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2.2.2 Interest Rate Futures and Forward Rate Agreements

Forward rate agreements (FRAs) are the first derivatives we encounter and are traded contracts betting on the future settings of LIBOR. Since they are over-the-counter instruments, their characteristics are far from standard. The contract consists of an exchange at some time in the future between a cash flow fixed at that time in the future and a cash flow fixed on the day in which the contract is entered upon. FRAs are referred to as โ€œthe in x months for x months FRA.โ€ For example, the USD in three months for a six-month FRA would be a contract in which one party pays the six-month rate fixed in three months and the other party pays a rate fixed today. From the screen- shot shown in Figure 2.3, the mid quote of that rate would be 0.457%. As we can also see from the same figure (which is in itself cropped from a bigger screen), the combinations of contract expirations and rate lengths are varied, at least for the major currencies.

Interest rate futures are similar to FRAs but are exchange traded. They are available only for the most developed currencies and are used for building the short end of the curve (less than one year). In the case of the U.S. Dollar, they are available up to 10 years and extremely liquid (hence the instrument

A sample of quotes of forward rate agreements for major currencies. Source: Thomson Reuters Eikon.

FIGURE 2.3 A sample of quotes of forward rate agreements for major currencies. Source: Thomson Reuters Eikon.

of choice for constructing a curve) for the first few years, and are usually used for maturities up to five years. Being an exchange-traded contract, it has a standardized quotation. For example, for USD it is a derivative on the three-month U.S. rate and there are four maturities every year in March, June, September, and December. The contract expires on the same weekday (two business days before the third Wednesday of the month) of the relevant month (e.g., March).

Futures are hedging instruments used by investors to lock in a specific interest rate: this is captured in the notation where the future is quoted as the difference between 100 and the rate locked at the moment of purchase. If today a future contract is trading at 97 it means that an investor is able to fix the rate at 3% at the maturity of the contract. Let us stress that the fixing or locking of a specific interest rate only happens when the future is used as a hedging instrument, that is, only when it is used in conjunction with another financial instrument taking an opposite view on interest rates movements.

We said that futures and FRAs are similar instruments. One could actually claim (a claim that we shall not prove) that they are the same thing seen in two different probability measures. Because of this difference, if we want to use interest rate futures in the construction of a discount curve we need to take into account the so-called convexity adjustment. The value itself depends on the model we use, but in essence this means that if we see a quote of 97, we actually need to use 97 + c, where c is the adjustment, before implying what the rate is that we expect to set at the maturity of the contract.

While it is perhaps early to discuss what type of instruments contribute to which of the two main aspects of curve construction (discounting and future rates generation), we can safely say that FRAs (and futures) are very important in the latter role: for some currencies, particularly the more liquid emerging markets currencies, they constitute the most liquid instruments in the six-month to one-year range.

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