Chapter 6:

INTEREST RATE FUTURES

▪Interest rate is the price of money.
LENDING/invest = INTEREST REVENUE (cash inflows)
BORROWING = INTEREST EXPENSE (cash outflows)
▪The level of interest rate determines the demand for and
supply of money.
▪The level of interest rate is a function of borrowing and
lending activities over a period of time in the financial
market.
 TYPES OF YIELD CURVE
1.Normal Yield Curve
Interest rate % per annum

Term in maturity

• Positive relationship between interest rate and time to maturity.

• The longer the maturity, the higher will be the interest rates.
• The longer the period of borrowing/lending, the higher interest rates of
payable/receivable.
2.Inverse Yield Curve
Interest rate % per annum

Term in maturity

• Negative relationship between the interest rates and maturity.

• The longer the maturity, the lower the interest rates
• For short term investment : higher interest rate is better
• For long term borrowing : lower interest rate is better
3.Flat Yield Curve
Interest rate % per annum

Term in maturity

• The interest rates will remain stable of reflects the transition phase of the yield
curve from normal to inverse, or vice versa.
• Example : Treasury bills (T-bills) , Government Securities
4.Hump-Backed Yield Curve
Interest rate % per annum

Term in maturity

• The curve can be associated with market expectations of higher short-term interest
rates in the near future but lower rates on a medium term outlook.
• This curve reflects immediate,relatively easy liquidity conditions(hence,the low rates
at the very short end) with the anticipation of a temporary tightness in the medium
term (hence the hump) before a gradual decline in longer term rates.
• At the stable stage,the longer period of investment or borrowing,the lower interest
rates receivable or payable.
• At the normal stage,interest rates increase when government increase BLR of
interest rates fluctuate.
THE UNDERLYING INSTRUMENT
• In Malaysia,interest rate futures (FKB3) trading are the trading of the
underlying 3-month KLIBOR, that is the interest rate charged or received
on short term funds placed in the interbank market for a period of three
months.
• It is the rate used as a benchmark for pricing money market instruments.
• Since the borrowers are expected to pay interest and lenders to receive
interest,the formula that can be used is :

Interest Revenue/Expense = Principal x Rate x Time

ADVANTAGES OF 3-MONTH KLIBOR FUTURES TRADING
1. International Standard
• It is the most actively traded and internationally accepted as compared to
other tenors.
• In major financial centres,interbank offer rate of three month is commonly
traded,such as the Eurodollar in New York,LIBOR in London and SIBOR in
Singapore.
2. Liquidity of the Underlying Instrument
• There are enough buyer and seller in the market ; and the instrument is
very easy to sell in the market.
3. Volatility of Interest Rates
• Interest rates are generally expected to have volatile movements,and hence
requires a reliable hedging medium for interest-rate risk management in
Malaysia.
• KLIBOR futures can provide hedging opportunities for the Malaysian
corporate borrowers and lenders.
4. Correlation with other Money Market Instruments
• KLIBOR has been used as a benchmark by financial institutions to charge
interest on loans or pay interest on deposits
CONTRACT
SPECIFICATION
(FKB3)
SUMMARY OF
CONTRACT SPECIFICATION KLIBOR FUTURES
• Contract Code = FKB3
• Underlying Instrument =KLIBOR RATE (CASH MARKET)
• Contract Size = RM 1 000 000 (ONE MILLION)
• Minimum price fluctuation = 25 / 0.01% / 1 tick
• Contract month = quarterly basis (March, June, Sept, Dec)
• Final Settlement value (if converged)
100 - KLIBOR RATE cash rate = KLIBOR FUTURES PRICE INDEX (FKB3)
100 - 3.50% = 96.50
100 - 5.50% = 94.50
100 – 7.50% = 92.50
Market Report
 FKB 3

cash
Serial
month
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MARKET REPORT

• 96.50 X 100 (BASIS) = 9650

• IMPLICATION on Calculation P/L for FKB3

PROFIT/LOSS = SELL - BUY X #C X BASIS X MIN. PRICE. FLUC.

