08 - mm futures

Interest Rate Derivatives / Page 17 of 37

2. Money Market Futures

Money market futures are exchange-traded interest rate contracts. Contrary to their

counterpart in the OTC market the FRA the specifications of futures are strongly

standardised. Usually, the underlying is a 3-month deposit, in some currencies also a 1-

month deposit, that represents the interest rate of a future time period.

Money market futures can be used like FRAs. That is, to

eliminate a future interest rate risk (hedging) speculate on interest rate trends (trading) to arbitrage between different markets (arbitrage)

Money market futures are standardised products, because they are traded in the exchange

market. Thus, some specifications are already fixed by the particular exchange:

contract volume maturity dates marginal price changes (tick size) value of a price change by one tick based on one contract (tick value)

For money market futures the most important exchanges are Euronext.Liffe (London), CME

(Chicago) and SGX (Singapore) resp. Tiffe (Tokio).

Mostly, futures contracts can only be closed at the same exchange where the position has

been opened. Some contracts can be sold or bought (and consequently closed), at different

exchanges [e.g. a USD 3-months contract purchased in Chicago (CME) and sold in

Singapore (Simex)]. Thus the contract can be traded 24 hours and not only during the trading

hours at the particular exchange.


2.1 Conventions and Contract Specifications

Trade dates

Trade dates of money market futures are set by the futures exchange. For the core markets

these are always the third Wednesday of the last month of the quarter (March, June,

September, December). These trade dates are called IMM-dates (International Money

Market dates).

The delivery months have the following abbreviations:

March H

June M

September U

December Z

(Note: the abbreviations do not follow any logic)

In addition, at most futures exchanges so-called serial months are traded. These are the

maturities between the IMM dates. At the LIFFE for example, in addition to the IMM dates,

4 serial months are traded. Consequently, there are maturities for all following 6 months.

Trade date: 4th April

Maturities:

May (serial month)

June (IMM)

July (serial month)

August (serial month)

September (IMM)

October (serial Month)

(after settlement of the May contract the next new serial month will be

November)

Front month is the contract with the next maturity. Contracts with a later maturity are called Back months. For the front month liquidity is usually the highest.


Last trading day

Last trading days of futures are determined by the exchanges and are usually two days

before delivery date (an exception is GBP, where the theoretical delivery date is the last

trading date, i.e. same-day fixing).

Quotation

The quotation for futures prices is: 100.00 minus interest rate Therefore a forward interest rate of 4.50 % p.a. (i.e. an interest rate for a future period)

equals a futures price of 95.50 (= 100 4.50).

The consequences of this quoting convention are illustrated below:

interest rates prices

interest rates prices

If the interest rate rises from 4.50 % to 5 %, the future price will fall

from 95.50 to 95.00.

If the interest rate falls from 4.50 % to 4 %, the future price will rise

from 95.50 to 96.00.

With the quotation of an interest rate on the basis of 100, the buying/selling of a money

market future has just the opposite effect to an FRA purchase/sale:

FRA purchase = future short FRA sale = future long

A future's quote of JUNE (M) 96.64 / 96.65 corresponds to an interest rate of 3.35 % /

3.36 % p.a. for the term from the third Wednesday in June XY until the third Wednesday in

September XY, in a specific currency.


Underlying

Usually, the underlying is a 3-months interbank deposit (e.g. Eurodollar, Euroyen, Euro

Swiss Franc, EURIBOR). The fixing for these contracts is normally BBA LIBOR (resp.

EURIBOR for EURIBOR futures). The term is always exactly 90 days for the 3-months

futures period (resp. 30 days for a 1-month futures period). The fixed LIBOR resp. EURIBOR

though is calculated on the exact number of days.

