Interest Rate

Tutorials
Interest Rate Fundamentals
Long Term Interest Rates refer to the Interest Rates of derivatives with a
Residual maturity of 7 years or more. In the Over-The-Counter (OTC) Bond
Markets Bonds trade out to 50 years.

These are not the Interest Rates at which the bonds were issued rather the interest
rates implied by the prices at which these (Government and Corporate) Bonds
are being traded in the financial markets.

Some of the Most actively traded Long Term Interest Rates:

Bunds – German Govt Bonds with a maturity circa 10 years

UST 10 year Notes – US Govt Bonds with a Maturity of circa 7 ½ years
Gilt 10 year – UK Govt Bonds with a maturity circa 10 years
CGB – Canadian Govt Bonds with a maturity circa 10 years
JGB – Japanese Govt Bonds with a maturity circa 10 years
The Price Yield Relationship for Bonds

Interest Rate Risk, is the risk that interest Risk will rise, thereby decreasing the value of a
bond. The Price of a bond is inversely related to movements in interest rates. In general, the
relationship between price and yield is Convex. In other words, the sensitivity of the bond
price to changes in interest rates varies on the level of interest rates.

Below you have a chart illustrating the price-yield relationship for two bonds with the same
5% coupon rate, but different maturities (3years versus 30 years). Note that the bond with the
3 year maturity is more linear, while the bond with the 30-year maturity is more convex.
Generally, bonds with longer maturities (beyond 7 years) are more convex, while short-term
bonds exhibit little convexity.
The Price Yield Relationship for Bonds

The Below Chart illustrates the price-yield relationship for two bonds with the same 10-year
maturity, but different coupons (10% versus 5%). The bond with the larger coupon is more
convex than the bond with the smaller coupon. Generally, bonds with higher coupons have
greater convexity.

The price-yield relationship is curvilinear because the coupons paid to the bond holder over
the life of the bond are reinvested, earning interest on interest. Intuitively, the magnitude of
the compounded interest depends positively on the size of the coupons and the period of
time for which the coupons are reinvested.
The Price Yield Relationship for Bonds – continued

The previous two slides show how convexity is larger at both very low yields and very high
yields. As such, convexity varies depending on the magnitude of the change in interest rates.

By implication, highly convex bonds are more valuable in volatile interest rate environments.
In this scenario of higher volatility the market charges a higher premium for convexity in the
form of a higher price and lower yield.
The Price Yield Relationship for Bonds – Duration.

Duration is a summary measure of maturity, coupon and yield effects that is used to
approximate interest rate risk. A bond with larger coupon and yield has lower duration,
while a bond with a longer maturity has higher duration. Bonds with lower duration are less
sensitive to change in yield, while bonds with higher duration are more sensitive to changes
in yield.

Duration Strategies versus Convexity Strategies.

Duration strategies attempt to capitalize on expected increases/decreases in interest rates,

while convexity strategies are based on changes in volatility. A position in a long bond (long)
is long duration and long convexity (i.e. long volatility).

Duration approximates interest rate sensitivity. Hence, increase duration if interest rates are
expected to fall, and reduce duration when interest rates are expected to rise. Longer
duration bonds have lower coupons and longer maturities.

Convexity is highly valued during periods of highly volatile interest rates. Hence, shift to
bonds with higher convexity if interest rate volatility is expected to rise, and shift to bonds
with lower convexity when interest rate volatility is expected to fall. Highly convex bonds
tend to have maturities beyond 10 years.

When uncertain about the direction of interest rate movements (or you agree with market
expectations), maintain a neutral duration position relative to the targeted benchmark.
Yield Curve Risk: The Yield – Maturity relationship.

The yield Curve – also known as the term structure of interest rates – illustrates
the relationship between the yield and maturity of bonds with the same credit
quality. There are four classic yield curve shapes:

I) Rising (normal): Yields rise continuously, with some reduction in the rate of
increase at longer maturities.
II) Falling (Inverted): Yields decline over the entire maturity range.
III) Flat: Yields are unaffected by maturity.
IV) Humped: yields initially rise, but then peak and decline.
Yield Curve Risk: The Yield – Maturity relationship.

The shape of the yield curve has important implications for the performance of a bond
portfolio. Yield curve risk is the risk that an unanticipated shift in the yield curve will reduce
the value of the bond portfolio. Exposure to yield curve risk depends on the spacing of the
maturity of bonds within a portfolio. Before considering different types of yield curve shifts
and their effect on the performance of a bond portfolio, it is useful to see how the shape of
the yield curve can affect performance of a single bond.
Curve Risk implications for Traders.

Yield Curve strategies involve taking positions in bonds of varying maturities in order to
capitalize on expected changes in the shape of the yield curve.

One Can Observe:

I) If the yield curve is expected to flatten, longer duration strategies should outperform
shorter duration strategies.
II) If the yield curve is expected to steepen, shorter duration strategies should outperform
longer duration strategies.
III) Longer duration bonds take advantage of a positively sloped yield curve.
Other sources of Risks for Bonds.

What else can affect the value of a bond?

I) Credit Risk (also known as default, downgrade or spread risk)

II) Event Risk
III) Exchange Rate Risk
IV) Inflation Risk
V) Liquidity Risk
VI) Political and Legal Risk
VII) Reinvestment Risk
Other Risks for Bonds

Credit risk - Relevant for all bonds. US Treasuries (UST) and German Bunds (Bunds) used to
be 100 % exempt from credit risk, but since 2008 global Financial Crisis and the 2010
European Crisis market practitioners view these bonds to display a slight credit Risk. Still
UST and Bunds are the Benchmark Bond that analysts look at for gauge the health of the
global Economy. In the Event Of Credit Risks, the Market Buys UST and Bunds as Safe
haven.

Event Risk – For corporate Bonds the likely causes of such risk are Natural disasters,
industrial Accidents, Takeovers or corporate restructurings. For Sovereign government debt
these are extreme flight to quality episodes, such as war, dramatic economic shocks or
changes in government policy.

Inflation Risk – Except for Inflation linked bonds or floating rate bonds. This is the risk that
unanticipated inflation will erode the value of the bond cash flows.

Liquidity Risk – The Primary measure of liquidity risk is the size of the bid-ask spread.
Illiquid bonds have wide bid ask spreads. Generally, Bunds and UST will not exhibit
liquidity concerns.
Interest Rate Futures

A Futures contract represents an obligation to buy (or sell) an asset at a specific

price on a specific date in the future. The seller of a bond futures contract has the
obligation to deliver to the buyer of the futures contract at the settlement date the
underlying bond with a prespecified period remaining to maturity and face
value. In selecting the issue to be delivered, the seller of the futures contract will
select from all the deliverable issues the one that is the cheapest to deliver. As
such, the buyer of the bond futures contract can never be sure exactly which
bond will be delivered.

The Pricing of Bond Futures.

The theoretical price of a bond future is equal to the cash price of the underlying
bond plus the cost of carry. In reality the actual price is lower than the theoretical
price because of the delivery options afforded to the seller of the futures contract.
The price of the futures contract moves with the price of the underlying asset.
Uses of Bond Futures.

I) To speculate on the movement of Interest Rates

II) To control the interest rate risk of a portfolio (i.e. manage duration)
III) To create synthetic securities to enhance yield
IV) The hedge price risk incurred from normal business operations.
V) End user does not have access to the underlying OTC Bond Markets

Types of End users in the Bond Markets.

I) Investment & Regional Banks

II) Asset Managers
III) Pension Funds
IV) Hedge Funds
V) Proprietary Trading Companies/CTAs
VI) High frequency Traders
VII) Central Banks
Interest Rate Swaps (IRS)

In an IRS two parties agree to exchange periodic interest payments. The most
common arrangement is the “plain vanilla” swap, where one party agrees to pay
the other party fixed interest payments (at a spread over Treasuries or another
benchmark government yield) in return for floating payments based on a
reference rate (usually 6-month London Interbank offered Rate – LIBOR) the
Fixed rate payer (i.e. the payer of fixed) is long the swap and benefits if interest
rates rise. Conversely, the floating rate payer (i.e. the receiver of fixed) is short the
swap and benefits if interest rates fall.

The Swap Rate = PV (floating payments)-PV (Fixed payments)

Swap Spreads

The swap spread is the interest rate differential between the swap rate and the
government benchmark yield of the same maturity.

Swap Spread = IRS rate – Government Benchmark yield.

Key Economic Data
Key Central Bank Policies.

European Central Bank (ECB) – The Primary objective of the ECB’s Monetary
Policy is to maintain price stability. The ECB aims at inflation rates of below, but
close to, 2% over the medium term.

UK Monetary Policy Committee (MPC) – The Primary objective of the MPC is to

enable the UK inflation target to be met.

Swiss National Bank (SNB) – Its sole responsibility is to define Price Stability
and use the tools at its fingers to ensure this target is met.

Federal Reserve (US Fed) – Its obligations are to Maximize Employment,

Stabilize Prices and Moderate Long Term interest Rates.

Bank of Japan (BOJ) – Decides and implements monetary policy with the aim of
maintaining price stability.
Key Drivers of STIRs (LL)

Direct Measures of Inflation Indirect Measures (via Economic Growth)

Consumer (retail) Prices Real GDP growth

Producer (Wholesale) Prices Equity market Weakness/strength

Core Inflation (Excluding Fodd and Energy) Personal income and consumption There are many Pieces of Economic Data
available to Traders every
Crude Oil and other Commodity Prices consumer confidence
month/Quarter. The most important
Labour (employment) costs Retail sales, homes sales, auto sales ones are opposite.

