3. GOVERNMENT BORROWING:- GOVT
ISSUES DIFFERENTS INSTRUMENTS LIKE
TREASURY NOTES, TREASURY BILLS AND
BONDS FOR FINANCING THEIR SPEND-
ING AND BUDGET DEFICITS. THE LOCAL
GOVT AUTHORITIES MAY FIND IT
CHEAPER TO TAKE DEPOSITS DIRECTLY
RATHER THAN BORROW FROM THE
BANKS AND OTHER FIN. INSTITUTION.
11 July 2013 PROF. D. GOPINATH 14
 THE TERM STRUCTURE OF
INTEREST RATES
THE VOLATILITY OF A DEBT INSTRUMENT
PRICE IS DEPENDENT ON ITS MATURITY,
THE LONGER THE MATURITY THE GREAT-
ER THE PRICE VOLATILITY.SINCE THE
MATURITY OF A BOND IS REFERRED AS
ITS TERM TO MATURITY OR SIMPLY
TERM THE RELATIONSHIP BETWEEN YIE-
LD AND MATURITY IS REFERRED TO AS
THE TERM STRUCTURE OF INTEREST RA-
TES.IT IS ALSO CALLED AS YIELD CURVE.
11 July 2013 PROF. D. GOPINATH 15
 THE TERM STRUCTURE OF
INTEREST RATES (HYPOTHETICAL)
1.UPWARD SLOPING YIELD:-YIELD RISES
AS MATURITY INCREASES.THIS IS REFE-
RRED AS POSITIVE YIELD CURVE.
2.DOWNWARD SLOPING YIELD:- WHERE
YIELD DECREASES AS MATURITY
INCREASES.
3.FLAT YIELD:- YIELD REMAINS THE SAME
IRRESPECTIVE OF CHANGES IN
MATURITY.

11 July 2013 PROF. D. GOPINATH 16

 FORWARD RATE AGREEMENTS
(FRAs)
THESE ARE ALSO KNOWN AS FUTURE RATE
AGREEMENTS. THESE REFER TO A
TECHNIQUE FOR LOCKING IN FUTURE
SHORT TERM INTEREST RATES.THESE
ARE AGREEMENTS THAT A CERTAIN
INTEREST RATE WILL APPLY TO A
CERTAIN PRINCIPAL AMOUNT FOR A
CERTAIN PERIOD IN THE FUTURE.

11 July 2013 PROF. D. GOPINATH 17

 HEDGING THE FRA
FRA CAN ALSO BE USED TO MANAGE THE RISK
BY ENTERING A NOTIONAL AGREEMENT TO
LEND OR BORROW IN THE FUTURES AT A RATE
OF INTEREST DETERMINED IN THE PRESENT. A
SET OF BID-OFFER SPREADS IS PUBLISHED
SHOWING RATES OF INTEREST FOR
DIFFERENT FUTURES TIME PERIODS. THE CUS-
TOMER AND THE BANKER MAY AGREE THAT
THE COMPENSATION WILL PASS BETWEEN
THEM IN RESPECT OF ANY DEVIATION OF
INTEREST RATES BETWEEN THE TWO DATES.

11 July 2013 PROF. D. GOPINATH 18

 TREASURY BILL FUTURES
TREASURY BILL ARE MAJOR SHORT TERM
INTEREST RATE SECURITIES AND
NORMALLY ISSUED 90 DAYS 180 DAYS
RESPECTIVELY. THE 90 DAY T-BILLS ARE
MOST POPULAR INSTRUMENT.THE T-BILL
FUTURES MARKET IS THE MOST LIQUID
AND CONTRACTS ARE WIDELY TRADED.
TREASURY BILL YIELD ARE QUOTED ON
A DISCOUNT BASIS WITH RELATION TO
THE FACE VALUE.
11 July 2013 PROF. D. GOPINATH 19
 TREASURY BILL AND FUTURES
AS SUCH THE DIFFERENCE BETWEEN THE
PURCHASE PRICE AND THE REDEMPTION
VALUE IS THE INTEREST EARNED BY THE
BUYER. THE DISCOUNT ON THE FACE
VALUE IS ALWAYS AS A PERCENTAGE OF
THE FACE VALUE. T- BILLS HAVE MATUR-
ITY OF LESS THAN ONE YEAR. THE
DIFFERENCE BETWEEN THE PURCHASE
PRICE AND ITS FACE VALUE DETERMINES
THE INTEREST EARNED BY THE BUYER.
11 July 2013 PROF. D. GOPINATH 20
 TREASURY BILL FUTURES
THE DISCOUNT ON THE FACE VALUE IS ALWAYS
AS A PERCENTAGE OF THE FACE VALUE. PRICE
QUOTATION FOR T-BILL FUTURES ARE ON AN
INDEX BASIS i.e. THE INDEX IS 100 MINUS THE
ANNUAL-ISED DISCOUNT RATE. IF DISCOUNT
IS SAY 7% THEN INDEX PRICE WILL BE 93.
THE MINIMUM PRICE CHANGE ALLOWED IS
ONE BASIS POINT WHICH AMOUNTS TO $25
($10,00,000*.01%*3/12) PER CONTRACT. (SIZE
OF US TREASURY BILL = 10,00,000 DOLLARS)