PROFIT/LOSS = SELL - BUY X #C X 100 X 25
MECHANICS OF TRADING FOR FKB3

1. HEDGING
• LONG HEDGING
• SHORT HEDGING
2. SPECULATING
• LONG SPECULATING
• SHORT SPECULATING
3. SPREADING
• BULL SPREADING
• BEAR SPREADING
4. ARBITRAGING
• OVERPRICED
• UNDERPRICED*
THE MECHANICS OF TRADING
1. Hedging with KLIBOR Futures (FKB3)

• The potential borrowers are concerned about the rising interest rate, and higher
interest expense can create cost to certain extent, they must not be able to
service the interest due.

• Potential lenders are concerned about falling interest rate, and lower interest
revenue can contribute a lower income.

• Hedging with KLIBOR futures can help to reduce, if not eliminate, the interest rate
risk in the Malaysian financial market.

• LONG HEDGE = INTEREST RATE FALL / POTENTIAL LENDER/investor

• SHORT HEDGE = INTEREST RATE INCREASE / POTENTIAL BORROWER
Long Hedge
CASE 6.1 : Hedging Against Falling Interest rate
As a treasurer of large insurance company, you expect an excess fund
of RM 200 million of 3 month in December to be deposited (invest) in
KLIBOR market. Today is October, in which 3 months KLIBOR (cash
market) is quoting at 4.5% per annum while December futures (future
market) is trading at 95.1 in the BMDB.
In anticipation of falling interest rate, establish your hedging strategy
by showing your effective interest rate (EIR) if the KLIBOR cash trades
at 3.8% (cash market) and December futures at 96.5 (future market)
respectively.
THE MECHANICS OF TRADING
1. Hedging with KLIBOR Futures

1. Position = Long hedge

2. Reason = interest rate expect to fall & lender want to deposit (invest)money
3. #c = AMOUNT PRINCIPAL / PRINCIPAL VALUE FKB3
= 200 000 000 / 1 000 000 = 200 lots.

4. Hedging strategy: (refer to Table 6.4).

5. Future position= S-B X basis X #c X MPF
6. Cash Position =
7. Net effect =
8. EIR =
9. Conclusion = hedging benefit??? YES. !
THE MECHANICS OF TRADING
Hedging with KLIBOR Futures

4. Hedging strategy: (refer to Table 6.4).

LONG HEGDE = BUY TODAY; SELL LATER

Cash market Future market

Today (OCT) Receive notification of RM 200 million BUY 200 lots December FKB3 @ 95.1
for 3 months.
Current rate =4.5%
Later (DEC) Received RM 200 million and deposit = SELL 200 lots December FKB3 @ 96.5
3.8%
THE MECHANICS OF TRADING
Hedging with KLIBOR Futures

5. Future position = SELL –BUY X #c X basis X MPF

= 96.5-95.1 X 200 X 100 X 25
= 700 000
6. Cash Position = int. revenue = P X R X T
= 200 000 000 X 0.038 X 90/360
= 1 900 000

7. Net effect = 700 000 + 1 900 000

= 2 600 000
8. Effective Int. rate (EIR) = 2 600 000 X 360 X 100
200 000 000 90
= 5.2%
9. Conclusion = there is a hedging benefit because the company get a higher interest
(5.2%) rate than cash market 3.8%.
Short Hedge
CASE 6.2 : Hedging Against Rising Interest rate
An infrastructure company has a special short-term borrowing
requirement for 500 million in June.
In this arrangement, the company will be charged 2.5% above KLIBOR.
Currently, the cash KLIBOR rate is 3.5% and expected to rise steadily
within the next three months.Today, early April, the June futures are
quoting at 96.05 in the BMDB.
Assuming in June , the KLIBOR cash rate closed at 5.1% and June
futures are quoting at 95.00, show the company hedging benefits as
measured by effective interest rate (EIR).
THE MECHANICS OF TRADING
Hedging with KLIBOR Futures

1.Position = SHORT hedge

2. Reason = interest rate expect to be RISING & BORROWER
3. #c = AMOUNT PRINCIPAL / PRINCIPAL VALUE
= 500 000 000 / 1 000 000 = 500 lots.
THE MECHANICS OF TRADING
Hedging with KLIBOR Futures