Average Hourley earnings Industrial production, factory orders

LL Traders need to follow all Tier 1 UK
Currency strength/weakness Capital spending by business (capex) data through each month. These Data
releases usually come out at 0930 UK
Business outlook
time with the exception of BOE-MPC
Corporate earnings
Meetings and Minute releases. LL
traders need to follow US Tier 1 Data
Business inventories also.
Durable goods orders
During Different Cycles, political /
Construction activity, housing starts geopolitical turmoil's different data
Unemployment rate
releases can become more important or
less important. But the golden Rule is
Initial and continuing jobless claims Watch Inflation data and signs Data tells
Non-Farm Payrolls
you it is increasing or failing.

Government Budget Deficit/surplus

Trade Balance

Productivity growth
Key Economic Data.

Direct Measures of Inflation Indirect Measures (via Economic Growth)

As you can tell from the Mandates that major Central banks
follow in ensuring present and future Economic growth for
Consumer (retail) Prices Real GDP growth their Countries, maintaining Inflation is the cornerstone of a
healthy balanced Economy. Given this, Markets wisely,
Producer (Wholesale) Prices Equity market Weakness/strength ensure they track both Economic Inflation data released by
the Official statistic offices and the inflation projections the
Core Inflation (Excluding Fodd and Energy) Personal income and consumption Central banks provide.

As you can see from the opposite diagram either a Piece of

Crude Oil and other Commodity Prices consumer confidence Economic Data is a direct measure of inflation or one which
in time indirectly impacts inflation.
Labour (employment) costs Retail sales, homes sales, auto sales
For STIRs traders, think Inflation, inflation, inflation…
Average Hourley earnings Industrial production, factory orders
Within each bucket of either Direct or Indirect Inflation
Currency strength/weakness Capital spending by business (capex) Economic releases traders will bucket these into which are
most important.
Business outlook In Reality Tier 1 Data will be the CPI, Employment, GDP,
Consumer Confidence, Retail sales, PPI, Average Hourly
Corporate earnings Earnings.

Business inventories But Markets are extremely sensitive to All Economic Data so
the Tier 1 Bucket gets filled with many more releases from
time to time.
Durable goods orders
The Tier 1 Data bucket Economic releases can often be that
Construction activity, housing starts significant their releases can completely change the direction
of a market for a significant period of time.
Unemployment rate
What is missing from the Opposite Economic Releases are
Initial and continuing jobless claims the Actual Central bank meetings and decision on Interest
Rates and also Points in time when Central governors make
Key note speeches. Traders need to watch for these.
Non-Farm Payrolls
Central Bank Interest rate decisions, minutes and speeches
Government Budget Deficit/surplus are always well known in advance to not knock markets
unawares with surprises.
Trade Balance

Productivity growth
The Taylor Rule

The Taylor Rule is a formula developed by Stanford economist John Taylor. It was
designed to provide “recommendations” for how a Central Bank like the Federal
Reserve should set short term interest Rates as economic conditions change to
achieve both its short run goal for stabilising the economy and its long run goal
of Inflation.

This is why GDP and CPI are so Important.

How does Economic Data impact the UK Bank Rate and ICE LIBOR futures?

LL Short Sterling Futures are highly sensitive to Key Economic

Data Releases from the UK Statistics offices (ONS). All Traders need
to know in advance what is coming out (Have a Current UK Figure
Sheet to hand). You will need to know;

a) What is the market estimation/consensus on this release?

b) What is the Range of the consensus, High/Low?
c) What was the Last Release?
d) What has been the trend in this release?
e) What happened Last time there was a significant ‘miss’ in the
Estimate to the Actual release? What products reacted the
most and by how much?
f) What Release levels will cause you to exit your current
position or enter into a new position?

There are two charts opposite, one of the Short Sterling Mar2017 (in
price) and one of the UK PMI Manufacturing Survey (a strong
indicator of the health of the Economy). The UK PMI would be your
Indicator and the LL Mar2017 the traded asset. We do not trade
Outrights at OSTC, in this example it is to show you the impact of
Economic release on one of the LL futures. Knowing in which
business cycle you are in will enable you to know how this impacts
the spreads we trade.

Although not a linear relationship, you can see clearly a strong

Inverse relationship/correlation between the UK PMI
Manufacturing Survey and the markets prediction on future 3
month LIBOR Rates.

Although, UK PMI is just one Piece of Economic Data out of 10 that

are really important to the UK BOE-MPC in setting future Interest
Rates, it demonstrates how sensitive LL futures are to these Pieces
of data. The theory is that weaker Manufacturing that we can
witness from the falling UK PMI from 58 to 50 from 2013 to 2016,
demonstrates a weakness in the UK economy. As each Release in
this 3 years is known by the markets the LL futures start to trade
higher (i.e. Market predicting the at BOE-MPC will start lowering
Interest Rates to stimulate the flagging economy)
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data?

Preparing for the Data.

1 Hour Prior to the US Jobs data. Non Farm Payrolls and

Unemployment Data. The US economy is the Largest by far and as
such if there is a dramatic slowdown or increased growth this will
impact all global Markets

Opposite you have 2 charts of the Upcoming US Employment Data

for the Major Global Markets to analyse.

The top Chart is Non Farm Payrolls Data. A higher number for this
release is highly positive for the US Economy, conversely a lower
number is adversely negative.

The Bottom chart is the Actual Unemployment Rate, this is a

measure of how much Unemployment there is across the US
Economy, as opposed to the Employment in Non Farm part of the
Economy.

So the Trend you can see is of an improving US Economy in the jobs

markets. This would imply more money in circulation and more
spending and potential (not always) for Wage Growth.

This brings us back to the conundrum for Central Banks, they have
to balance Inflation. So signs of Economic Indicators that can
ultimately drive up Inflation will concern the Central banks into
potentially withdrawing stimulus and potentially Raising Interest
Rates.

Although one Economic release ultimately will not drive the

Central bank into rushing to change policy, the Financial Markets
will begin to make changes to the probability of future changes in
interest Rates.

So conclusion one will be the trend is for improved or sustained Job

Growth, traders will be watching for an acceleration of this or a
reversal of this trend in Job Growth.
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data?

Preparing for the Data.

1 Hour Prior to the US Jobs data. Non Farm

Payrolls and Unemployment Data. The US
economy is the Largest by far and as such if there
is a dramatic slowdown or increased growth this
will impact all global Markets.

Despite the Smartest people on the planet(Bank

analysts/Economists) analysing the Upcoming
data from all technical, mathematical models the
actual precise number is very hard to predict.

Most Economists predictions are not supposed to

predict the exact release number but more the
direction of the economic Release. I.e. Is it going to
be inflationary or not inflationary for the Economy
and ultimately this will decide how the market
should trade in the period afterwards.

Opposite chart shows two variables. The Blue

chart is the Actual release of US NFP and then
Orange line is the Economists prediction of the
upcoming Release.

As you can see about half the time the number is

accurate and the other half the Consensus
prediction is about as useful as a chocolate Tea
pot.
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data?

Preparing for the Data.

Actual Expectation Revision

1 Hour Prior to the US Jobs data. Non Farm

Payrolls and Unemployment Data. The US
economy is the Largest by far and as such if there
is a dramatic slowdown or increased growth this
will impact all global Markets.

Unfortunately for the market the Government

statistics offices often release several Economic
Releases at exactly the same time. As you can
imagine, often each of the Economic releases can
have equal / opposite impacts on the expectations
for inflation. Equally you can have two highly
Inflationary or non-inflationary pieces of data
released at exactly the same time doubling the
impact on the markets.

Most often the Financial Markets will focus on just

one economic release as the most market
impactful.

For Each Economic release you have the Market

Expectation. Market analysts will watch carefully
the actual release and the revision to last months
release.
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data?

Preparing for the Data.

Actual Expectation Revision

1 Hour Prior to the US Jobs data. Non Farm Payrolls and Unemployment Data. The US economy is the Largest by far and as such if there is a dramatic
slowdown or increased growth this will impact all global Markets.

Market Players will look at the expected 180,000 prediction of the US NFP and make the following predictions on how this will impact the LL Futures.

A NFP release of > 300,000 LL Sep17 sell down to 99.68 from Baseline 99.72
A NFP release between 249,000 and 299,000 LL Sep17 sell down to 99.71 from Baseline 99.72
A NFP release between 191,000 and 249,000 LL Sep17 sell down to 99.70 from Baseline 99.72
A NFP release between 170,000 and 190,000 LL Sep17 no price change from Baseline 99.72
A NFP release between 169,000 and 129,000 LL Sep17 Buy up to 99.73/99.74 from Baseline 99.72
A NFP release of < 100,000 LL Sep17 buy up to 99.75 from Baseline 99.72
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data? Defining the Baseline.

1 Hour Prior to the US Jobs data. Non Farm Payrolls

and Unemployment Data. The US economy is the
Largest by far and as such if there is a dramatic
slowdown or increased growth this will impact all
global Markets.

Opposite is a look at the Short Sterling Outright

futures 1 hour Prior to, arguably, the Biggest Non
Central bank Economic Data of the Month for all
global Markets. Traders will ‘stack’ the CLOB with
orders as they are confident of the Next few minutes
price action.

