Page 3: Interest rates
Hedging is an action which is taken to avoid making a financial loss, in this case because of adverse movements in interest rates. This is achieved by setting up an identical, but opposite, contract in the futures market to the one in the ‘cash’ market, i.e. the ‘cash’ market here is the mortgage market.
Interest rate futures are bought and sold according to an index pricing system. If interest rates are currently 6%, then the index price of interest rate futures is calculated as: 100 - 6 = 94.00 This figure of 94.00 is not a figure in £ or pence, it is just an index figure for use in calculations. You can see how it is used in the example (1) overleaf. First it must be noted that interest rate futures are always sold/bought in ‘contracts,’ each contract, for sterling, has an underlying value of £500,000. When you become a party to an interest rate contract, you are agreeing to pay/receive the difference in the value of that contract at a specified time in the future
One party must sell a contract and one party must buy that contract. The party who buys a contract will make money if interest rates fall, because the contract that they have bought is at a higher interest rate than that prevailing in the current market, the value of the contract has gone up e.g. if interest rates go down by 1% to 5%, the future price rises to 100 - 5 = 95.00. In contrast, the seller of the contract would lose money by the equivalent amount if interest rates fall by 1%. However, if interest rates rise, the converse would be true, the buyer would lose money and the seller would make money.
So if a building society wanted to protect itself against a rise in interest rates over the next three months on a sum of £5 million, then it could sell 10 sterling three month interest rate futures contracts. If the current interest rate is 6%, but it then rises to 7%, i.e. the index falls from 94.00 to 93.00, the building society will receive the difference between 94.00 and 93.00 (or the equivalent of 1% in interest on £5,000,000 over three months). A movement of 0.01 in the futures price index is the smallest amount that it is allowed to move and is called a ‘tick.’ To calculate the monetary value of a one tick movement, we can use the following equation:
In example 1, you can see how a building society will protect itself against a rise in interest rates over a three month period. The money that it makes on its futures contracts is the same as the extra interest that it has to pay to its depositors due to the higher interest rates. In the same way, if interest rates had fallen, then money that it would have saved from having to pay out less interest to depositors, would have to be paid to the buyer of its futures contracts, because the building society would have lost money on its futures contract. So in this way, having fixed the rate at which it lends money, a building society can effectively fix its liabilities for paying out interest.