4. Hedging strategy: (refer to Table 6.4).

SHORT HEGDE = SELL TODAY; BUY LATER

Cash market Future market

Today (APRIL) Need to borrow RM 500 million SELL 500 lots June FKB3 @ 96.05
for 3 months.
Current rate =3.5%
Later (JUNE) Borrowing at special BUY 500 lots June FKB3 @ 95.00
arrangement of RM 500 million
@ 5.1 + 2.5 = 7.6%
THE MECHANICS OF TRADING
Hedging with KLIBOR Futures

5. Future position= SELL –BUY X #c X basis X MPF

= 96.05-95.00 X 500 X 100 X 25
= 1 312 500

6. Cash Position = interest expense = P X R X T

= 500 000 000 X 0.076 X 90/360
= 9 500 000
7. Net effect = 1 312 500 - 9 500 000
= - 8 187 500

8. EIR = 8 187 500 X 360 X 100

500 000 000 90
= 6.55%

9. Conclusion = there is a hedging benefit because the company get lower interest rate
(6.55%) than cash market borrowing rate 7.6%.
2. Speculating with KLIBOR Futures (FKB 3)

• Speculative activities are generally outright positions, and therefore are exposed to
huge profits or losses.
• Speculating involved with daily futures trading, that want to advantage from the
price volatility.
• This daily trading of futures also known as marked-to-market position.
• Two types of speculative trading:
• (i) Long speculating.
• (ii) Short speculating.
Short speculating (example)

• Example (p.116)
• Assume a trader sold fives lots KLIBOR futures at the price 96.5 (Day
0) because he expect the prices to fall in the near futures. If you are
required to pay an initial margin of RM 1000 per contract with the
maintenance margin at Rm 800, show your marked-to-market
position on the following prices:

• DAY 1 : 95.42
• DAY 2 : 96.39
• DAY 3 : 96.32
• DAY 4 : 96.35
• DAY 5 : 96.39
1. Position = Short Speculating because the price is to fall / ‘r’ is to increase.
2. #c = 5 lots (given in questions)
3. Initial margin = 1000 X 5lots = RM 5000
4. M. Margin = 800 X 5 lots = RM 4000
5. Contract value (DAY 0) = 96.5 X 5 X 100 X 25 = RM 1 206 250

• 6. Marked to market table

Trading Closing Price Floating Profit/Loss Current Margin
Day
0. S 96.50 - RM 5000
(96.50-95.42 )X 5 X 100 X 25 = 1000
1 96.42 RM 6000
(96.42-95.39) X 5 X 100 X 25 = 375
2 96.39 RM 6375
3 96.32 RM 875 RM 7250
4 96.35 - RM 375 RM 6875
5 96.39 - RM 500 RM 6375
• Leverage effect day 5

• Change in Price (DAY 5) = S - B X 100

B
= 96.5 – 96.39 X 100 = 0.114%
96.39
• Change in Return(DAY 5) = R5. – R0 X 100
Ro
= 6375 – 5000 X 100 = 27.5%
5000

A small change in Price (0.114%) will lead a bigger

change in Return (27.55)
Long speculating (example)

• Example (p.116)
• Assume a trader buy fives lots KLIBOR futures at the price 96.5 (Day 0)
because he expect the prices to increase in the near futures. If you are
required to pay an initial margin of RM 1000 per contract with the
maintenance margin at RM 800, show your market-to-market position on the
following prices:

• DAY 1 : 95.42
• DAY 2 : 96.39
• DAY 3 : 96.32
• DAY 4 : 96.35
• DAY 5 : 96.39
1. Position = Long Speculating because the price is to increase / ‘r’ is to fall.
2. #c = 5 lots (given in questions)
3. Initial margin = 1000 X 5lots = RM 5000
4. M. Margin = 800 X 5 lots = RM 4000 (refer p.44 in textbook)
5. Contract value (DAY 0) = 96.5 X 5 X 100 X 25 = RM 1 206 250

• 6. Market to market table

Day Position Closing Floating Profit / Loss Current CALL MARGIN New Current
Price margin (< 4K) Margin