The Markets are very smart at understanding

volatility and how it can impact the markets, volume
and trading ranges of LL futures.

Major economic data releases can impact the Central

banks thoughts on future Interest Rate decisions, as
such the probability of volatility can increase. As a
Major Event Like US NFP (despite not being a UK
economic Release) causes uncertainty of the next
movement in price, so traders will delete their orders
until they confident again and probability is back in
their favour,
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data? Defining the Baseline.

1 Hour Prior to the US Jobs data. Non Farm Payrolls

and Unemployment Data. The US economy is the
Largest by far and as such if there is a dramatic
slowdown or increased growth this will impact all
global Markets.

A function of expected forthcoming volatility is

liquidity drying up in most global Markets for short
period of time. You can see from the opposite
Diagram from stellar of the Short Sterling (LL)
futures., there is a huge reduction from 50,000 lots on
the bid and ask prices to nearly 1,000 lots or less from
the previous slide 1 hour prior to the upcoming event.
This reduction in Liquidity in the market only
exacerbates any potential shock from the forthcoming
Economic Release.

Depending how impactful the upcoming event could

be will depend how much liquidity pulls from the
market CLOB.

For the upcoming release we are going to look at the

Sep17 LL Future. Its current VWAP price is 99.726 and
last traded price is 99.73. This implies that the ICE
GBP 3 month LIBOR is currently expected to fix at
0.27 Basis Points. This current Price is what is
described as the Baseline Price we will use for our
analysis.

The previous slides analysis of the upcoming Data is

usually fully automated by Major Players. This
analysis allows each player to know in advance what
they will do as there is a very small amount of times
between receiving the Release data and the market
reaction.
Tier 1 Data.

What happens after the release of a Tier 1 Piece of economic Data?

Post the Data Release.

Actual Expectation Revision

1 Hour Prior to the US Jobs data. Non Farm Payrolls and Unemployment Data. The US economy is the Largest by far and as such if there is a dramatic
slowdown or increased growth this will impact all global Markets.

Market Players will look at the expected 180,000 prediction of the US NFP and make the following predictions on how this will impact the LL Futures.
Actual Release LL Sep 17 Price
A NFP release of > 300,000 LL Sep17 sell down to 99.68 from Baseline 99.725 avg
A NFP release between 249,000 and 299,000 LL Sep17 sell down to 99.71 from Baseline 99.725 avg
A NFP release between 191,000 and 249,000 LL Sep17 sell down to 99.70 from Baseline 99.725 avg
A NFP release between 170,000 and 190,000 LL Sep17 no price change from Baseline 99.725 avg
A NFP release between 169,000 and 129,000 LL Sep17 Buy up to 99.73/99.74 from Baseline 99.725 avg 151,000 99.735 avg
A NFP release of < 100,000 LL Sep17 buy up to 99.75 from Baseline 99.725 avg
Tier 1 Data.

What happens post to the release of a Tier 1 Piece of economic Data?

1 Hour Post US NFP Release.

The Weaker than expected US NFP has caused the

Financial Markets to think the US economy is not as
Strong as previously thought. We see global Interest
Rate Futures trade higher ( lower expected future
interest Rates ) and LL Sep17 trade 1 tick higher.
Other Drivers of
Interest Rate Markets
Other drivers of Interest Rate markets

Upcoming Elections – If there is a chance of significant shift in Economic Policy

of a future new government the Market in its approach to the Bond Market, will
become very nervous and watch carefully all Political research and surveys. A
recent example of where Markets were transfixed by these was the recent Brexit
referendum in the UK.

Budget Blowouts are Bond Bearish – Fiscally loose governments, like seen in
Southern Europe in the early 2010’s can cause horrific Bond stress and cause huge
falls in bond prices as confidence wanes and thus huge rises in the Government
Bond prices.

Political Crisis - Will undoubtedly cause a bond crisis in the domestic Country.
Recent Crisis in Europe in 2010 caused much contagion to other developed
Economies.
A trader's Strategy template

I) Fundamentals:
A) Growth (direction, pace)
B) Inflation (pace, variability)
C) Demographics (trend)
II) Politics:
A) Monetary policy changes
B) Fiscal policy changes
C) Geopolitical considerations
II) Behaviour:
A) Risk Appetite (volatile)
B) Sentiment
C) Momentum

II) Technical Factors:

A) Flows (Market Position)
B) Seasonals
C) Issuance vs transient demand

II) Quantitative Indicators:

A) Rich versus Cheap
B) Extreme versus normal valuations

Every trader should understand where the Economy is right now and look to
understand most or all of the trends and factors above.
Fundamentals

How do the Swap, Bond, STIR, FRA, OTC, Futures Markets interact?
What is a Bond Future?

We can broadly define a Bond Future as;

A physically deliverable futures contract.

An underlying (government) bond, that matches the deliverable criteria, must either be delivered on a given date (Eurex) or during a
given time window (CME).

Expiry dates are quarterly in March, June, September and December, but may be on the 10 th of the month (Eurex) or during the
month (CME).

The prices are quoted with reference to a ‘standard’ bond contract with a defined yield to maturity of 6% (CME and Eurex) or 4%
(ICE).

The Tick value of a bond future is the smallest price increment possible multiplied by the face value. For Eurex Bond Futures (which
are quoted in Decimals and quoted with a 0.01% increments), this makes life straight forward, being the tick Value EUR 10, apart
from Shatz (2year contracts) which can move in 0.005% increments and hence have a EUR 5 tick value. For CME, it varies with the
futures contract, from $7.8125 to $31.25.

The Actual invoice price of the deliverable bond is calculated using a Conversion Factor.

Conversion factors can be complex, suffice to say that because bond futures are not based on a single underlying bond issue, but
rather a basket of eligible (“deliverable”) bonds, there is always a bond that makes more economic sense than others to deliver.
Therefore, the market assumes that any contract seller will always deliver this “cheapest to deliver” bond in the event of delivery.

Think of it this way, if you are trading Coffee and you had to deliver Coffee to the Buyer at the Warehouse, and you had a choice
between various different grades and cost of Coffee, you would always deliver the cheapest grade of Coffee within the acceptable
grades per the contract specifications . Bond Deliveries are much the same.

This link gives a concise approach to calculating a conversion Factor on Eurex.

http://www.eurexchange.com/exchange-en/market-data/clearing-data/deliverable-bonds-and-conversion-factors/Deliverable-Bonds-
and-Conversion-Factors/173146

Size wise, Bond futures are simply huge trading a notional daily volume of $12 trillion per day.
What is an interest rate swap?

An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a
set period of time. Swaps are derivative contracts and trade over-the-counter.

The most commonly traded and most liquid interest rate swaps are known as “vanilla” swaps, which exchange fixed-rate
payments for floating-rate payments based on LIBOR (London Inter-Bank Offered Rate), which is the interest rate high-
credit quality banks charge one another for short-term financing. LIBOR is the benchmark for floating short-term interest
rates and is set daily. Although there are other types of interest rate swaps, such as those that trade one floating rate for
another, vanilla swaps comprise the vast majority of the market.

What is the swap rate?

The “swap rate” is the fixed interest rate that the receiver
demands in exchange for the uncertainty of having to pay the
short-term LIBOR (floating) rate over time. At any given time,
the market’s forecast of what LIBOR will be in the future is
reflected in the forward LIBOR curve.

At the time of the swap agreement, the total value of the swap’s
fixed rate flows will be equal to the value of expected floating
rate payments implied by the forward LIBOR curve. As forward
expectations for LIBOR change, so will the fixed rate that
investors demand to enter into new swaps. Swaps are typically
quoted in this fixed rate, or alternatively in the “swap spread,”
which is the difference between the swap rate and the equivalent
local government bond yield for the same maturity.
What is the Swap Curve?

The plot of swap rates across all available maturities is

known as the swap curve, as shown in the chart below.
Because swap rates incorporate a snapshot of the forward
expectations for LIBOR, as well as the market’s perception
of other factors such as liquidity, supply and demand
dynamics, and the credit quality of the banks, the swap
curve is an extremely important interest rate benchmark.
Although the swap curve is typically similar in shape to the
equivalent sovereign yield curve, swaps can trade higher or
lower than sovereign yields with corresponding maturities.
The difference between the two is the “swap spread”,
which is shown in the chart below. Historically the spread
tended to be positive across maturities, reflecting the higher
credit risk of banks versus sovereigns. However, other
factors, including liquidity, and supply and demand
dynamics, mean that in the U.S. today the swap spread is
negative at longer maturities
Because the swap curve reflects both LIBOR expectations
and bank credit, it is a powerful indicator of conditions in
the fixed income markets. In certain cases, the swap curve
has supplanted the Treasury curve as the primary
benchmark for pricing and trading corporate bonds, loans
and mortgages.

Theoretically, Swap Rates trade higher to that of the

Treasury Rate. Although, that theory is blown apart with the
US Swap Spread curve opposite. Balance sheet pressures
and Ultra low Rates have pushed the US Swap spreads
strongly negative for a long period of time.
Mechanics and Definitions of Swap Spreads

Trading strategy; to take a view on the difference in rates between an Interest Rate Swap and a Government Bond.

