Hedging with Eurodollar and BAB Futures
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Thirusha balamuraliHedging with Eurodollar and BAB Futures
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Thirusha balamuraliCommon questions
Powered by AIA sudden interest rate change impacts the price of futures contracts inversely. For example, purchasing a December 90 Day BAB futures at 95.22 becomes less valuable if rates rise unexpectedly. If the Reserve Bank increases the cash rate to 5.00% causing futures to drop to 94.90, the loss is calculated as the price change per contract, multiplied by contract value. Here, the loss would be 0.32 per unit (95.22 - 94.90), which, multiplied by the contract value, provides the total financial loss.
The gain or loss on a bond futures trade is calculated by taking the difference between the selling price and purchase price of the futures multiplied by the contract size. For instance, going short at 94.310 and closing at 94.515 results in a loss since the price increased. The change per contract (0.205) multiplied by the contract size denotes the financial impact. Factors such as interest rate movements and contract specifications influence this calculation.
To hedge a future 180-day commercial paper issuance, considerations include the expected interest rate environment and timing. With a September Eurodollar price at 92.00 indicating an implied rate of 8.00%, the treasurer can short futures to lock in this cost. Hedging mitigates the risk of adverse rate movements by securing a borrowing cost; however, potential disparities between futures settlement and actual issuance rate remain a challenge.
The settlement price of a Eurodollar futures contract directly affects financial outcomes when actual interest rates differ from projections. If a company locks in a rate at a futures contract price but the actual rate is lower, the company incurs a loss on the futures position since the eventual borrowing cost is higher than it could have been without the hedge. Conversely, if actual rates rise, the gain on the futures offsets higher borrowing costs, maintaining a planned financing cost level.
Interest rate futures are more beneficial than forward rate agreements when liquidity, transparency, and market responsiveness are important. Futures markets offer greater volume and visibility, allowing for more efficient price discovery and execution. They are preferable when precise timing and flexibility are needed, such as when the hedging horizon coincides with futures contract expiration, giving more alignment over specific borrowings compared to over-the-counter FRAs.
Evaluating forward rate agreements (FRAs) involves considering scenarios where the company's rate expectations align or differ from market movements. If a 3 x 6 FRA is set at 5.10% and actual rates rise to 5.50%, the FRA effectively hedges against increased costs. Conversely, if rates fall to, say, 5.00%, the company pays more than necessary. These scenarios show FRAs' effectiveness in stabilizing financing costs against unpredictable market changes.
An investor would take a short position in BABs futures when anticipating an increase in interest rates. A short position allows the investor to profit as futures prices fall due to rising rates. For example, if rates increase unexpectedly like when a Reserve Bank raises the cash rate, the value of BABs futures would decrease, leading to a potential profit for the short position holder, offsetting any costs from increased interest expenses.
To lock in a borrowing rate using Eurodollar futures, a company can enter into a futures contract adjusting for the basis between the futures rate and the actual borrowing rate. If the December Eurodollar futures contract is quoted as 98.40, the implied futures rate is 1.60% (100 - 98.40). Adding 0.5% to this rate for the company's borrowing terms, the rate locked is approximately 2.10%. To hedge, the company would take a short position in the futures if they expect to borrow at this rate, locking in the cost of funds regardless of market fluctuations.
A change in central bank policy significantly impacts hedge strategies using 90 day BAB futures due to sudden rate adjustments influencing futures prices. If, for example, the Reserve Bank raises interest rates unexpectedly, futures prices decline. A company with a long futures position faces potential losses. However, if the company anticipated such a change and held a short position, it could lock in gains. Thus, staying informed on policy changes is crucial to adjust hedging positions effectively.
To hedge against interest rate risks, the company can use forward rate agreements (FRAs) and 90 day BAB futures. For the next two rollover dates, the company can: (1) Enter into a 3 x 6 FRA at 5.10% and a 6 x 9 FRA at 5.20% to lock in borrowing rates for future quarters. (2) Use BAB futures to hedge against fluctuations, taking a short position to benefit from rising rates. If the 3 month bank bill rate ends up at 5.02%, rolling over the BAB futures at 94.98 would provide a hedge against higher actual costs. Alternatively, if the 6 month rate is 5.50%, settling at 94.50 would offset the increased interest costs.