Are you apprehensive about interest rate movements? If yes, hedge yourself against adverse developments in rates and thereby you can control your costs with an effective instrument – Interest Futures (IRF). These short term contracts are based on underlying assets which are usually interest bearing securities.
Various types of IRFs are normally exchange traded and few examples of IRFs are 13 week Treasury Bills, 3 month Eurodollars, one month Fed funds etc.
• Treasury bills are normally regarded risk free as they are backed by the United States government, however to hedge against interest movements on these securities T-bill futures are used and they are usually available in quarterly contracts.
• Eurodollars, unrelated to Euro, are deposits in banks outside the United States which are denominated in U.S. Dollars. Such deposits do not fall under the jurisdiction of the Federal Reserve. Similarly Euroyen are deposits in Japanese Yen held outside Japan.
• Fed Funds are mandatory reserves with Federal Reserve contributed by all commercial banks.
Hedging with Interest Rate Futures
The most common practice in rate futures market to hedge positions bearing interest risk is to enter into an offsetting futures contract. One can also hedge forward borrowing rates using IRFs. Investors normally enter into a buy or sell transaction in the futures market today, which they transact in the cash market in future.
The size of interest rate future contracts depends on exchanges and the type of contracts being traded. Price of short term interest contracts are usually based on index value (set at 100) less the interest rate. Bond based contracts derive their price from the yield on notional security.
IRFs yield multiple benefits to various players. These instruments enable Primary Dealers to manage their interest rate risk and also enhance earning capacity. IRFs further also aid in reducing transaction costs, eliminate credit and settlement risks. Banks are benefited with IRFs in managing their repricing risk, yield curve risk and basis risk. Capital adequacy ratio can also be improved with IRFs as hedged assets require lesser capital allocation. Corporates can improve their credit ratings as hedging enhances their ‘interest coverage’ and ‘debt-service coverage’ ratios.
Though, interest rate futures are extremely beneficial in the current times against interest rate movements, one must be fully aware of the various risks and complications involved in its usage.