Volume of the contract

Not only the underlying but also the volume (principal) of a future contract is exactly

specified. (see table below)

Futures purchase

as hedging operation: protection against falling interest rates as speculation: speculation on falling interest rates

Futures sale

as hedging operation: protection against rising interest rates as speculation: speculation on rising interest rates

Tick

A tick is the marginal movement of the futures price. For EUR, USD and JPY money market

futures, a tick is usually half a basis point, i.e. a hundredth of 0.5 % (= 0.005 % or 0.00005),

for GBP contracts it is 1 BP. (see table below)

Tick value

The tick value is the profit or loss which occurs when the price changes by one tick. Also the

tick value is specified by the exchange (e.g. USD 12.5 for the 3-months Eurodollar contract

at LIFFE). The tick value can be determined in the following way:

360termticktheofquantitycontracttheofvolume


3-months Eurodollar 1,000,000 x 0.00005 x 36090 = USD 12.5

1-months LIBOR 3,000,000 x 0.000025 x 36030 = USD 6.25

3-months EURIBOR 1,000,000 x 0.00005 x 36090 = EUR 12.5

3-months short sterling 500,000 x 0.0001 x 36090 = GBP 12.5

2.2 Main Markets of Money Market Futures

Currency Futures exchange

Contract volume

Underlying Tick size

Tick value BP value

EUR EUREX 1,000,000 3-mo EURIBOR 0.5 BP 12.5 EUR 25 EUR

EUR LIFFE 1,000,000 3-mo EURIBOR 0.5 BP 12.5 EUR 25 EUR

GBP LIFFE 500,000 3-mo LIBOR (Short

Sterling)

1 BP 12.5 GBP 12.5 GBP

JPY LIFFE 100,000,000 3-mo TIBOR (Euroyen) 0.5 BP 1,250 JPY 2,500 JPY

CHF LIFFE 1,000000 3-mo LIBOR (Euroswiss) 1 BP 25 CHF 25 CHF

USD CME 1,000,000 3-mo LIBOR (Eurodollar) 0.5 BP*) 12.5 USD*) 25 USD

USD CME 3,000,000 1-mo LIBOR 0.25 BP 6.25 USD 25 USD

USD CME 1,000,000 13 weeks T-bill 0.5 BP 12.5 USD 25 USD

*) At the CME the tick size for the 3-month Eurodollar future can vary from 0.25 BP to 0.5 BP or 1 BP, depending

on the delivery month.

Some contracts are traded at several exchanges, e.g.:

3-months Eurodollar: CME, Euronext.LIFFE and SGX

3-months Euroyen: CME, Euronext.LIFFE and SGX

Links:

Eurex: www.eurexchange.com

Euronext.Liffe: www.liffe.com

CME: www.cme.com

SGX: www.sgx.com


2.3 Exchange and Clearing House

The exchange specifies the conditions for the trading. It defines among other things

which contracts are traded and their specifications.

The settlement of the deals is carried out by the clearing house of the exchange.

The clearing house has the following main functions:

It is counterparty for both the buyer and the seller in all traded contracts. Placing the clearing house between buyer and seller reduces the credit risk. To reduce this risk to a

minimum, the clearing house deals solely with registered clearing members who for their

part offer their services as brokers or clearers. In order to protect against default risk of

exchange members, so-called initial margins and variation margins are calculated.

Daily revaluation and accounting of variation margins for all open deals

Fixing of the initial margin; the initial margin depends on the markets volatility. Therefore it is adjusted regularly to the actual market conditions.

2.4 The Margin System

As mentioned above, margins are required when dealing with futures. They reduce the credit

risk for the exchange to a minimum. They are demanded either one-shot and up-front in

relation to the number of contracts (initial margin) or daily for the accrued profits and losses

(variation margin).

The initial margin is a fixed amount; differing by contract and currency, e.g. USD 350 for each 3-month eurodollar contract.

The amount is fixed by the clearing house and changes in relation to the volatility of the

markets. The initial margin serves as an additional protection against default risk in

order to cover the potential loss of a market participant that could result from the daily

price fluctuations.

The initial margin is usually not paid in cash but securities. The returns of these

securities belong to the market participant.

The initial margin is returned to the market participant at expiry of the position or if the

position is closed earlier.


