interest rate forwards

Question 1

What is a day count?

Answer 1

Day count is defines how interest is earned over time. It is a way of calculating interest, and different methods are used for different types of interest rate derivatives. The interest is calculated by dividing the number of days between two dates by the total number of days in the period, this number is the multiplied by the interest in the period

Question 2

Three day count conventions commonly used in the united states are? What are they used for

Answer 2

1. Actual/actual - used for treasury bonds
   
   2. 30/360 - used for corporate bonds
      
      3. Actual/360 - treasury bills and other money market instruments

Question 3

In a treasury bonds futures contract, how is delivery determined?

Answer 3

It is determined by the short seller. The short seller can only choose to deliver bonds that are at least 15 years to maturity and not more than 25 years to maturity. Because there are many futures for the same bond, the seller must choose the cheapest one. They may also be entitled to a wild card play, in which if the 2pm price had fallen, they can signal intent for delivery. If the price stayed the same or had risen, they may choose to hold off until the 2pm price falls.

Question 4

What is the conversion factor in regards to bonds?

Answer 4

Conversion defines the price received for the bond. It is calculated by subtracting the interest from the present value of the bond. This figure is then divided by the face value of the bond. The delivery price is then determined by subtracting the most recent settlement price times the conversion factor from the quoted bond price.

Question 5

Explain interest the difference between Eurodollar futures and a forward rate agreement
There are two main differences:

Answer 5

1. The difference between a Eurodollar futures contract and a similar contract is that there is no daily settlement. A forward rate agreement is a hypothetical forward contract where a payoff equal to the difference between the forward interest rate and the realised rate is paid at time T1
2. The difference between the hypothetical forward contract and a true forward contract where there is settlement equal to the difference between the forward interest rate and realised interest rate at time T2

Question 6

in terms of percentages, what is one basis point?

Answer 6

0.01% p.a

Question 7

When duration is used for bond portfolios, what happens if the duration changes?

Answer 7

The yield is expected to change by the same amount

Question 8

When hedges are constructed using interest rates futures, what happens if an interest rate rises?

Answer 8

Interest rates and futures work in opposite directions, therefore if interest rates rise, the futures contract will fall. Conversely, if interest rates fall, the futures contract will rise.

Question 9

A company in a position to lose money if interest rates drop should take what position in interest rate futures?

Answer 9

A long position

Question 10

A company in a position to lose money if interest rates go up should take what position in interest rate futures?

Answer 10

A short position

Question 11

What duration should a hedger choose in regards to interest rate futures?

Answer 11

One that is closest to the duration of the underlying

Question 12

What is the best derivative to use for a floating-rate loan and why?

Answer 12

Eurodollar forwards, because it is closely related to the rate at which companies borrow money

Question 13

what is the difference between reference rates and interest rate futures?

Answer 13

reference rates serve as benchmarks for many financial institutions. Interest rate futures are financial contracts on debt securities, where parties agree to buy or sell an underlying asset at a predetermined interest rate, often tied to the reference rate.

Question 14

what are reference rates used for in regards to futures contracts?

Answer 14

a basis for pricing and settling interest rate futures, allowing market participants to manage and hedge against interest rate fluctuations

Question 15

what is a Eurodollar?

Answer 15

a US dollar deposited in a bank outside the united states. Eurodollar futures are futures on the 3-month eurodollar deposit rate (effectively the 3-month LIBOR Rate). one contract on the rate earned on $1,000,000

Question 16

what are the characteristics of a Eurodollar futures contract?

Answer 16

Underlying: Eurodollar deposit
Risk: interest rate fluctuations
Size: $1,000,000
Settlement: cash
Settlement price: 100-actual 3 month rate
Length of contract: 3 months
Delivery months: March, June, september, December up to 10 years
Settlement: 3rd wednesday of delivery month

Question 17

in a Eurodollar contract, what is one basis point in $

Answer 17

$25

Question 18

what is the settlement price formula for Eurodollar contracts

Answer 18

P = 100 - r

Question 19

how does a short trader profit from interest rate futures?

Answer 19

a short trader gains $25 per basis point when interest rates rise. When the rates rise the price falls, hence go short i.e. sell high, buy low

Question 20

how does a long trader profit from interest rate futures?

Answer 20

a long trader gains $25 per basis point when interest rates rise. Rate falls mean price rises. Hence, go long to profit from futures, i.e. buy low sell high

Question 21

when is the 3 month SOFR futures contract settled?

Answer 21

after all overnight rates have been observed, then 3 months later, for the same contract month

Question 22

what are the assets underlying short-term interest rate futures contracts offered on the ASX?

Answer 22

90-day bank accepted bills (BABs)

Question 23

what are BABs?

Answer 23

short-term debt securities that are offered by companies that may not have a good enough credit rating to borrow directly through direct markets, so they get the bank to accept the credit risk.

Question 24

what happens to BABs futures if interest rates rise?

Answer 24

The contract falls

Question 25

how would you hedge against rising interest rates using BABs futures

Answer 25

short Babs futures

Question 26

how do you hedge against interest rate falls using babs

Answer 26

go long babs

Question 27

what are the characteristics of BABs futures?

Answer 27

contract size: $1,000,000
Maturity: 90 days
Delivery months: March, June, September, December up to 20 quarters ahead
settlement: 2nd friday of every month
quotation: 100 - annual yield %
Minimum price movement: 1 basis point (0.01%)

Question 28

explain tick value

Answer 28

tick value is the dollar amount gained or lose for a minimum movement in futures price. The minimum value change of contract is one basis point.
Tick value = difference between the value of contract at original price and value of contract at new price

Question 29

what are forward rate agreements?

Answer 29

OTC interest rate contracts. They are equivalent forward contracts as compared to the futures contracts for interest rates.

Question 30

what is the difference between FRAs and interest rate futures?

Answer 30

the underlying in FRAs is not a price, but the interest rate itself. Futures are not linked to the current interest rate

Question 31

What are the characteristics of FRAs

Answer 31

• the underlying is an interest rate
• OTC whereby a certain rate of interest will apply to a certain notional principal in the future
• equivalent to an agreement where interest at a predetermined rate is exchanged for interest at the market rate
• something that can be value by assuming that the forward interest rate is certain to be realised, and the main difference between the market rate and FRA rate at the settlement date is the gain or loss is the cash settled