0 BUY 96.50 - 5000 - -

1 96.42 (96.42-96.50) X 5 X 100 X 25 = -1000 4000 - -

2 96.39 -375 3625 1375 5000

3 96.32 -875 4125 - -

4 96.35 +375 4500 - -

5 96.39 +500 5000 - -

• Leverage effect day 5

• Change in Price (DAY 5) = S - B X 100

B
= 96.39 – 96.5 X 100 = - 0.114%
96.5
• Change in Return(DAY 5) = R5. – R0 X 100
Ro
= 5000 – 5000 X 100 = 0%
5000

NO LEVERAGE EFFECT
Spreading Rule
Rules / Justificaton:

1. Market Condition (Bull market (increase) / Bear market (fall))

Strategy ? Bull spread strategy or bear spread strategy
2. Price discovery
May July
Today (march) 96.30 95.93
Later 95.62 95.42

3. Sell higher futures price today and buy lower futures price today

May July

Today (march) 96.30 95.93

SPREADING STRATEGY

• BULL SPREAD (pg.70)

•
• the term refers to buying the nearby month, and selling the
deferred month today

• BEAR SPREAD
• In most, the term refers to selling the nearby contract month,
and buying the deferred contract today
•
•
• Source: (http://www.smithbarney.com/prod_svc/futures/glossary.html)
•
3.Spreading with the KLIBOR Futures

Example FKB3:
TODAY December 2006: 96.30
March 2007: 95.93

In the situation of “bear spread” which requires sell nearby contract month and
sell at deferred contract month.

Therefore;
Spread = (96.30-95.93) = 0.37 X 100 (basis) = 37 basis point (bp)
 • Example :
December 2006:95.62
March 2007: 95.42

Market/Month December 2006 March 2007 Basis Spread

Today (April) Open : Open : 37bp
Sell 6 Dec KLIBOR Buy 6 March
Futures @ 96.30 KLIBOR Futures @
95.93

Later (June) Close-out : Close-out :Sell 6 20bp

Buy 6 Dec KLIBOR March KLIBOR
Futures @ 95.62 Futures @ 95.42

Dec 2006 :
Profit (Loss) = (96.30 – 95.62) x 100 x 6 x RM 25 = RM 10,200

March 2007 :
Profit (Loss) = (95.42 – 95.93) x 100 x 6 x RM 25 = - RM 7,650

Gross Profit = RM 10,200 – RM 7,650 = RM 2,550

4. Arbitraging with the KLIBOR Futures (FKB3)

• It is the simultaneous buying and selling of futures contract to take advantage of

temporary price difference in the market.
• Arbitraging with KLIBOR futures involves the calculation of the expected future
interest rates,which refers to the Implied Forward Rate (IFR) that reflects the
expected interest rates that prevail in the future.

IFR =

( 1 + higher % x t2/360 ) - 1 x 360 x 100

(1 + lower % x t1/360 ) t2 -t1

• Example 2 :
IFR is 4.25% in September 2006 while cash rate is 4.00% in July.
Fair Value = 100 – IFR
= 100 – 4.25
= 95.75
cont..
➢ If the quoted price is higher than the fair value and an
overpriced situation,an arbitrageur can :
i. Make short-term borrowing (B for 30days)
ii. Sell KLIBOR futures (SELL)
iii. Lends fund until maturity date,plus additional three months (L for 120 days)
iv. Roll-over the borrowing requirement upon maturity. (B for 90days)

➢ If the quoted price is lower than the fair value and an under
price situation exist,an arbitrageur can :
i. Make short-term lending (L for 30days)
ii. Buy KLIBOR futures (BUY)
iii. Borrow funds to cover its period until maturity date,plus additional three
months (B for 120days)
iv. Roll-over the lending opportunity upon maturity. (L for 90 days)
Overpriced Situation
Tutorial Chapter 6 (past year exam)

• Hedging= July 17 Q1, Jun 13 Q3 ,

• Speculating = Jun 14 Q3b,
• Spreading = Jun 16 Q3, Dec 15 Q4
• Arbitraging = Dec 16 Q3, Jun 15 Q4
THANK YOU