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Forward Rate Agreements (FRA)

A Forward Rate Agreement (FRA) is a forward contract on interest rates. While FRAs exist in most major currencies, the market is dominated by U.S. dollar contracts and is used mostly by money center banks.

An FRA is a cash-settled contract between two parties where the payout is linked to the future level of a designated interest rate, such as three-month LIBOR. The two parties agree on an interest rate to be paid on a hypothetical deposit that is to be initiated at a specific future date. The buyer of an FRA commits to pay interest on this hypothetical loan at a predetermined fixed rate and in return receive interest at the actual rate prevailing at the settlement date.

Example Trade

Assume that in December 2017, a June 2017 Eurodollar futures is priced at 99.10.  This price reflects the market’s perception that by the June 2017 expiration, three-month LIBOR rates will be .90% (IMM Price convention= 100 – 99.10 = .90%).  Eurodollars are really a forward-forward market and their prices are closely linked to the implied forward rates in the OTC market.

Eurodollars and FRAs

Just as stock index futures reflect the cash S&P 500 market and soybean futures reflect the spot soybean market, Eurodollar futures should price at levels that reflect rates or implied rates in the FRA market. In addition, Eurodollar futures prices directly reflect, and are a mirror of, the yield curve. This is intuitive if one considers that a Eurodollar futures contract represents a three-month investment entered into N days in the future. Certainly, if Eurodollar futures did not reflect IFRs, an arbitrage opportunity would present itself.

Example

Consider the following interest rate structure in the Eurodollar (Euro) futures and cash markets. Assume that it is now December. Which is the better investment for the next six months:

• Invest for six months at 0.80%;
• Invest for three months at 0.70% and buy March Euro futures at 99.10 (0.90%); or
• Invest for nine months at 0.90% and sell June Euro futures at 98.96 (1.04%)?

Assume that these investments have terms of 90- days (0.25 years), 180-days (0.50 years) or 270- days (0.75 years).

March Euro Futures 98.10 (0.90%)

June Euro Futures 98.96 (1.04%)

Three-month Investment 0.70%

Six-month Investment 0.80%

Nine-month Investment 0.90%

The return on the first investment option is simply the spot six-month rate of 0.800%. The second investment option implies that you invest at 0.700% for the first three months and lock in a rate of 0.900% by buying March Eurodollar futures covering the subsequent three-month period. This implies a return of 0.800% over the entire six-month period.

The third alternative means that you invest for the next 270 days at 0.90% and sell June Eurodollar futures at 1.04%, effectively committing to sell the spot investment 180 days hence when it has 90 days until maturity. This implies a return of 0.83% over the next six-months.

The third alternative provides a slightly greater return of 0.83% than does the first or second investment options with returns at 0.80%.

Eurodollar futures prices reflect IFRs in the FRA market because of the possibility that market participants may pursue arbitrage opportunities when prices become misaligned. Thus, one might consider an arbitrage transaction by investing in the third option at 0.83% and funding that investment by borrowing outright at the term six-month rate of 0.80%. This implies a three basis point arbitrage profit.

Conclusions

This module demonstrates the close linkage of the FRA and Eurodollar futures market. These contracts allow a firm to replace floating interest rates with fixed interest rates or vice-versa. FRAs are customized contracts that can be obtained through investment banks. These banks hedge the risk of these products by using Eurodollar futures. In hedging the sale of a forward contract with futures, the marking to market feature of futures must be considered. As a result, the pricing of FRAs is very competitive and bid-ask spreads are very narrow as arbitrage opportunities keep prices in the two markets very closely aligned.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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One of the key reasons the Eurodollar contract has become so liquid and successful is because of hedgers using the market to hedge against adverse interest rate fluctuations.

Because Eurodollar futures move inversely with interest rates, if you are concerned about rising rates, you can sell Eurodollar futures and if  you are concerned about declining rates, you might buy Eurodollar futures.

Many loans are structured such that the rate floats periodically (i.e. the interest rate is reset quarterly) as a function of LIBOR plus a fixed premium. This introduces a periodic risk that rates may fluctuate before the time of each periodic loan reset date. Eurodollar futures may be used to address this possibility to the extent that they are listed on a quarterly basis extending 10 years out into the future.

Eurodollar Strip Example

There exist various strategies for hedging with Eurodollars involve stacking and stripping futures contracts as well as products called packs and bundles, which are packaged strips.

Assume that it is March 2017 and a corporation assumes a two-year bank loan repayable in March 2019 for $100 million. The loan rate is reset every three months at LIBOR plus a fixed premium. As such, the loan may be deconstructed into a series, or strip, of eight successively deferred three-month periods. Note: If the loan is secured currently, the effective rate may be fixed at the current rate for the first three months. Thus, there is no risk over the first three-month period between March and June 2017. However, the corporation remains exposed to the risk that rates advance by each of the seven subsequent loan rate reset dates.