Any interest rate swap will make or lose money as rates go up or down. But what if an investor does not
have an opinion on whether rates will go up or down? Perhaps, they think that the credit-worthiness of
the financial industry will change relative to sovereign debt? Maybe our investor thinks that markets are
poised for a Flight to Quality, or that other investors want to avoid Libor-based instruments and the lack
of liquidity in associated swaps. In this case, they can transact a Spread over.
Consider an investor who believes that 10 year Interest Rate Swaps will move differently to 10 year Government Bond
yields. They would be well served to enter into a Spread over trade. If they think 10 year Interest Rate Swap rates will go
up by more (or go up faster) than the yield on a 10 year Government Bond, then they should pay the fixed rate on a 10
year swap and buy the 10 year Government Bond. If they think 10 year Interest Rate Swap rates will go down more (or go
up slower) than 10 year Government Bond yields, then they should receive on a 10 year swap and sell the 10 year
Government Bond.
This strategy highlights a very important feature of Spread over
trading. These trading strategies rely on relative moves between two markets.
In the case of a 10 year swap versus a 10 year bond, if interest rates on
the two instruments moved exactly in tandem, then we would not
make or lose money (assuming cost of carry and the shape of the
curves are consistent across the two markets).
Eonias, Sonias and OIS – Risk free Term Structure

The “risk-free” term structure of interest rates is a key input to the pricing of derivatives. It is used for defining the expected
growth rates of asset prices in a risk-neutral world and for determining the discount rate for expected payoffs in this world. Before
2007, derivatives dealers used LIBOR, the short-term borrowing rate of AA-rated financial institutions, as a proxy for the risk-free
rate. The most widely traded derivative is a swap where LIBOR is exchanged for a fixed rate. One of the attractions of using
LIBOR as the risk-free rate was that the valuation of this product was straightforward because the reference interest rate was the
same as the discount rate.

The use of LIBOR to value derivatives was called into question by the credit crisis that started in mid-2007. Banks became
increasingly reluctant to lend to each other because of credit concerns. As a result, LIBOR quotes started to rise. The TED spread,
which is the spread between three-month U.S. dollar LIBOR and the three-month U.S. Treasury rate, is less than 50 basis points in
normal market conditions. Between October 2007 and May 2009, it was rarely lower than 100 basis points and peaked at over 450
basis points in October 2008.

Most derivatives dealers now use interest rates based on overnight indexed swap (OIS) rates rather than LIBOR when valuing
collateralized derivatives.

Overnight Indexed Swaps

Overnight indexed swaps are interest rate swaps in which a fixed rate of interest is exchanged for a floating rate that is the
geometric mean of a daily overnight rate. The calculation of the payment on the floating side is designed to replicate the aggregate
interest that would be earned from rolling over a sequence daily loans at the overnight rate. In U.S. dollars, the overnight rate
used is the effective federal funds rate. In Euros, it is the Euro Overnight Index Average (EONIA) and, in sterling, it is the Sterling
Overnight Index Average (SONIA). OIS swaps tend to have relatively short lives (often three months or less). There are two
sources of credit risk in an OIS. The first is the credit risk in overnight federal funds borrowing which we have argued is very
small. The second is the credit risk arising from a possible default by one of the swap counterparties.

The three-month LIBOR-OIS spread is the spread between three-month LIBOR and the three-month OIS swap rate. This spread
reflects the difference between the credit risk in a three-month loan to a bank that is considered to be of acceptable credit quality
and the credit risk in continually-refreshed one-day loans to banks that are considered to be of acceptable credit quality. In normal
market conditions it is about 10 basis points. However, it rose to a record 364 basis points in October 2008. By a year later, it had
returned to more normal levels, but it rose to about 30 basis points in June 2010 and to 50 basis points at the end of 2011 as a result
of European sovereign debt concerns. These statistics emphasize that LIBOR is a poor proxy for the risk-free rate in stressed
market conditions.
Bundles.

ICE Futures Europe packs and bundles are recognized trading strategies that enable you to
easily execute a combination of contract months in Short-Term Interest Rate (STIR) Euribor,
Sterling, Eurodollar and Euroswiss futures contracts. This allows users to gain exposure to
longer term interest rates, without the legging risk and cost of trading the individual months.

Leg Pricing

Average Difference Change Pricing

Packs and Bundles prices will be quoted using the annualised price convention, also known
as Average Difference Change (ADC) Pricing. The tick increment to be used in the pack and
bundle markets for Three Month Sterling Futures will be:

The Exchange will use a price factor of 100 to convert the displayed screen price of a pack or
bundle into basis point tick increments. Packs and Bundles leg prices will be assigned in
whole basis points and allocated starting from the back months of the strategy and moving
forwards. For example: a user submits a price of 2.75, which is then converted to 0.0275 ticks
by dividing the price by the price factor (2.75/100). This tick price can then be assigned to each
individual leg price.
What does a Listed Interest Swap look Like?

There are USD and Euro denominated Swap Futures with very similar contract specs,
below I have focused on the GBP denominated version. They are designed to give the
holder (buyer or seller of the swap) exactly the same economic cash flow as to holding a
notionally equivalent Interest Rate swap in the OTC Market.

ERIS GBP LIBOR Interest Rate Future

£100,000 notional principal whose value is based upon the difference between a stream
of semi-annual fixed interest payments and a stream of quarterly or semi-annual
floating interest payments based on 3 or 6 month GBP LIBOR, over a term to maturity.

Tenors available: 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 30 years

1 Contract = 1 lot = £100,000 face value

Trading conventions - Buy = Pay Fixed & Sell = Receive Fixed

Quarterly IMM Dates (3rd Wednesday of each March, June, September, December) (e.g.
2YR Tenor may read “Mar 18, 2015” or “Mar 15”) Up to 8 consecutive future Effective
Dates tradable at one time

The last day on which the Contract can be traded is the Holiday Calendar business day
preceding the Maturity Date. On the Last Trading Day trading will cease at 6:00 PM
London Time.

Net Present Value (“NPV”) per Contract will be used for trade execution. NPV is
expressed in per contract terms for the Buyer (Pay Fixed). Each Future negotiated in
NPV terms has an implicit Futures-Style Price of:

Trade Price = 100 + Anegotiated +Bt – Ct

Where Anegotiated is the NPV per Contract agreed upon between the counterparties
(divided by 1,000 to normalise units to 100 face amounts), Bt is the value of the historical
fixed and floating amounts, and Ct is the PAI†† at time t

The B and C components are calculated once daily and applied by IFEU, and are not
subject to negotiation by the counterparties.
All the Interest Rate Markets discussed prior are linked intrinsically to one another.

Bootstrapping, interpolation and extrapolation are used commonly in the Interest Rate markets to plot yield curves. We don’t
need to dive into the math of these approaches, we just need to know this is how the Financial Engineers plot yield curves on a
day to day basis.

Between each of the derivatives listed there is a Strong traded ‘basis’ product which ties all our Interest Rate curves together.

As the only key difference between an Interest Rate Swap and a Government bond with equal start dates and Maturity dates
will be the Credit Difference, it is no surprise the price difference will be very small and to the most part, the prices of the two
instruments, will remain tightly linked to one another. This strong ‘bond’ between these two instruments holds for all the
tenors up and down the yield curve, 2yr, 3yr, 5yr, 10yr and 30yr.

Given Interest Rate Swaps are a string of Forward LIBOR Rates one would expect, and be right, that a 2 year EUR Interest Rate
swap (a string of 4 consecutive 6m EURIBOR rates) will resemble closely a string of 8 Euribor Futures (2 year bundle). There is a
basis, which is pretty constant, between 3Month and 6Month Euribor or Libor Rates, this is called the 3s*6s Basis.

IMM Dated Forward Rate Agreements or FRAs are the Over-the-Counter STIR essentially. The ONLY differences are the FRA
is quoted in Yield Terms and the STIR is quoted in terms of price (100-Yield) and that a FRA is quoted with another
counterparty/Bank and a STIR is traded in the Clearing House of an Exchange.

Bond
Markets Swap Spread Basis

OIS/Eonia/ Interest Rate

Sonia/Fed Swap
Funds Markets

1s/3s Eonia – Euribor Basis 3s*6s Basis and Convexity

FRAs STIRs
All the Interest Rate Markets discussed prior are linked intrinsically to one another, yet the curve shapes remain very simil ar.

The 2 year EUR Interest Rate Swap’s price discovery/direction is 97.5 % correlated on average to that of the 2year Shatz Future. To
further illustrate this tight ‘bond’ between these derivatives I have created two (intraday) charts below. The left hand chart shows
the intraday price movement of the actual Swap spread between the two derivatives. This shows a stable relationship between the
two ‘different’ but highly connected markets. The right hand chart illustrates the intraday price movements of the actual 2
products that create the 2 year EUR swap spread, i.e. the 2year German Govt Bond (benchmark 2 year in Europe for 2 years) and
the 2 year EUR Interest Rate Swap. It is no surprise that the two derivatives are 97.5% correlated as you can see their close
relationship in the chart, as one product trades higher so does the other product.

Banks are the major users of Interest Rate Swaps and usually are the Major Market Makers to their clients (Hedge Funds and Asset Managers)
Liquidity in both is very high and these Major players will use both markets to hedge open positions when they need. If a Bank is requested to quote
a large trade in the 2 year EUR IRS from a client and then the client trades with him, he will use all the Tools he has in front of him to hedge the
immediate ‘outright risk’ of the Interest Rate swap. He will / could hedge all the risk in the 2yr Govt bond Future or a combination of both products.
The Banks will then ‘warehouse this Basis Risk’ between the two derivatives, much preferring this basis risk to outright exposure of the IRS.
Long Term Trends can drive Swap Spreads in one direction or another to form a Long
Term Trend.

