An Introduction to International Capital Markets: Products, Strategies, Participants, Second Edition

11

Interest Rate Forwards and Futures

11.1 CHAPTER OVERVIEW

Interest rate forwards and futures are derivative contracts based on underlying money market interest rates. This chapter begins by discussing a key product known as a forward rate agreement (FRA). An FRA is a bilateral over-the-counter derivative contract directly negotiated between two parties fixing the rate of interest on a notional loan or deposit for a period of time in the future. The chapter sets out the FRA settlement procedure and how the forward interest rate can be established by cash market interest rates. It considers a typical hedging application for a corporate, using an FRA to lock into a future funding rate. Interest rate futures are the exchange-traded equivalents of FRAs. Because they are freely tradable they have the advantage of liquidity. The chapter explores the structure of key interest rate contracts such as the three-month Eurodollar futures traded on the Chicago Mercantile Exchange and the three-month EURIBOR futures contract traded on Eurex. It considers trading and margining procedures and the role of the clearing house. Finally, the chapter assesses the trading and hedging applications of interest rate futures and how they can be used to lock into a known investment or borrowing rate for a future period of time.

11.2 FORWARD RATE AGREEMENTS (FRAs)

An FRA is a bilateral contract agreed between two parties fixing the rate of interest that will apply to a notional principal sum of money ...