9.3 Derivatives markets

Even if a contract turns out to be protable, the possibility that additional margin

payments may have to be made on a daily basis requires an investor to keep a certain

proportion of his assets in a liquid form.

Another common type of nancial future is the interest rate future. Short-term

interest rate futures are contracts on three-month or one-month time deposits in

specied currencies. The buyer of such a contract would, on delivery, receive a time

deposit at an eligible bank of the amount specied beside the title of the contract.

Contracts quoted in the Financial Times in April 2006 included a Three Month

Sterling Future and a number of contracts on the euro and on eurocurrencies (see

Chapter 10) such as a Three Month Euro Swiss Franc Future and a Three Month

Euroyen Future. The gamble in such contracts relates to changes in short-term inter-

est rates relative to those rates at the time the contract is negotiated.

The Three Month Sterling Futures contract offered by Euronext-liffe is for £500,000

at points of 100 per cent. That is, the price of the contract is quoted in the form of

subtractions from 100 per cent – a price of 94.81 represents an annual interest rate

of 5.19 per cent (100–94.81). The minimum price movement (or tick size) is one basis

point (0.01%). For a £500,000 three-month time deposit, a change in the price of

1 basis point translates into a change in the value of the contract of £12.50 (0.01 per

cent per annum interest on £500,000 for three months). This is known as the tick

value of the contract. The tick value provides a simple way of quoting the prot or

loss on a contract – a prot of 10 ticks on the Euronext-liffe Sterling contract is a

prot of £125. Box 9.2 provides some more detail.

Long-term interest rate futures are to be found in the Bond Futures section of

the Financial Times. They are based on notional government bonds. The form of

the quotation is given. Interest rates in Europe are all expressed in basis points

but for the US are still quoted in 32nds of 1 per cent, with one tick being 1/32 of

1 per cent, as used to be the case in the UK before 1999. In June 2006, the prices

of almost all of the contracts quoted in the Financial Times were above 100. This

might have indicated that interest rates were then lower than the coupon rates on

the notional bonds.

However, the fact that long-term bond futures are based on notional bonds intro-

duces an additional complication. In the unlikely event that the contract leads to the

delivery of bonds, the seller of the contract is extremely unlikely to be able to deliver

a bond with the exact characteristics of the notional bond. Thus, the exchange

establishes a list of eligible bonds, any one of which may be used to effect delivery.

For example, the notional bond may have a period to maturity of twenty years

and a coupon rate of 9 per cent, while the eligible list established by the exchange

might include bonds with periods of maturity between fteen and twenty-ve years

and coupon rates ranging from 6 to 12 per cent. This causes a complication at the

point of delivery because the buyer of the contract must pay for the bond actually

delivered whereas the nal settlement price of the futures contract will be based on

the notional price. To overcome this problem, the exchange publishes a price factor

or conversion factor for each eligible bond that reects the difference in value between

the notional bond and the actual bond delivered. The nal settlement price for the

notional bond is multiplied by the price factor (which may be either greater than or

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Chapter 9 • Exchange rate risk, derivatives markets and speculation

Box 9.2

Interest rate futures

In the Financial Times of 16 June 2006, the following information was provided for the

Three Month Sterling Futures contracts due for delivery at the end of June, September

and December 2006 and March and June 2007.

June 2006Sept 2006Dec 2006March 2007June 2007

Opening price95.2795.1795.0694.9894.92

Settlement price95.2795.1495.0194.9194.84

The interest rates implied by the settlement prices were thus:

June 20064.73%

September 20064.86%

December 20064.99%

March 20075.09%

June 20075.16%

At the time, the repo rate set by the Monetary Policy Committee of the Bank of Eng-

land was 4.5%, having been unchanged since August 2005 when it had been reduced

from 4.75%. At the market close on 15 June 2006, the following interest rates applied to

interbank sterling:

Overnight	4.531%	one month	4.612%	three months	4.703%
six months	4.703%	one year	4.953%

The prices of the futures contracts suggested a market belief that the Bank of England

would increase interest rates by 50 basis points in the following nine months, probably

in the form of two 25-basis-point increases.

Source: Financial Times, 16 June 2006

Exercise 9.2

Look at the information in Box 9.2 and answer the following questions:

(a)	Consult the Bank of England website (http://www.bankofengland.co.uk/ monetarypolicy/decisions/). Find the minutes for the MPC’s meeting on 8 June 2006 (published on 21 June 2006) and see if there is anything in these minutes to support the views of the markets.

(b)	How does the behaviour of interest rates implied by settlements prices of interest rate futures differ from those applying to interbank sterling?

(c)	Why does the behaviour of these two sets of rates differ?
		Answers at end of chapter

less than one). Thus the settlement prices will also reect the closeness or otherwise

of the terms of the notional bond to those of the bonds eligible for delivery.

Another complication arises because bonds have accrued interest added on whereas

futures contracts do not. Consequently, allowance has to be made for interest accrued

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