Despite this long term trend in the ‘basis’ between the two derivatives the intraday price action, of the
component legs of the basis, are highly correlated to one another and one we must watch.

Despite large fiscal deficits in the US, UK and Germany, government bond supply implies tighter spreads however the flight to
quality from Eurozone crisis and Central Bank bond buying have pushed swap spreads wider (higher, as illustrated in the 2
year chart of the EUR 2 year Swap spread above). This widening is exacerbated as the panel of Euribor banks is made up of
banks from the whole Eurozone as well as a handful of non-Eurozone banks.

While the current Longer term drivers of the 2 European Swap spreads have been driven by the initial uncertainty around the
partial repayment of the 3 year LTRO and continued pressure from the European crisis, expectations of European interbank
stress are contained by the ECB’s actions and should keep a lid on further widening in this spread.

These longer term drivers of Swap spreads are very subtle or appear not present in the microstructure of the Euribor and Shatz
futures, yet underneath they are part of a strong current that we should understand at the very least.
Interest Rate Swaps, STIRs and Bond curve shapes.

Despite this long term trend in the ‘basis’ between the two derivatives the intraday price action, of the
component legs of the basis, are highly correlated to one another and one we must watch.

To highlight the symbiosis between the Shatz-Bund (bond spread - blue) and EUR 2yr-10yr (IRS spread - orange), I have
overlaid a 60 minute chart of each above.

Statistically these two spreads are 79% correlated in their price action.

There is not a Perfect correlation for a few reasons;

a) Supply and Demand. These markets have different players making different trades at different times for different reasons.
b) Liquidity.
c) Slight difference in Duration. Bund is 9 years Approx. in Maturity and the 10 yr. EUR IRS start value spot and not Dec 2016
when the Bund start date is.
Price action of 2 year Shatz, 2 year EUR IRS and 2year Euribor Bundle.

Despite this long term trend in the ‘basis’ between the two derivatives the intraday price action, of the
component legs of the basis, are highly correlated to one another and one we must watch.
Price action of 5 year Bobl, 5 year EUR IRS and 5 year Euribor Bundle.

Despite this long term trend in the ‘basis’ between the two derivatives the intraday price action, of the
component legs of the basis, are highly correlated to one another and one we must watch.
Price action of 10 year Bund future and the 10 year EUR IRS.

Despite this long term trend in the ‘basis’ between the two derivatives the intraday price action, of the
component legs of the basis, are highly correlated to one another and one we must watch.
Short Term Interest
Rates
What is a Short-Term Interest Rate Future (STIR)?

STIRs are very liquid instruments. They are one of the most important tools for managing interest rate risk.

We can broadly define a Short-Term Interest Rate future as:

• A cash settled futures contract (i.e. there is no delivery of an underlying asset)

• Settlement in cash occurs on the value date of the reference interest rate.
• Expiry dates are generally on International Monetary Market dates
(the third Wednesday of March, June, September and December). Australian Bills and
New Zealand Bills are notable exceptions. So-called monthly “serial” contracts also exist,
typically expiring on the third Wednesday of a non-benchmark month.
• For “T+2” currencies, (such as USD and EUR), the relevant fixing date for the reference
interest rate is the Monday before the third Wednesday. For “same-day” currencies (such as GBP and CAD
plus other Commonwealth currencies), the relevant fixing date is the third Wednesday itself.
• The price is quoted as 100 minus a reference interest rate.
• The reference interest rate is a 3 month tenor.
• The face value of the contract is normally 1,000,000 of local currency (in JPY it is 100m).
• A move of 1 “tick” or 0.01 on the price of the contract is therefore equal to 25 of local currency. This is simply #
the non-discounted value of a 1 basis point move in interest rates for three months:

0.01% * 1,000,000 * 90/360 = 25

The contracts are quoted as “100 minus interest rate” so that the price of the contract mirrors the
properties of a bond – price up, yield down and vice versa.

That’s so that us simple traders don’t get too confused when trading between different instruments!
STIRs at ICE Futures Europe

When ICE bought NYSE Euronext in 2012/2013, they also gained control of the LIFFE derivatives exchange in
London. LIFFE is an acronym for the London International Financial Futures Exchange. The STIR contracts
traded on LIFFE are:

• Euribors, known as ‘Bors. These contracts cash settle at 100 minus the 3 month Euribor fixing. (see slide
48)
• Short Sterling. These contracts cash settle at 100 minus the 3 month GBP Libor fixing. (see slide 47)
• EuroSwissy. These contracts cash settle at 100 minus the 3 month CHF Libor fixing. (see slide 49)

And for completeness sake, the other notable STIRs around the globe are:

• Eurodollars, traded at CME. These contracts cash settle at 100 minus the 3 month USD Libor fixing. (see
slide 50)
• Euroyen vs TIBOR, traded at SGX and TFX. These contracts cash settle at 100 minus the 3 month JPY
Tibor fixing on a notional of JPY100m.
• Aussie Bills, traded at ASX. These contracts are deliverable! Quoted as 100 minus the 3 month
AUD BBSW fixing.
• Kiwi Bills, traded at ASX. These contracts cash settle at 100 minus the 3 month NZD BKBM fixing.
CME Eurodollar volumes are huge

You cannot get away from this fact as soon as you look at the data. Below is the percentage market share
of the STIR market by currency (last 12 months):

• The chart shows USD-equivalent notional volume traded each day in Eurodollars (USD),
Euribors (EUR), Short Sterling (GBP) and Euroswissy (CHF), expressed in percentage of total
traded.
• The blue bars, representing USD notional traded dominate.
• As a rule of thumb, CME Eurodollars make up 70-75% of STIR trading on any given trading
day.
Euribor volumes are surprisingly small

Ask any trader, and they will confidently assert that Euribors are liquid and Short Sterling is a pig to
trade due to a lack of liquidity. I was therefore surprised when I analysed recent volumes for the
European STIR contracts:

A few notes on the Chart below;

a) Volume and Liquidity is important but does not guarantee or confirm whether a
Particular product can be a profitable product to trade.
b) The below Volume breakdown clearly shows a increase in Liquidity/volume in Short
Sterling in the last 4 months relative to the previous 2 months. This is mainly because of Volatility /
Uncertainty around the Brexit ( UK vote on EU referendum ) vote and outcome In June 2016.
c) Volume will pick up in Euribor and Euroswissy Futures if there is Economic news to
impact Interest Rates.
d) Negative Interest Rates / Low Interest Rate Policy by Central Bank is very damaging for
Volumes and Volatility in STIRs.
BREXIT affected volumes

One of the motivations to include ICE STIR volumes now is to monitor events in GBP markets. June saw
elevated volumes in Short Sterling as a result of the referendum:

• Volumes, in USD-notional equivalents, traded per day for Euribors (EUR), Short Sterling (GBP) and Euroswissy
(CHF) for June 2016.
• Volumes in Short Sterling (in Red) have overtaken Euribors on 11 trading days in June!
• This might be a fleeting phenomenon, but anyone running risk in these products should be aware of these
market changes.
STIRs and FRAs

FRAs are essentially an OTC version of a STIR future. Less Liquidity (as you can see from the Volume
comparison on slide 49) but far more granularity in Maturity Dates.

An FRA is a contract in which the underlying rate is simply an interest payment, not a bond or time deposit, made in
dollars, euribor or any other currency at a rate that is appropriate for that currency. A forward rate agreement is a forward
contact on a short-term interest rate, usually LIBOR, in which cash flow obligations at maturity are calculated on a
notional amount and based on the difference between a predetermined forward rate and the market rate prevailing on that
date. The settlement date of an FRA is the date on which cash flow obligations are determined.

• The structure is the same for all currencies.

• FRAs mature in a certain number of days and are based on a rate that applies to an instrument maturing in a
certain number of days, measured from the maturity of the FRA.
•The structure is as follows: The short party or dealer and the long party or end-user will agree on an interest rate,
a time interval and a "hypothetical" contract amount. The end-user benefits if rates increase (she has locked-in a
lower rate with the dealer). Because the end-user is long, the dealer must be short the interest rate and will benefit
if rates decrease.
•The contact covers a notional amount but only interest rate payments on that amount are considered.
•It is important to note that even though the FRA may settle in fewer days than the underlying rate (i.e. the number
of days to maturity in the underlying instrument), the rate that the dealer quotes has to be evaluated in relation to
the underlying rate.
•Because there are two-day figures in the quotes, participants have come up with a system of quotes such as 3 x 9,
which means the contract expires in three months and in six months, or the nine months from the formation of the
contract, interest will be paid on the underlying Eurodollar time deposit upon which the contract's rate is based.
•Other examples include 1 x 3 with the contract expiring in one month based on a 60-day LIBOR, or 6 x 12, which
means the contract expires in six months based on the underlying rate of a 180 day LIBOR.
•Usually based on exact months such as 30 day LIBOR or 60 day LIBOR not 37 days and 134 day LIBOR. If a client
wants to tailor an FRA, it is likely that a dealer will do it for the client. When this occurs, it is considered to bean
off-the-run contract
•The best way to see it is through an example, which we will cover in the next section.
STIRs and FRAs

FRAs are essentially an OTC version of a STIR future. Less Liquidity (as you can see from the Volume
comparison) but far more granularity in Maturity Dates.
• Aggregated weekly notional amounts of STIR futures (Euribors, Short Sterling and Euroswissy) vs
FRAs (EUR, GBP and CHF).
• On average, FRA notional traded makes up around 20% of total short-term interest rate risk.
• This is a much higher percentage than I anticipated. In futures markets there is a lot of risk
recycling by liquidity providers, which inflates volumes for a given change in open interest.
• FRA volumes are far more likely to be down to risk management of large swaps desks – akin to
“compressing” short dated interest rate risk of swaps with FRAs.
Fed Funds Futures

The Fed Funds futures contract price represents the market opinion of the average daily fed funds
effective rate as calculated and reported by the Federal Reserve Bank of New York for a given calendar
month. It is designed to capture the market’s need for an instrument that reflects Federal Reserve
monetary policy. Because the Fed Fund futures contract is based on the daily fed funds effective rate for a
given month, it tends to be highly correlated with other short-term interest rates and is useful for
managing the risk associated with changing credit costs for virtually any short-term cash instrument. Fed
Funds futures can be used either speculatively to anticipate changes in monetary policy or more
conservatively to hedge inventory financing risk across many different markets.