11 July 2013 PROF. D. GOPINATH 21

 TREASURY BILL FUTURES
THE T-BILL PURCHASE PRICE IS:-
FACE VAL* (1 – % DIS) * DAYS TO MATU)
100 360
IF DISCOUNT IS 7% THE CORRESPONDING
PRICE PAID FOR A 90 DAY T- BILLS =
$10,00,000[ 1-0.07 *(90/360)]
= $9,82,500

11 July 2013 PROF. D. GOPINATH 22

 TREASURY BILL FUTURES
WE CAN CALCULATE THE RETURN ON
PURCHASE OF 90 DAY T-BILL i.e.
FACE VALUE - ISSUE PRICE * 360
ISSUE PRICE DAYS TO MATURITY
10,00,000 - 982,500 * 360
9,82,500 90
= 7.13%.

11 July 2013 PROF. D. GOPINATH 23

 EURO DOLLAR FUTURES
EURO DOLLAR IS ANOTHER MOST POPUL-
AR SHORT TERM INSTRUMENT IN THE
MONEY MARKETS.EURO DOLLAR DEPOS-
ITS ARE US $ DEPOSITS HELD IN A
COMMERCIAL BANK OUTSIDE THE USA.
THESE BANKS MAY BE EITHER FOREIGN
BANKS OR FOREIGN BRANCHES OF US
BASED BANKS. THE DEPOSITS ARE NON-
TRANSFERABLE AND THEY CANNOT BE
USED AS COLLATERAL SECURITY.
11 July 2013 PROF. D. GOPINATH 24
 EURO DOLLAR FUTURES
EURO DOLLAR FUTURES CONTRACTS ARE
NON NEGOTIABLE, 3 MONTH TIME
DEPOSITS IN DOLLARS AT BANKS
LOCATED OUTSIDE THE US MAINLY IN
EUROPE WITH PARTICULAR PRESENCE IN
LONDON. LONDON DOMINATES THE
EURO DOLLAR DEPOSIT MARKET SO
LIBOR HAS BECOME THE BENCHMARK
SHORT TERM INTEREST RATE FOR THE
TRADERS.
11 July 2013 PROF. D. GOPINATH 25
 EURO DOLLAR FUTURES
THE LIBOR IS QUOTED AS AN “ADD- ON
YIELD” BASIS WHICH MEANS THAT IT IS
A PERCENTAGE OF THE TIME DEPOSIT
PURCHASE AMOUNT.IT IS AN ANNUALIZ-
ED RATE BASED ON A 360 DAY A YEAR.
EX:- IF THE 3 MONTH LIBOR IS 10%,
THE INTEREST ON $1 MILLION =
(0.10)(90/360)($1 MILLION) = $25,000.

11 July 2013 PROF. D. GOPINATH 26

 FACTORS FOR THE SPEEDY
GROWTH OF EURO $ FUTURES
1. MOST OF THE BANKS IN THE WORLD
DEPEND ON EURO DOLLAR MARKET
FOR SHORT TERM LOANS.
2. MANY CORPORATES DEPEND HEAVILY
ON EURO DOLLAR MARKET FOR THEIR
BORROWING REQUIREMENTS.
3. EURO$ FUTURES ARE TRADED IN SING-
APORE,LONDON AND CHICAGO AND
CAN BE USED GLOBALLYON 24 HOURS.

