Eurodollar futures, T Bill futures, Fixed Income futures against, reason, tough

johnnyBuz

I seem to have a tough time understanding when to go long these and when to go short. Can anyone explain? What does each one hedge against?

Caps and floor and swaps/swaptions im good with. For some reason these trip me up.

jbaldyga

Allow me to elaborate on Euro dollar futures contract.
Eurodollar rates are the interest rates at which US dollars are borrowed and lent outside US.

If you have gone long in Eurodollar futures at 95, you have agreed to lend the money at 5% (100 minus 95) in future. You have locked yourself to earning 5% in future.
Subsequently, if the euro dollar interest rate goes down to 4.99%, the new quote will be 95.01 and the person holding long position has gained because she has locked herself into lending at 5% while the market rate is only 4.99%.
In fact, for every move down of one basis point (5% to 4.99% is a move of 1 basis point), $25 is deposited into futures account of the person who went long.
This is assuming that you have entered into 90 day futures contract for a notional principal of $1 million.
The calculation is as follows.
1 million * (0.01/100) * (90/360).

If the interest goes up to 5.01%, then the long position will have to pay $25.

lunarfollies

nvm i got it



Edited 1 time(s). Last edit at Thursday, June 9, 2011 at 05:42AM by mr_moose.

iteracom

Pretty sure I went 1 for 6 on this...I wrote some notes on caps and floors late last night...Might not make any sense but worth a shot...

Interest Rate Derivatives - Hedging using Caps and floors

1. Borrowing Money that has a variable rate (Variable Mortgage loan) - If rates start to increase, I will have to pay more. But, if I enter into a cap, I will limit the amount I will have to pay because eventually the cap will be in the money. The loss by paying extra money as rates rise will be offset by the gain in the cap.

2. Investing in a security that had a variable rate - (Buying a variable bond) - If rates start to decrease, I will not be getting as much income as before. Therefore, I will need to hedge against the decrease in interest rates and buy a Floor. I will be able to limit the amount of lost income because at some point in the future, the floor will be in the money. The loss on the variable interest will be offset by the gain on the Floor.

Interest Rate Collar - Enter into an agreement with a caplet and a floor.

1. Borrowing Money - Long Cap, Short Floor - I will great a "Collar" that will let me keep my borrowing costs between a certain range.

2. Hedging against a Liability - Long put, Short Cap - I will be able to keep the returns between a specific "Collar"



Edited 1 time(s). Last edit at Sunday, May 29, 2011 at 01:49PM by beingthatguy.

tobeornottobe

ok i think ive understood this topic. Eurodollar futures are quoted as a discount yield. If the LIBOR Drops, the value of the Eurodollar goes up (this is kind of like a bond and interest rates). SO if you are hedging something from dropping interest rates, you would go long a eurodollar future because it would increase in value if the predicted decrease in rates occurs.

Caps and floors are are also used for hedging. If you have a floating rate asset, you are worried about decreasing rates. Therefore, you buy a floor and if rates drop you get a payment from the short. You could also buy an interest rate put, or a call on a bond (again if rates drop in this case, the bond value would increase and you get payment). If you have a floating rate liability, you are worried about rising rates. Therefore, you can buy a cap or interest rate call. If rates rise, you would get payment from the short. You could also buy a put on a bond. If rates rise, the bond value decreases and you win.

dmrktrading

This is a problem area for me too. In your example why would you win if rates go up wouldn't your bond value decrease?

morebeans

Are you referring to the first derivatives item set in Volume 1 of Schweser? Like caps/floors/calls/puts/etc... you're simply using the aforementioned derivatives to make directional bets or hedges on the underlying interest rates. These are much less confusing than swaptions.

example: i own a floating rate bond indexed to LIBOR. How can i best hedge this? When interest rates rise, in this case LIBOR, I win. I need a derivative that will hedge me if rates fall. We all are acutely aware of the inverse relationship with interest rates and bond prices. My loss exposure is if rates fall so I need to go LONG a futures contract on a LIBOR instrument to hedge my existing position. This position will gain in value in the event of falling rates.

If you're hedging a LIBOR based security then go with EURODOLLAR futures
If you're hedging a US rate based security then use T BILL futures