Key Product Specifications;

a) Notional Face Value of $5,000,000 for one month calculated on a 30-day basis at a rate
equal to the average daily Fed funds effective rate for the delivery month.
b) 100 minus the average daily Fed Funds effective rate for the delivery month.
c) Nearest month: one-quarter of one basis point (0.0025), or $10.4175 per contract. All other
contract months: one-half of one basis point (0.005), or $20.835 per contract.
d) 36 consecutive Monthly contracts listed (3years)
e) Last business day of the delivery month. Trading in expiring contracts closes at 4:00 p.m.,
Chicago time (CT), on the last trading day.

CME Group FedWatch Tool

The CME Group FedWatch tool lets you quickly gauge the market’s expectations of potential changes to
the fed funds target rate at upcoming FOMC meetings. Users can view the probabilities of future rate
movements for the next scheduled FOMC meeting, as well as the probabilities of rate movements for
deferred FOMC meetings.

To view the CME Group FedWatch tool, visit

cmegroup.com/fedwatch
tool, visit
CME Group FedWatch Tool

Below you have the CME Group Fed Watch tool. This computes, by upcoming Fed Fund Futures
Contracts, the current expectation (by current Market Price of Fed Funds Futures) of a change in
Monetary Policy by the federal reserve.

On the Right hand side you have the FOMC’s assessment of the future path of Interest Rates given the
current FOMC projections on Growth and Inflation. tool, visit
Short Term Interest Rates refer to the Interest Rates of derivatives with a
Residual maturity of 5 years or less. In the Over-The-Counter (OTC) Short
term interest rate markets you can trade as short as Overnight and 1 week.

These are not the Interest Rates at which the bonds were issued rather the interest
rates implied by the prices at which these (Government and Corporate) Bonds
are being traded in the financial markets.

Short Term Interest Rates Players trade are:

Euribor 3 Month Interest Rate Futures – Tracks 3 month EUR Euribor Interest
Rate
Short Sterling 3 month Interest Rate – Tracks 3 Month GBP Libor Interest Rate
EuroSwiss 3 Month Interest Rate – Tracks 3 month CHF Libor Interest Rate
Eurodollar 3 month Interest Rate – Tracks 3 month USD Libor Interest Rate
Canadian 90 Day Bankers Acceptance – Tracks 90 Day CAD Bankers
Acceptance Interest Rate
ICE 3 month Short Sterling Futures (LL):

Cash Settled future based on ICE benchmark Administration limited London

Interbank Offered Rate (ICE LIBOR) rate for three months deposits.

Notional: £500,000
Quotation: 100 minus Rate of Interest
Minimum Price Movement & tick Value: 0.005 Front month £6.25
0.01 All other Contracts £12.50
Trading Hours: 07:30 AM – 18:00 PM London Time
Last Trading Day: 11:00 on the 3rd Wednesday of Delivery month
Execution algorithm: Time Based Pro-Rata matching algorithm
Settlement: Based on ICE benchmark LIBOR for 3 month Sterling deposits at 11:00 on Last
Trading Day.
Delivery Months: March, June, September, December such that there are 26 delivery months
are available for trading. In addition to this at the Front of curve there are 3 consecutive
Monthly contracts.

Related Products:

LL Calendar Spreads, LL Butterfly, LL Condors, LL Combos, LL Options.

ICE 3 month Euribor Futures (Euribor):

Cash Settled future based on EMMI EURIBOR rate for three month deposits.

Notional: EUR 1,000,000

Minimum Price Movement: 0.005
Tick Value: EUR 12.50
Quotation: 100 minus Rate of Interest
Trading Hours: 01:00 AM – 21:00 PM London Time
Last Trading Day: 10:00 on the 3rd Wednesday of Delivery month
Execution algorithm: Time Based Pro-Rata matching algorithm
Settlement: Based on the European Money Markets Institute Euribor Rate (EMMI Euribor)
for three month Euro Deposits at 11:00 Brussels time on Last Trading Day.

Related Products:

Euribor Calendar Spreads, Euribor Butterfly, Euribor Condors, Euribor Combos, Euribor
Options.
ICE 3 month EuroSwiss Futures (EuroSwiss):

Cash Settled future based on Swiss Franc LIBOR rate for three month deposits.

Notional: SFr 1,000,000

Minimum Price Movement: 0.01
Tick Value: SFr 25
Quotation: 100 minus Rate of Interest
Trading Hours: 07:30 AM – 18:00 PM London Time
Last Trading Day: 11:00 Two Business days prior to the 3rd Wednesday of Delivery month
Execution algorithm: Time Based Pro-Rata matching algorithm
Settlement: Based on the ICE Benchmark Administration Limited LIBOR Rate (ICE LIBOR)
for three month Swiss Franc deposits at 11:00 London time on the Last Trading day.
Delivery Months: March, June, September, December such that there are 16 delivery months
are available for trading.

Related Products:

Euroswiss Calendar Spreads, Euroswiss Butterfly, Euroswiss Condors, Euroswiss Combos,

Euroswiss Options.
CME 3 month EuroDollar Futures (Eurodollar):

Cash Settled future based on Swiss Franc LIBOR rate for three month deposits.

Notional: $1,000,000
Minimum Price Movement: 0.0025 Very Front contract Tick Value $6.25
Minimum Price Movement: 0.005 Very Front contract Tick Value $12.50
Quotation: 100 minus Rate of Interest
Trading Hours: 17:00 PM – 16:00 PM Chicago Time (23 Hours)
Last Trading Day: 11:00 Two Business days prior to the 3rd Wednesday of Delivery month
Execution algorithm: Pro-Rata matching algorithm
Settlement: Based on the ICE Benchmark Administration Limited LIBOR Rate (ICE LIBOR)
for three month EuroDollar deposits at 11:00 London time on the Last Trading day.
Delivery Months: March, June, September, December such that there are 40 delivery months
are available for trading. In Addition to these there are four monthly contracts at the very
front of the curve.

Related Products:

Eurodollar Calendar Spreads, Eurodollar Butterfly, Eurodollar Condors, Eurodollar Combos,

Eurodollar Options.
What are Three month Short term Contracts (STIRs) ?

LL Three Month Short Sterling Futures Eurodollar Three Month Futures

What are Three month Short term Contracts (STIRs) ?

LL Three Month Short Sterling Futures

26th August 2016 Three Month ICE Libor Rate is
0.38969%. In futures terms that Price would be 100
minus Rate = 99.61

If there was a 3month Futures expiring today then

that would be trading around 99.61 exactly as these
futures always trade at 3month LIBOR on expiry date.

STIRs are the markets prediction of Futures LIBOR

Rates on specific dates in the Future. What affects
these rates are a blend of Supply/Demand of incoming
orders and the markets perception of future economic
growth and Monetary policy.

The actual current trading price (as in 99.59 for Dec

2019) almost never will be equal to the actual LIBOR
Rate on that expiry date. It is the current perception of
where the LIBOR would fix.

What can take away from this .jpg on LL Futures?

a) There is more liquidity (Volume/Players) in the

Front contracts i.e. SEP2016 to JUN2018 than
JUN2020 to MAR2021.
b) The current market prices indicate that the
BOE/MPC will only Raise Interest Rates by 16
Basis Points from SEP2016 and MAR2021.
c) Given the current backdrop of Economic data and
news following Brexit Interest Rate are ‘expected’
to go lower by 11 basis Points between SEP2016 to
MAR2018
d) The SEP2016 to SEP2017 part of the curve is
‘flatter’ than the SEP2017 to SEP2019 part of the
curve.
e) The LL curve is smooth in nature.
What are STIR Calendar Spreads, Butterflies and Combos?

LL Three Month Short Sterling Futures

A STIR futures trader can utilize multiple Strategies
along the yield curve to extract alpha from the
Markets in a safe way.

In the .jpg opposite you can see a sample of the types

of common strategies STIR traders use as tools in
trading the STIRs markets every day.

Starting from the top with the ‘naked’ outright future

(long or short) and moving down to the bottom to the
6 month Condor, each strategy increases in potential
amount of risk associated with that strategy. We look
at that as the actual and potential volatility associated
with that strategy.

