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Who are the Users of Interest Rate Futures? |
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Monday, 10 December 2007 |
Almost all companies will have some exposure to the change in the cost of money or the interest rate. This may be as a result of bank loans, bonds, either issued as debt or held as assets, or because of any future expected cash flows. The current value of any future cash flow is a function of the interest rate between now and the time of the expected cash flow. All of this exposure to interest rates can be managed. Bank loans are usually issued against a floating or variable interest rate often this is LIBOR. By selling interest rate futures a company can offset any rise in the cost of the loan interest. As the interest rate rises the futures prices fall so the extra cost of the loan is offset by the gain on the future. The company is effectively locking or fixing the cost of the loan by hedging its exposure to interest rates.
Bonds are usually issued at a fixed rate or coupon. A company, which has issued bonds as debt, may decide that they would prefer to have the cost of their borrowing at a variable or floating rate. Rather than pay off the bond and enter into a bank loan as above, the company may decide to buy interest rate futures thereby having a hedge to their fixed borrowing costs. If interest rates were to fall they would still be paying the coupon on their outstanding bonds at the rate when issued but this cost may be offset by gains on the futures position.
Bonds are often held as assets. Most commonly this is by a group of investors known as asset and liability managers, which includes pension funds and insurance companies. This group of investors has liabilities in the form of future cash flows. In the main these are annuities and pension payments to individual investors. Annuity rates are linked to current interest rates so it is easy to see this group of fund managers have an exposure to interest rates in their stream of future liabilities. They may try to manage this exposure by buying bonds or, with a similar pay off, by buying interest rate futures.
All of these above may use interest rate futures to manage their interest rate exposure. However, interest rate futures are only the tip of the iceberg in the interest rate product world. Interest rate swaps provide another means of hedging interest rate risk. Interest rate futures have standard delivery dates and trading units. This means they are unlikely to be the perfect hedge for every user’s needs. An interest rate swap on the other hand can be tailor made for a client to match off or cancel out existing future cash flows. This brings us neatly to another user of interest rate futures - banks.
Banks use interest rate futures as a hedging tool for the other interest rate products that they trade in the market with other banks and with clients such as those mentioned above. Banks can tailor-make products for their clients and take the ensuing risk onto their books as part of a bigger portfolio. The residual risk can be hedged using interest rate futures. Because futures are liquid interest rate products they are used not only in hedging but also in the pricing models used to calculate the prices of many other different types of interest rate products
As you have read, futures are commonly used as a hedging tool. There is however one group of investors who use futures for taking risks. These investors are known as hedge funds. Their aim is to correctly predict the future course of interest rates and to take positions in them to make profits purely by the following change in rates.
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