Considering that the floating rate loan may be decomposed into seven successively deferred 90-day loans. The BPV associated with each of those seven loans equals $2,500.

BPV = $100,000,000 x (90÷360) x 0.01% = $2,500

The corporation might sell 100 Eurodollar futures in successive quarterly contract months to match the seven successive quarterly loan reset dates. Therefore, one might effectively hedge each of the seven loan periods independently. This transaction is often referred to as a strip hedge, or a series of short (or long) Eurodollar futures in successively deferred contract months to hedge the risk of rising (or declining) rates, respectively.

Conclusion

If rates climb higher over the term of the loan, the short Eurodollar futures contracts would be profitable as the futures decline as rates rise. The profit on the strip of Eurodollar futures would offset the increase borrowing costs effectively locking in a lower rate.

Corporate treasurers and bank asset liability mangers are particularly aware of fluctuations in interest rates as borrowing and lending rates directly influence profitability. They have many tools available to hedge their interest rate exposure and on the Eurodollar or LIBOR side of the business, there is no better instrument.

Indeed, the hedging community has embraced strip hedging so enthusiastically that CME Group has launched a variety of pre-packaged strips that are called packs and bundles.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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To understand the convexity bias, you must understand the parallels between the Eurodollar futures market and the forward rate agreement (FRA) market. Both of these markets are large, liquid and have a vast influence on short-term interest rate pricing.

FRAs are an over the counter (OTC) bilateral agreement that allows the buyer/seller to notionally borrow/lend a specified amount at a LIBOR-based linked rate over a forward period.

What is Convexity Bias?

Convexity bias appears in short-term interest rate instruments because of the payoff differences in the futures market versus the OTC FRA market (aka forward market).

For example, as Eurodollar futures (the underlying interest rate for Eurodollar futures) moves up and down, the payoff for the Eurodollar futures contract remains the same. If rates move up one basis point, the futures will change by $25.00 per contract. If rates move down one basis point, futures will also change by $25.00 per contract. Whether you profit or book a loss depends on if you are long or short on the futures.

With FRA agreements there is a convex payoff. Increases and decreases in rates produce differing payoffs. Its market value rises more for a given decline in rates than it would for a decline for the same size in the forward rate.

As rates decrease 10 basis points from 2.00 to 1.90, notice the Eurodollar (ED) futures lose $250,000, but the FRA payoff is 250,062. The same thing happens for an increase in rates. ED futures gain $250,000 but the FRA loses $62.00 less.

Remember ED futures move inversely with interest rates.

The table shows the convexity bias between a position of short 1000 Eurodollar (ED) futures and an offsetting short $1005m 3-month FRA (slightly more than $1000m to compensate for discounting methodology), both instigated at a rate of 2%.

• An increase in underlying rates from 2% to 2.10% would result in a credit to the variation margin account of short 1000 ED STIR position of $250,000 and a debit of slightly less than that in the discounted equivalent of $1005m-3M FRA collateral account (assuming zero threshold – zero threshold means every dollar of value change has to be made good.).
• A decrease in underlying rates of 10 basis points to 1.9% would result in a debit to the variation margin account of a short 1000 ED STIR position of $250,000 and a credit of slightly more than in the $1005m 3-month FRA collateral account (assuming zero threshold).

Source:  STIR Futures—Trading Euribor and Eurodollar futures, by Stephen Aikin

The amount of the convexity is small at the short end of the curve. The example is using a three-month FRA and Eurodollar futures. Further out on the curve the convexity increases and sometimes dramatically.

Why is Convexity Important?

Although changes in the market have diminished the convexity phenomenon, fixed income traders have to be aware of the bias because of the effects on larger OTC transactions, like FRAs, that are further out on the yield curve. While the change might only be a few hundred dollars on a short term FRA, the changes in a 5-year FRA could be orders of magnitude higher, costing portfolio managers valuable capital.

Still the Eurodollar futures markets and the underlying FRA market closely track each other as spreading and arbitrage opportunities keep them from getting too far out of line.

What Contributes to Convexity Bias?

It is thought that the Convexity bias is due to the following:

• The way Eurodollar futures are margined versus an FRA instrument
• The cash flows paid out over the life of a futures contract versus an FRA. Futures are marked-to-market each day by the clearinghouse, while cash flows in an FRA are paid off differently.
• Volatility in the interest rate markets, generally increasing volatility could cause margin changes.

Final Considerations

Over the years since the financial crisis, the convexity bias has significantly declined.  Since many OTC swaps/FRAs etc. have migrated to central counterparty clearing models such as the exchanges, the margining similarities have contributed to a decline in the convexity bias.

Uncleared margin rules also have impacted funding on OTC trading such as swaps and forward rate agreements. Higher funding rates should, in theory, drive such transactions to the exchanges, such as CME Group, where margin benefits and margin offsets can be realized.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument.