What can take away from this .jpg on LL Strategy

combinations?

a) Apart from the Extended Double Fly, each of

these Strategies are actual Exchange Traded
Products. This refers to the fact there is an actual
Market Price listed so End users can trade. The
Extended Double Fly needs to be Executed
manually through 2 separate transactions.
b) Each of these strategies are 3 month ‘Curve
Neutral’ (Reduced Risk)
c) Each of these strategies can be executed by
trading separate contracts to build it.
d) The most actively traded Spreads are the
Calendar Spreads then the Butterflies.
e) As STIRs Futures are prediction of the Futures
Interest Rate path by a Central Bank and
predicting this is very tough for Traders, larger
gaps between expiries in the combination
deployed increase volatility and Risk. This is
because of Uncertainty.
 Microstructure Fair Value of STIR futures & spreads?

Volume Weighted Average Price (VWAP)

Top of Book refers to the Best Bid Ask Price in the Central Limit Order book (CLOB) at any time. The VWAP calculated here takes into account all the
Best Bids and offers in the CLOB and their Size and calculates the average price based on price and volume at any time. You can see this in the snapshot
in the column G under AVG.

To calculate this using:

Use the Formula: =IF(B2<E2,((C2*(B2/B2)+D2*(B2/E2))/(1+B2/E2)),(C2*(E2/B2)+D2*(E2/E2))/(1+E2/B2))

In the example of LL Jun17-Sep17-Dec17 the VWAP Price is consistent with the CLOB price with a skew of 3 times the amount of orders looking to sell
this combination than buy it at the current price. In the example of LL Jun17-Sep17-Dec17 Prices created from the outrights, it is suggesting that the bid
price of -0.01 is weak and despite having 8491 lots on the bid, potentially could trade out lower.
 LL Futures, Calendar Spreads and Butterflies.
What Drives Price Discovery of the LL Futures, Calendar spreads and Butterflies?

a) Domestic Central Bank Policy – Fundamental Analysis of Current Central Bank Policy
b) Political Backdrop
c) Global Central Policy
d) Government Bond Market Prices
e) Quantitative Research and Technical research.

What can we take away from the below .jpg of Short Sterling futures prices on Central bank Policy and market Interpretation of the current
and Future Economic climate?

a) LL Futures are pricing in a Future Easing in UK interest Rates of 11 to 12 bps between SEP2016 and SEP2017, which
signifies UK economic outlook looks more weak than strong.
b) Between DEC2017 and DEC2020 the Market is expecting that the current Economic weakness will subside a little (Hence
DEC2020 is pricing in a Higher Interest Rate than DEC2017) and Economic activity would increase.
c) Despite the BOE/MPC having cut rates in August2016 the market is expecting a further easing before the current
Economic downturn subsides.
Short Sterling (LL) Sep2017, LL Sep2017-Dec2017 & LL Sep2017-Dec2017-Mar2018
Butterfly

We have four charts opposite; LL Sep2017 Future, LL Sep2017-Dec2017

Calendar spread, LL Sep2017-Dec2017-Mar2018 Butterfly and the FTSE
Future.

Analysing the ranges for the last 6 months you can determine how Volatile
each of the contracts are. We calculate this by comparing the last 6 months
trading range versus the Bid-Ask spread of each Contract:

a) LL Sep2017: Hi 99.80 Lo 99.12

Range=(99.80-99.12)*£12.50
Range=£850 or 68 Bid-Ask Spreads
b) LL Sep2017-Dec2017: Hi 0.07 Lo 0.00
Range=(0.07-0.00)*£12.50
Range=£87.50 or 7 Bid-Ask Spreads
c) LL Sep2017-Dec2017-Mar2018 Butterfly: Hi 0.02
Lo -0.01
Range=(0.02—0.01)*£12.50
Range=£37.50 or 3 Bid-Ask Spreads
d) FTSE Future: Hi 6923 Lo 5728
Range=(6923-5728)*£10
Range=£11,950 or 1195 Bid-Ask Spreads

What can take away from this .jpg on LL Futures and Strategies and the
Bid-Ask Analysis above?

a) By trading LL Futures in spreads or Combos we eliminate excessive

volatility, or Reduce Opportunity?
b) Despite Much Economic Data, UK EU Referendum in between
Marc2016 and today the Butterfly has remained in a very tight Range.
c) The LL Sep2017 Future is strongly inversely Correlated to the direction
of the Sep2017-Dec2017 Calendar Spread.
d) The LL Sep2017-Dec2017-Mar2018 Butterfly is mildly inversely
Correlated to the Direction of the LL Sep2017 Future.
e) The LL Sep2017 Future is currently positively Correlated to the
direction of the FTSE Future.
f) The FTSE future is Inversely Correlated to the direction of the LL
Sep2017-Dec2017 Calendar Spread, LL Sep2017-Dec2017-Mar2018
Butterfly
Characteristics of STIR Futures?

With a few exceptions, Central Banks will rarely act

on impulse when changing policy and direction of the
Monetary and fiscal policy of a domestic country.

A rule of thumb in determining a future path of STIR

futures is that it takes 9 to 12 months for any
Economic event today to impact the real market.
Another rule of thumb is that a Central Bank will
rarely (with a few exceptions) move Interest Rates in
one direction and then the next Interest rate move
being in the other direction. Given historical evidence
of ‘paths’ of monetary Policy change, rather than one
off moves, STIR markets observe a Smooth shape up
and down the curve. Given the complexities (almost
impossible) of predicting exactly what a 3 month
LIBOR will be in 3 or 4 years time, and given the
Central bank tendency to move in a path of moves,
this makes it almost impossible for three contracts
next to each other in the future having vastly different
predictions of 3 month LIBOR rate. An example can
be seen with the continuation of the gradient of the
curve shape being fairly equal up and down the LL
futures curve.
Golden Rules for (STIRs) ?

LL Three Month Short Sterling Futures

What Golden Rules are there for STIR futures?

a) As Central Banks move very slowly in deciding Monetary

Policy, always wanting multiple pieces of data to confirm
trends in the underlying economy, the First STIR future
(whether it be LL, EuroSwiss or Euribor) will be the lowest
volatile contract as it has the most certainty of being fairly
priced to the LIBOR rate outcome.
b) As you move further out the curve, or further into the future,
you start to see Market Sentiment moving the LL Futures. On
the day opposite there was some Gloomy news about the
Economy and the Markets started to price in the chance the
BOE/MPC could be prompted into lowering interest rates
more. This Sentiment and Market Flow buys the LL Futures.
Therefore, Bad Economic News prompting Lower implied
Interest Rates pushes LL Futures Higher. Conversely,
Positive Economic Data will push Market Sentiment to sell
Lower and push implied Interest Rates Higher.
c) As Central Banks (CBs) will make monetary policy changes
slowly and not just one move, STIR curves will display a
‘traditional’ or typical STIR move.
d) This will be Front contract flat or up small, the next 3 to 5
contracts will rally (go up) but not be the highest point in the
curve, the next 3 or 4 contracts will be the highest point in the
up move and then you will see the last few contracts be
slightly lower.
e) In the example opposite, the Markets are very quick to absorb
new variables of new Economic Data or commentary from
Central Banks. So the Rationale behind the Markets’ moves is
as follows. Front 1 or 2 contracts the BOE-MPC will not react
and cut rates on the Gloomy data. Contracts 3 to 7 the Market
presumes the BOE-MPC will begin to cut Rates. Contracts 8 to
15 the BOE-MPC has Moved interest rates again lower again.
Finally the back, or last 4 contracts are lower than the highest
contracts as the Market will presume the Interest Rate cuts
made will have had a positive effect on the Economy and the
BOE-MPC will start to consider unwinding the Cuts with a
hike.
f) It is highly likely none of the scenario in e) will be done by the
BOE-MPC but this is the process the market makes on every
piece of data.
g) The Economic Cycle we are in will have a large factor in where
the ‘pivot point’ or Inflection point actually sits.
STIR Classic Yield Curve
Shapes and Dynamics
Rule 1.

STIR Futures prices are ONLY the Current Market perception of where Future 3 Month ICE LIBOR will be set and NOT the current
LIBOR Rate. The LL futures price action takes into account Day by Day Economic Updates to gauge where future policy will be set.
As you can imagine these are almost always wrong to where the actual rate is set as predicting such accurate points in time’s
LIBOR rates is next to impossible.

Central Banks usually move, with the exception of the Bank of Japan (BOJ) and the European Central Bank (ECB), in 25 or 50 Basis
Points. The BOJ and ECB have recently started to move in 10 basis point increments.

LL futures move in 1 Basis Point increments, so very gradual/small compared to the Central Bank Policy moves.

A) LL Futures 31st August 2016. Gloomy Economic Data Pushed Market B) LL Futures 1st September 2016. UK economic activity gripped with concern over
Sentiment that the BOE-MPC would ease Interest Rates. Brexit impact, despite this, UK Manufacturing Data suggested the Economy remains
strong, and up to 8 Basis points of Easing is removed from LL futures.
Rule 2.
STIR futures are very sensitive to every piece of Economic data, Central Bank release and Geopolitical news. Such that in the short
space of time between Diagram A (31st August 2016) to Diagram B (1st September 2016) the LL Futures perception of Future ICE 3
month LIBOR rates can change from very gloomy (probability of further Interest Rate cut by the BOE-MPC) to very positive
(probability of further Interest Rate Rise by the BOE-MPC).

