CFM13290 | Understanding corporate finance: derivatives: interest rate futures and forwards

Managing risk using interest rate futures and forwards

Both interest rate futures (see CFM13310) and forward rate agreements (CFM13300) are used to hedge interest rates. Both of these types of derivative have a notional loan, or a notional deposit, as their underlying asset.

It helps if you think of money - either borrowed or lent - as a commodity like any other, and of interest rates as the price of that commodity. When interest rates rise, it becomes dearer to borrow money, and more profitable to lend it.

A forward contract or future of any kind derives its value from market expectations of how the price of the underlying asset will move.

Suppose, for example, a grain merchant has contracted on 1 July 2008 to buy wheat from a farmer in 6 months’ time at £150 per tonne. If there is a bad harvest, supply and demand will push up the price and the grain merchant will have got a very good deal. Someone with knowledge of the market might predict that, on 31 December 2008, the spot price of wheat will be £180 per tonne or even more. The rights under the contract held by the grain merchant will become more valuable.

Exactly the same principle applies to interest rates. If I want to borrow money now, I know how much interest I must pay; but I cannot know for certain how much it will cost me to borrow money in the future. I might, hypothetically, contract to borrow £1,000 in a year’s time at an interest rate of 4%. Such a loan, for one year, would cost me £40 in interest. Someone who believed that interest rates in a year’s time will be 5% (i.e. the loan would cost £50 rather than £40) would therefore be willing to buy my rights under the contract.

It is possible to calculate how much they should pay for the contract. It will be less than £10, because of the time value of money - a £10 saving in a year’s time is worth less than £10 now. Conversely, if someone offers to buy my contract for, say, £8, I can calculate what they think interest rates will be in a year’s time - the implied interest rate.

If the market’s expectations of future interest rates continue to rise, the value of this notional contract would continue to increase. In exactly the same way, the value of a forward contract based on a notional deposit would decrease as interest rates rise - the right to lend out money at, say, 4% interest is valuable while market rates are 3%, but worthless if rates rise to 5%.