One basis point is equivalent to 0.01% (1/100 of a percent) or 0.0001 in decimal form. If interest rates rose from 2.00% to 2.50%, it would be said that rates rose 50 basis points. In many cases, basis point refers to changes in short-term interest rates, such as Eurodollars, but it is also important with longer-term bond yields.

Basis Point Value, also known as DV01 (the dollar value of a one basis point move) represents the change in the value of an asset due to a 0.01% change in the yield.

BPV or DV01 calculations are used in many ways, but primarily to show the dollar amount of change for each increase or decrease in interest rates. If the value of the Eurodollar futures contract moves by one basis point (.01%), it would equate into a $25.00 move in the contract value. If Eurodollar futures moved four basis points or .04%, it would equate to a $100 move in the value of the contract.

Show graphic calculating this BPV or DV01  for Eurodollars:

Basis Point Value Calculation

The face value of the Eurodollar futures contract is $ 1,000,000. The futures track three-month Eurodollar rates (three-month LIBOR) hence we use 90 days in the equation, and .01% in decimal form is .0001.

Basis Point Value (BPV)  =  Face Value x (#days ÷ 360) x .01%

 BPV = 1,000,000 x (90 ÷ 360) x .0001

 BPV = $25.00 

Example

This example shows Eurodollars in terms of the IMM Price index. Assume Eurodollar interest rates rose from 1.00% to 1.05%, this would represent a .05% or five basis point rise in Eurodollar interest rates. But remember from the prior modules that Eurodollar futures are priced off the IMM price index.

IMM price index = 100 – Eurodollar rate (or three month LIBOR)

In the example above, Eurodollars were at 1.00%. The IMM price index, therefore, would be 100 – 1.00 = 99.00. Subsequently, interest rates rose to 1.05%. The IMM price index at that point would be 100 – 1.05   = 98.95.

As you can see, interest rate prices move inversely with interest rate yields. As rates rose five basis points, the Eurodollar IMM price index declined from 99.00 to 98.95.  

To find out how much that means in terms of dollar value, we have to convert basis point movement into dollar movement. This requires knowing the DV01 (dollar Value of a .01 move)

The basis point value in Eurodollar futures from our calculation above is $25.00.  Therefore, a five basis point move equates to $125.00

5 basis points x $25.00/basis point = $125.00.

Basis Points and Tick Size in Eurodollar Futures

The minimum allowable price fluctuation, or tick size, is generally established at ½ basis point., or .005%. Based on a million-dollar face value 90-day instrument, this equates to $12.50. However, in the nearby expiring contract month, the minimum price fluctuation is set at 1/4 basis point, or .0025%, equating to $6.25 per contract.

Nearby Expiring Contract:

One Tick (.0025 basis pts) = $6.25

All Other Expiring Contracts: 

One Tick (.005 basis pts) = $12.50

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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What is the Eurodollar Settlement Process?

Some futures contracts are cash-settled, others are settled via physical delivery.

Soybeans, for example, are physically-delivered as part of the contract terms. They settle with the exchange of actual physical soybeans or cash soybeans between buyer and seller.

Eurodollar futures however, are cash-settled. Buyers and sellers of Eurodollar futures contracts that hold their contracts through final settlement will be credited the difference, in cash, between what they paid for the contract and what they sold the contract at, if there is a profit. If there is a loss, their account will be debited cash.

It is CME Clearing, in conjunction with the FCMs (Futures commission merchant or broker), that makes sure trader accounts are debited and credited accordingly and that cash settlements are made in a timely and accurate fashion.

Eurodollar Settlement Process

Assume that in March, a trader bought March Eurodollar futures at a price of 98.75 when three-month LIBOR was trading at about 1.25 (using the IMM price quotation convention the Eurodollar futures price would be 98.75 (100.00 – 1.25 = 98.75).

The trader decides to hold onto the futures contract until the final settlement day (usually the third Monday of the expiration month). The final settlement is determined using the IMM price quote convention.

Final Settlement of an expiring contract shall be 100 minus the three-month Eurodollar interbank time deposit rate, determined by the ICE LIBOR setting administered by ICE Benchmark Administration Ltd, as first released on the second London bank business day immediately preceding the third Wednesday of the contract delivery month.

Returning to our example, the three-month Eurodollar interbank time deposit rate according to the ICE LIBOR setting is 1.19. The final settlement is arrived at by subtracting the ICE LIBOR setting from 100.00.

100.00 – 1.19 = 98.81 = the final settlement price of the March Eurodollar settlement.

If the trader originally bought the futures at 98.750, and they settled at 98.810, the trader would make 12 ticks profit (a tick = .005 price points). Each tick is worth $12.50. So, the trader profits by $150.00 per contract.

The clearinghouse, working through the trader’s broker, will credit his account with $150.00 cash. And the losing side of the trade will have $150 cash debited from his account to finalize the cash settlement process.

Regards,
Peter Knight Advisor

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