A) LL Futures 31st August 2016. Gloomy Economic Data Pushed Market B) LL Futures 1st September 2016. UK economic activity gripped with concern over
Sentiment that the BOE-MPC would ease Interest Rates. Brexit impact, despite this, UK Manufacturing Data suggested the Economy remains
strong, and up to 8 Basis points of Easing is removed from LL futures.
Rule 3.
The 3 month ICE LIBOR rate is NOT the Bank Of England Bank Rate. The ICE LIBOR Rate is the rate at which banks will borrow
from one another in the International Money Markets. As you can imagine the UK Government has a higher credit Rating (Aaa or
there about) and Interbank Credit Rating is somewhere between A to BBB. Much like in the Real world those with Better credit
Ratings can borrow money cheaper than those with adverse Credit ratings. This means that the ICE GBP 3 month LIBOR Rate is
higher than the UK Bank Rate, usually around 12 basis points higher.

B) LL Futures 1st September 2016. UK economic activity gripped with concern over
A) LL Futures 31st August 2016. Gloomy Economic Data Pushed Market Brexit impact, despite this, UK Manufacturing Data suggested the Economy remains
Sentiment that the BOE-MPC would ease Interest Rates. strong, and up to 8 Basis points of Easing is removed from LL futures.
Rule 4.
Central Banks meet every month or two to analyse the current economic climate and plan a path of Monetary policy that can ensure
the economy meets their mandate. This mandate is devised to ensure long Term growth for the Country. Central Banks (BOE-MPC)
are often ‘bombarded’ with dozens of confusing sets of economic data to analyse to determine the correct path of interest Rates.
Often these interest Rates are set to ensure Inflation remains at the correct level (not to high not to low)

Central Banks are looking at the exact same economic data that banks, Hedge Funds and Prop traders are. With this, the Market
knows from historical Evidence and mathematical probability of how certain sets of Data will impact the LL futures prices and
ultimately the 3 month ICE LIBOR Rate. Therefore, markets are quite efficient in pricing in probability changes in perception of
future interest Rates. These changes are evident in the two diagrams below.

B) LL Futures 1st September 2016. UK economic activity gripped with concern over
A) LL Futures 31st August 2016. Gloomy Economic Data Pushed Market Brexit impact, despite this, UK Manufacturing Data suggested the Economy remains
Sentiment that the BOE-MPC would ease Interest Rates. strong, and up to 8 Basis points of Easing is removed from LL futures.
Classic Curve Shape of STIR Futures (LL)
The magnitude of the economic data news will impact the propensity of changes in LL futures and where the Inflection point is
located. During the 2008 Financial crisis daily price fluctuations were over 50 basis points in LL futures.

A C

B
D

Classic Shape 1: Weak Economic Data, STIR futures (LL) go higher/Lower Interest Rates.

The Chart above depicts the Short Sterling futures moves from the start of day (Blue line) to the End of Day (Orange line), these are in Tick Increments where in the
example Mar17 closed at 0.020 up on the day.

What ever causes the STIR markets to move at any point in time the STIR futures (LL) will react in a highly repetitive manner. This pattern of cause and reaction is
displayed in all STIR curves. The only difference between different STIRs will be the ‘PIVOT’ point. Above diagram shows the inflection point marked with arrow C.
Usually this inflection point is located in the future where monetary Policy can have had enough time to impact the current economic climate. Thus will need
reversing with the opposite monetary policy.

A – All STIR futures curves will roll down to the current ICE 3 month LIBOR rate. With Central Banks policy changes usually 6 to 9 months in the future the very
front contracts will be least impacted by the bad Economic news and will rise very small.
B – STIR futures will start to predict from the Economic bad data, that there is higher probability of BOE-MPC cutting interest rates than before. This drives the
contracts from DEC 2016 to Mar2018 to go higher (lower int rates)
C – The current LL futures inflection point. This is usually the highest Point of the LL futures Daily move where the Economic news is bad.
D – In this typical STIR Futures up move the Markets will start to predict that the LL futures should not be higher than the contracts at Point C because it believes
that the economic Data will improve with the stimulus from the Central Banks, thus increasing probability that the Central banks will reverse the Interest Rate cut
with a hike.

This shape of the STIR curve will ensure you understand where each STIR future should be trading in an up move* of LL futures. As most of you will only trade as
far as the 12th LL future the General rule is Economic Data/News Weak Back contracts rise more than the front. Conversely, we see the opposite if the Economic
News is good.

* An up move in LL futures is defined as where the LL futures prices are trading higher than yesterday’s settlement (closing price)
Classic Curve Shape of STIR Futures (LL)

Classic Shape 1: Very Strong Economic Data, STIR futures (LL) go lower/Higher Interest Rates.

The Chart above depicts the Short Sterling futures moves from the start of day (Blue line) to the End of Day (Orange
line), these are in Tick Increments where in the all STIR curves.

A) The Inflection point in the STIR futures (LL) curve moves much further down the curve. This inflection point in this
instance reflects where the market is increasing the probability that GBP LIBOR rates, after the Strong Economic
Data, will increase from previous levels out to Dec 2020.
B) The General rule of thumb that the further out the LL future is it will move more (up or down depending on the
direction) than the nearer in contracts up until the inflection point.
C) Thankfully, the inflection point does not jump around much. This is because Central banks will keep communicate
and be transparent on their Economic Planning/monetary policy.
Classic Curve Shapes at end or Beginning of an Economic / Business Cycle

At the beginning or end of an Economic Cycle you will expect to see a

change in Monetary Policy to either; a) Cut Interest Rates to promote
Spending and Lending in the Real Economy or b) Raise Interest Rates to
reduce Lending, cool the Economy and encourage People to Save.

Either way as the UK Bank Rate and the ICE three month Libor rates
are highly correlated to one another in their direction, the LL Futures
will begin to move.

‘Bear’ refers to a downward direction in the LL futures.

‘Bull’ refers to a upward direction in the LL futures.
‘Steepening’ refers to the shape/slope of the LL futures curve when the
Further out contracts are lower than the nearer in contracts.
‘Flattening’ refers to the shape/slope of the LL futures curve when the
Further out contracts are higher than the nearer in contracts.

Remember the LL futures are prediction of the Future ICE LIBOR at

each point in time.

The Economic cycle can also be referred to the Business cycle*. To

understand what cycle we are in we need to ask ourselves the following
questions; Is the UK experiencing Strong Growth? Is the UK
experiencing Strong or weak inflation or is the UK Economic Growth
likely to slow? Is the current economic indicators showing the UK MPC
is on track with its mandate and if not what would need to be done to
adjust the economy into a correct path to meet its mandate.

Note -No-one really knows the exact point that you enter a new
Business cycle until you are months into it as you can go into a new
cycle and come out very quickly.

If the UK economy had been growing too fast and Interest Rates were
too Low for the Growth path (U.K. Bank Rate & ICE GBP LIBOR will
Rise) or the UK economy had been growing too slow and Interest Rates
were too High for the Growth path (U.K. Bank Rate & ICE GBP LIBOR
will Fall) Either way UK Interest Rates will need to be on a new Path. In
these scenarios we will expect to see;

a) Scenario Need for Rate Cuts from opposite Rate path course – Bear
Steepening curve shape. 70-80% of the time in this phase the LL
futures will trade higher.

b) Scenario Need for Rate Hikes from opposite or neutral Rate path
course – Bull Flattening curve shape. 70-80% of the time in this
phase the LL futures will trade lower.
Classic Curve Shapes in the middle of an Economic / Business Cycle

‘Bear’ refers to a downward direction in the LL futures.

‘Bull’ refers to a upward direction in the LL futures.
‘Steepening’ refers to the shape/slope of the LL futures curve when the
Further out contracts are lower than the nearer in contracts.
‘Flattening’ refers to the shape/slope of the LL futures curve when the
Further out contracts are higher than the nearer in contracts.

The Middle of the Business cycle refers to the state of the Economy
when a direction of growth or weakness is experienced for a prolonged
period of time. This will be confirmed by Economic Data pointing to
sustained strength or weakness. Central Banks will talk about a path of
Interest Rate Cuts or Rises.

Even if the Economic Data is strong or weak enough to sustain a

monetary Policy path of Cutting or Raising Interest Rates for several
years, LL Futures can move up or down during this period of time.
During this part of the business cycle the markets can experience Data
which does not ‘agree’ with the current forecast by the Central Bank
and Markets.

In an Interest Rate cutting Cycle where the Economy is not strong

enough and needs stimulus, the curve shape will be 70-80% of the time
Bull Steepening. This is because Interest Cuts in the next few years will
improve the economic climate and at some point in the future will be
unwound by removing these cuts and possibly Raise Interest Rates as
Inflation and growth Picks up.

In an Interest Rate Raising (Hiking) Cycle where the Economy is too

strong and needs stimulus removed, the curve shape will be 70-80% of
the time Bear Flattening. This is because Interest Raises in the next few
years will lower/cool the economic climate and at some point in the
future will be unwound by removing these Hikes and possibly cutting
Interest Rates as Inflation and growth slows down.

The Inflection point of each of these curves is usually around the 5th
Generic STIR (LL) to the 12th Generic STIR (LL)
Thank you