A spread margin is a reduced initial margin due to simultaneous long and short positions (in different periods), e.g. Eurodollar March long, 100 contracts and June short,

100 contracts.

Instead of paying a margin of USD 350 for 200 contracts (total amount of contracts), i.e.

USD 70,000, a reduced spread margin is applied, e.g. USD 250. New calculation 200

(total amount of contracts) x 250 = USD 50,000.

Some clearing houses calculate the initial margin by means of a risk-based system with certain parameters. This method is called span margin (Standardized Portfolio Analysis of Risk). Here the total risk of a position is calculated based on a series of risk factors.

The result is converted by a specific ratio into a margin that is eventually charged.

Variation margin (Margin Calls)

The variation margin is the daily accounting of all accrued profits or losses. Here the

difference between closing price and purchase price (or the closing price of the day before) is

determined daily, and thus, the real profits or losses are charged.

5th of May 10:00 a.m., buy 100 June Eurodollar futures, price 96.60

(without initial margin)

closing price 5th of May 96.65:

variation margin: 10 ticks x 12.5 tick value x 100 = USD 12,500

(credit)

closing price 6th of May 96.57:

variation margin: 16 ticks x 12.5 tick value x 100 = USD 20,000

(charge)

Realised loss since the purchase = 6 x 12.5 x 100 = USD 7,500 (this equals the total sum of all margin calls)

Note: as the variation margin is paid cash, for the exact calculation of the total result of a

futures position also the refinancing costs (resp. investment returns) have to be taken into

account.


Settlement on the last Trading Date (EDSP)

While bond futures (e.g. US T-bonds, UK gilt, Euro-Bund) need to be settled by physical

delivery of the underlying, the money market futures are settled cash on the last trading date.

The "cash settlement" is based on the EDSP (Exchange Delivery Settlement Price) which is determined on the last trading day. Thus, the EDSP is 100 fixing rate (e.g. 3-months USD

LIBOR). The settlement amount is calculated as the difference between the EDSP and the

closing price of the day before. The result of a futures position is the sum of the daily

variation margins plus the settlement amount of the last trading day.

You are long 100 contracts 3-months June Eurodollar futures.

Purchase price: 96.50

Yesterday closing price: 96.75

3-months BBA LIBOR today: 3.30% ( = last trading date)

What is the settlement amount?

The EDSP is 96.70 (100 3.30).

Settlement amount: (96.70 96.75) x 2 = -0.1 (10 ticks)

10 x 12.5 x 100 = USD -12,500

You have to pay USD 12,500.

(Note: Of course the total result of this position is a profit. The

remaining result has been taken into account for the daily variation

margins.)

Closing a Futures Position

Each futures position can be closed by an appropriate, opposite futures position before or at

the last trading date. The closing leads to the elimination of the position and the related initial

margin. The profits and losses result from the daily variation margin payments (plus possible

interest returns resp. payments).


2.5 Comparison: Money Market Futures vs. FRA

Since money market futures and forward rate agreements have very similar effects, we

compare these two instruments:

FRA Money Market Futures

quotation = interest rate (e.g. 4.50 %) quotation = 100 interest rate (e.g. 95.50)

OTC product product of exchange market non-standard contracts standard contracts volume: unlimited (depending on dealer) volume (e.g. EUR, USD 1 m )

fixed, depending on currency terms: unlimited (also broken dates) terms: 1 or 3 months (often only specific

months, as March, June, etc.)

spread: 1 4 points (main currencies) spread: mostly 1 bp, sometimes bp small credit risk no credit risk small charge of capital no charge of capital reversal (doubled charge of the line, twice charge of capital, two FRAs in the

books)

buying / selling possible: in the future's book only balanced, open positions

low back office requirements a lot of back office work : margins must be booked daily

calculation of interest: real number of days

calculation of interest: always 30 or 90 days

difference between interest rates is discounted

if paid "flat, no discounting "front fee by margins

08 - mm futures

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