11 July 2013 PROF. D. GOPINATH 27

 TED SPREAD
TED SPREAD IS THE DIFFERENCE BETWE-
EN THE PRICE OF A 3 MONTH T-BILL FU-
TURES CONTRACT AND A 3 MONTH EURO
DOLLAR TIME DEPOSIT FUTURES CONTR-
ACT BOTH EXPIRING AT THE SAME DAY.
GIVEN THAT THE T-BILLS ARE LESS
RISKY THAN EURO DOLLARS THE TED
SPREAD VARIES CONSIDERABLY OVER
THE LIFE OF THE FUTURES CONTRACTS.
11 July 2013 PROF. D. GOPINATH 28
 TED SPREAD
THE T-BILLS BEING GUARANTEED BY THE
US GOVT ARE LESS RISKY THAN THE
GUARANTEE GIVEN BY THE COMMERCI-
AL BANKS ISSUING THE EURO DOLLAR
TIME DEPOSITS.THEREFORE THE T-BILLS
CARRY A LOWER RATE OF RETURN THAN
THE EURO DOLLARS.SO THE TREASURY
BILLS FUTURE PRICES ARE HIGHER THAN
THE EURO DOLLAR DEPOSIT FUTURES.
11 July 2013 PROF. D. GOPINATH 29
 HEDGING INTEREST RATE WITH
THE INTEREST RATE FUTURES
1. HEDGING A RISE IN INTEREST RATE FOR
BORROWING DECISIONS OR SHORT TERM
HEDGING.
2. HEDGING A FALL IN INTEREST RATE FOR
INVESTING DECISIONS OR LONG TERM
HEDGING.
THERE ARE TWO POPULAR HEDGING STRA-
TEGIES IN FUTURES USED BY INVESTORS TO
ENSURE THE SURETY OF THEIR EARNINGS
FOR A LONGER PERIOD OF TIME.

11 July 2013 PROF. D. GOPINATH 30

 TWO STRATEGIES FOR SECURITY
1. STRIP HEDGING:-IT INVOLVES BUYING
VARIOUS FUTURES CONTRACTS WITH
DIFFERENT DELIVERY TIMES WHICH ARE
MATCHING THE INVESTORS EXPOSURE
DATES.THE BASIS RISK IS LESS HERE.
2. STACK HEDGING:BUYING VARIOUS FUTURES
CONTRACTS WHICH ARE CONCENTRATED IN
THE NEARBY DELIVERY MONTHS. HERE THE
BASIS RISK IS MORE THE LIQUIDITY POSITI-
ON IS FAR SUPERIOR TO STRIP HEDGING.
11 July 2013 PROF. D. GOPINATH 31
 TREASURY BOND FUTURES
THE MOST POPULAR LONG TERM INTERE-
ST RATE FUTURES CONTRACT IS THE
TREASURY BOND FUTURES CONTRACT
TRADED ON THE CHICAGO BOARD OF
TRADE.THE UNDERLYING INSTRUMENT
IS A $1,00,000 PAR VALUE HYPOTHETIC-
AL BOND FOR A 20 YEAR PERIOD.THE
NOTIONAL COUPON RATE IS AT PRESENT
6% . THE TREASURY BOND FUTURES
PRICE IS QUOTED AT PAR OF 100.
11 July 2013 PROF. D. GOPINATH 32
 TREASURY BOND FUTURES
QUOTES ARE IN 32nds OF 1%. SO A QUO-
TE OF 94-16 MEANS 94 AND 16/32 OR
94.50. SO A BUYER IS PREPARED TO
ACCEPT DELIVERY AT 94.50% OF PAR
VALUE.SINCE THE PAR VALUE IS
$1,00,000 THE HYPOTHETICAL T-BOND
PRICE IS $94,500 FOR BUYER AND
SELLER.THE MINIMUM PRICE FLUCTUATI-
ON IS 1/32nd OF 1% i.e $31.25 FOR
$1,00,000 PAR VALUE.
11 July 2013 PROF. D. GOPINATH 33
 TREASURY BILLS, NOTES AND
BONDS.
T-BILLS:- THESE ARE SHORT TERM GILT
EDGED SECURITIES SOLD BY US TREAS-
URY AT A DISCOUNT.
T-NOTES:- THESE ARE MEDIUM TERM COU-
PONS BEARING GILT EDGED SECURITIES
SOLD THROUGH PERIODIC AUCTIONS.
T-BONDS:-THESE ARE LONG TERM COUP-
ONS BEARING GILT EDGED SECURITIES
SOLD AT PERIODIC AUCTIONS.

11 July 2013 PROF. D. GOPINATH 34