Solutions Topic4

Topic 4: Interest Rate Futures
Suggested Solutions to Tutorial Questions

Hull (2017) Ch. 6
Problem 6.16
The treasurer can hedge the company’s exposure by shorting Eurodollar futures contracts. The
Eurodollar futures position leads to a profit if rates rise and a loss if they fall.
= 5m – 4.820 < 5m - 4.720
Date of issue 90 days 90 days
Feb 20 July 17 Jan

Eurodollar contracts mature 180 days
No of contracts = 5,000,000/1,000,000 = 5 contracts x 2 = 10 contracts

The contract price of a Sept Eurodollar futures contract is $980,000. Note that the Eurodollar price of
92.00 implies a yield to maturity of 8% per annum or a discount of $25 per basis point times 800 basis
points = $20,000 or (8% x $1m x 90/360).
P = 100 – R
R = 100 – P = 100 – 92 (P) = 8% (R)
1,000,000
= 980,392.16 ≈ 980,000
1 + .08 𝑥 90⁄360
The number of contracts that should be shorted is, therefore,
4,820,000
𝑥 2 = 9.84 ≈ 10 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠
980,000
$4,820,000 / $980,000 = 4.92 or for, practical purposes, 5 contracts

Note that the duration of the commercial paper is twice that of the of the Eurodollar deposit
underlying the Eurodollar futures contract. Therefore, we need to multiply our answer by 2 which gives
an answer of 9.84 contracts (or 10 contracts rounded up).
For example, if Sept Eurodollars were quoted at 91.00 on July 17, the borrower would gain 100 basis
points x $25 per basis point x 10 contracts = $25,000 on the short Eurodollars position. This would
offset the incremental interest expense of a rise of 1 percent on the $5m loan ($5m x 1% x 0.5 years =
$25,000).
1
Problem 6.25
(a) The company can lock in a 3-month rate of 100 − 98.4 =1.60%. The rate it pays is therefore locked
in at 1.6 + 0.5 = 2.1%.
8,000,000
(b) The company should sell (i.e., short) 8 contracts = .
1,000,000
If rates increase, the futures quote goes down and the company gains on the futures. Similarly, if
rates decrease, the futures quote goes up and the company loses on the futures.
(c) The final settlement price is 100 − 1.30 = 98.70.
The futures contract is settled in December, but the interest rate on a loan starting in December is
paid three months later.
Additional Questions
1. You have just bought a December 90 Day BAB futures contract at a price of 95.22.
Immediately after your purchase, the Reserve Bank announces a surprise increase in the
cash rate to 5.00%. The yield on spot 90 day BAB’s rises to 5.03% and the December
futures contract price falls to 94.90. Calculate your gain or loss on this trade (use formula
not approximation technique).
Obligation to buy at 95.22 = $988,351 (value of contract)

Closed out contract at 94.90 = $987,581 (value of contract)
Therefore loss = $ 770
P = 100 – r
95.22 = 100 – r
R = 100 – 95.22 = 4.78%
P = 100 – r
94.90 = 100 – r
r = 100 – 94.9 = 5.1%
1,000,000 1,000,000
−
90
1 + .0478 𝑥 ⁄365 1 + .051 𝑥 90⁄365
= 988.351 - 987,581
= $770 (Loss)
Check approximation: -32 points x $24 per point (approx) = - $768 (Loss)
2. Answer (c)
3. You observe the following information relevant to Australian conditions:
Forward rate agreements available today:
3 x 6 FRA = 5.10%
6 x 9 FRA = 5.20%
90 day Bank Bill futures quotes maturing in:
3 months = 94.90
6 months = 94.75
Your company has a rolling 90 day bank bill facility with its bank. It has just issued 200 x
$100,000, 90 day bank bills at Bank Bill Rate (BBR) + 1.5% and intends to roll over this debt at
the end of each quarter for the next three quarters. Company management is concerned about
the possible effect of forecasts for rising interest rates over the forthcoming year and has
instructed you to propose interest rate hedging strategies using (i) forward rate agreements and
(ii) bank bill futures.
Construct appropriate hedges for the next two rollover dates and evaluate the outcomes if the
BBR is (a) 5.02% in 3 months time, and (b) 5.50% in 6 months time (assume that 90 BAB
futures close 94.98 in 3 months and 94.50 in 6 months time).
(a) Hedging the first rollover using a Forward Rate Agreement
Forward rate agreements available today:

3 x 6 FRA = 5.10%
6 x 9 FRA = 5.20%
90 day Bank Bill futures quotes maturing in:
3 months = 94.90 = 100 – r , where r = 100 – 94.9 =5.1%
6 months = 94.75 = 100 – r , where r = 100 – 94.75 = 5.25%
BBR is (a) 5.02% in 3 months time, and

(b) 5.50% in 6 months time (assume that 90 BAB futures close 94.98 in 3 months and
94.50 in 6 months time).
To hedge, buy a 3 X 6 FRA at 5.10% with face value of $20m = 200 x 100,000 = Long position
in the FRA
Payoff from FRA =
FV FV
Payoff = −
 days   days 
1 + frate  1 + r 
 DIY   DIY 
20,000,000 20,000,000
= -
1+.051 𝑥 90⁄365 1+.0502 𝑥 90⁄365
= 19,751,617 – 19,755,467 = – $3,850
The payoff from the FRA was negative because the company was able to rollover its debt at
5.02% on the rollover date which was below the rate of 5.1% locked in by the FRA. – that is, the
company must pay the bank $3850. All up, the company’s rate of interest for the 90 day period
will be 5.1% which is the rate locked in by the FRA
Hedging the second rollover with a Forward Rate Agreement
Go long on 6 X 9 FRA at 5.20% with face value of $20m.
Payoff from FRA =

FV FV
Payoff = −
 days   days 
1 + frate  1 + r 
 DIY   DIY 
20,000,000 20,000,000
−
1+ .052 𝑥 90⁄365 1+ .055 𝑥 90⁄365
= 19,746,808 – 19,732,397 = + $14,411
The payoff from the FRA was positive because the company rolled over its debt at 5.5% on the
rollover date which was above the rate of 5.2% locked in by the FRA. – that is, the bank must
pay the company $14,411. All up, the company’s rate of interest for the 90 day period will be
5.2% which is the rate locked in by the FRA
(b) Hedge first roll-over with Bank Bill futures
Short 20 x 3 month bank bill futures contract at 94.90 = 5.10%

Why short? - We have a future obligation to sell bank bills and are concerned about interest
rates (YTM) rising. Therefore, profit from a short position in futures but pay higher rate in
physical market.
Spot and futures price must converge, so assume futures price to close out is 5.02%
Loss on futures
= BB at 5.10% - BB at 5.02
= $20m / [1 + 0.0510{90/365} ]
= $20m/[1 + .0510(90/365)] - $20m/[1 + .0502(90/365)]
= 19,751,617 – 19,755,467 = – $3,850
Hedge second roll-over with Bank Bill futures
Short 20 x 3 month bank bill futures contract at 94.75 = 5.25%
Spot and futures price must converge, so futures price to close out is 5.50%
Profit on futures
= BB at 5.25 - BB at 5.50% -
= 19,744,405 - 19,732,397 –= + $12,008
Note: this answer is lower compared to the FRA hedge because the interest rate locked into
with BAB futures was higher at 5.25% (compared with 5.2% for the FRA). On this basis, the
FRA was the better (cheaper) hedging instrument to choose.

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Topic 4: Interest Rate Futures

Suggested Solutions to Tutorial Questions

Date of issue 90 days 90 days

Feb 20 July 17 Jan

No of contracts = 5,000,000/1,000,000 = 5 contracts x 2 = 10 contracts

The number of contracts that should be shorted is, therefore,

$4,820,000 / $980,000 = 4.92 or for, practical purposes, 5 contracts

Obligation to buy at 95.22 = $988,351 (value of contract)

R = 100 – 95.22 = 4.78%

(a) Hedging the first rollover using a Forward Rate Agreement

Forward rate agreements available today:

BBR is (a) 5.02% in 3 months time, and

= 19,751,617 – 19,755,467 = – $3,850

Payoff from FRA =

= 19,746,808 – 19,732,397 = + $14,411

(b) Hedge first roll-over with Bank Bill futures

Short 20 x 3 month bank bill futures contract at 94.90 = 5.10%

Hedge second roll-over with Bank Bill futures

Short 20 x 3 month bank bill futures contract at 94.75 = 5.25%

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