Interest Rate Derivatives

Futures, Caps, Floors, and FRAs

This topic covers several instruments used to manage interest rate risk.

A. Interest Rate Futures:

• What it is: A futures contract where the underlying asset is an interest-bearing instrument (e.g., a Treasury bill, a Eurodollar deposit, or a government bond). The contract specifies a future date for the delivery of the underlying asset.
• Key Features:
  • Standardized Contracts: Exchange-traded and have standardized terms, including the delivery date, the quality of the deliverable asset, and the contract size.
  • Marked to Market: Profits and losses are settled daily.
  • Underlying Asset: Can be short-term interest rates (e.g., Eurodollar futures, Treasury bill futures) or long-term interest rates (e.g., Treasury bond futures).
• Purpose:
  • Hedging Interest Rate Risk: Companies and investors can use interest rate futures to protect themselves against changes in interest rates. For example, a company that plans to issue bonds in the future can short Treasury bond futures to lock in a borrowing rate.
  • Speculating on Interest Rate Movements: Traders can use interest rate futures to bet on the direction of interest rates.
• Examples:
  • Eurodollar Futures: Based on the 3-month LIBOR (London Interbank Offered Rate) or SOFR (Secured Overnight Financing Rate). Used to hedge or speculate on short-term U.S. dollar interest rates.
  • Treasury Bond Futures: Based on U.S. Treasury bonds. Used to hedge or speculate on long-term U.S. interest rates.
• Pricing:
  • The price of an interest rate future is inversely related to the expected future interest rate. If interest rates are expected to rise, the price of the futures contract will fall, and vice-versa.

B. Interest Rate Cap:

• What it is: A series of call options (called caplets) that protect the buyer against interest rates rising above a specified level (the strike rate or cap rate). The seller of the cap agrees to make payments to the buyer if the reference interest rate exceeds the strike rate on any of the payment dates.
• Key Features:
  • Strike Rate: The maximum interest rate the buyer will pay.
  • Caplets: Individual options that cover specific periods.
  • Premium: The upfront cost of purchasing the cap.
• Purpose:
  • Hedging Floating-Rate Debt: A company with a floating-rate loan can buy an interest rate cap to limit its borrowing costs if interest rates rise.
• Example:
  • A company buys an interest rate cap with a strike rate of 5% on a notional principal of $10 million. If the reference interest rate (e.g., LIBOR) rises above 5% on any of the payment dates, the seller of the cap will pay the company the difference between the reference rate and 5% on the notional principal.
• Payoff (per Caplet):
  • Notional Principal * Max(0, Reference Rate - Strike Rate) * (Day Count Fraction)

C. Interest Rate Floor:

• What it is: A series of put options (called floorlets) that protect the buyer against interest rates falling below a specified level (the strike rate or floor rate). The seller of the floor agrees to make payments to the buyer if the reference interest rate falls below the strike rate on any of the payment dates.
• Key Features:
  • Strike Rate: The minimum interest rate the buyer will receive.
  • Floorlets: Individual options that cover specific periods.
  • Premium: The upfront cost of purchasing the floor.
• Purpose:
  • Guaranteeing a Minimum Return: An investor can buy an interest rate floor to ensure a minimum return on an investment.
• Example:
  • An investor buys an interest rate floor with a strike rate of 3% on a notional principal of $5 million. If the reference interest rate falls below 3% on any of the payment dates, the seller of the floor will pay the investor the difference between 3% and the reference rate on the notional principal.
• Payoff (per Floorlet):
  • Notional Principal * Max(0, Strike Rate - Reference Rate) * (Day Count Fraction)

D. Forward Rate Agreement (FRA):

• What it is: An agreement to lock in an interest rate for a specified future period. It's a contract between two parties to exchange the difference between a fixed interest rate (the FRA rate) and a floating interest rate on a notional principal at a future settlement date.
• Key Features:
  • Single Payment: Only one payment is made at the settlement date, representing the difference between the fixed and floating rates.
  • No Exchange of Principal: The notional principal is not exchanged.
• Purpose:
  • Hedging Future Borrowing Costs: A company that plans to borrow money in the future can use an FRA to lock in an interest rate.
  • Speculating on Interest Rate Movements: Traders can use FRAs to bet on the direction of interest rates.
• Example:
  • Company A enters into an FRA with Bank B to receive a fixed rate of 4% on a notional principal of $1 million for a 3-month period starting in 6 months.
  • At the settlement date (6 months from now), the 3-month LIBOR is 5%.
  • Bank B pays Company A the difference between 5% and 4% on the notional principal for the 3-month period.
• Payoff:
  • Notional Principal * (Reference Rate - FRA Rate) * (Day Count Fraction) / (1 + Reference Rate * Day Count Fraction)

Relationships and Comparisons:

• Caps and Floors: Caps and floors are related through put-call parity. Buying a cap and selling a floor with the same strike rate is similar to a swap.
• FRAs and Interest Rate Futures: FRAs are similar to short-term interest rate futures, but FRAs are over-the-counter (OTC) contracts, while interest rate futures are exchange-traded.