Download Hedging with Interest Rate Futures

liquid capital
__________________________________
Interest Rates Derivatives Products
An Overview
Moscow Interbank Currency Exchange
21 November 2006
Summary
•
•
•
•
•
Liquid Capital Market’s - who we are and what we do
–
Our markets
–
Our specialities
Options market making
–
A view from the trading desk
–
How do we provide liquidity
Futures trading
–
A word on pricing
–
Basic strategies
What makes a market?
–
Product development as an integrated process
–
A fine balancing act
MOSIBOR / MOSPRIME: key considerations
–
Futures contracts: what market structure?
–
The virtuous circle: liquidity breeds liquidity – how do you build it and maintain it
liquid capital
__________________________________
•Liquid Capital - who we
are and what we do
– Our markets
– Our specialities
A short introduction
leading Market Maker and
liquidity provider on the main European and Asian
equity and fixed income products
• Liquid Capital Markets
• Liquid Capital Securities offers an
independent global execution
brokerage service for futures and options to an institutional
client base spanning more than
16 countries
Who we are
first
•We are the
port of
call for brokers with
institutional business
•We trade
large volume
What do we think
•Profitable trading is a
function of:
What do we think
•Speed and accuracy
•Research, knowledge
and insight
What do we think
believe
passionately
• We
in:
What do we think
relationships
based on trust
• Building
Why are we different
absorb
more trades in larger
volume therefore we can
make narrow spreads
even in difficult market
• We are able to
conditions
Why are we different
•We
control
volume and
therefore keep our
competitive
prices
Why are we different
•We are able to be the
first to act to the
changes in risk
Why are we different
commit to stand by
our prices
•We
Why are we different
understand the
• We
interplay between
technology and our
markets and products
Our specialities – Liquid Capital Markets
•Options
Our specialities – Liquid Capital Markets
•Pure market
making
Our specialities – Liquid Capital Markets
•Volatility
Our specialities – Liquid Capital Markets
•Risk
management
Our Markets
London
•
Single stock options
– All component stocks of Dax 30
– Nokia AG
•
Interest rate options
– Eurex Euro-BUND
– Eurex Euro-BOBL
– Eurex Euro-Schatz
– Euronext LIFFE Euribor
– Euronext LIFFE Short Sterling
•
Equity Index options
– FTSE 100
– DAX 30
– EuroStoxx 50
– AEX
Sydney
• Asian Index Product
– KOSPI options
– KOSPI futures
– NIKKEI options
– NIKKEI futures (NK225)
– JGB (Japanese Government Bond)
– XJO (options on ASX 200)
– AP (futures on Australian Share
Price Index – SFE)
•
Australian Single Stocks
– National Australia Bank (NAB)
– Telstra Corp (TLS)
– BHP Billiton Ltd (BHP)
– Rio Tinto (RIO)
– Woodside Petroleum (WPL)
– Woolworths (WOW)
– Commonwealth Bank (CBA)
– News Corporation (NWS/NWSLV)
Our specialities – Liquid Capital Securities
•Best
execution
Our specialities – Liquid Capital Securities
•Price
discovery
Our specialities – Liquid Capital Securities
•Specific
product
expertise
Our specialities – Liquid Capital Securities
•Coverage of futures
and options
worldwide and
across asset classes
Our specialities – Liquid Capital Securities
•Access to quotes
from Liquid Capital
Markets
Our specialities – Liquid Capital Securities
•Analysis and
research
Summary
•Options market making
–A view from the trading
desk
–How do we provide
liquidity
A view from the trading desk – A day in
the life…
• 6:30 am: trading team
gets in
• 6:35 am: catch-up with news and review
of book marks and quote sheets
• 6:55 am:
coffee and gents break
• 6:59 am:
last checks
A view from the trading desk – A day in
the life…
hell
breaks
loose!
•7:00 am:
A view from the trading desk – A day in
the life…
•6:00 pm: market closes
world returns to its
normal state
-
Who is the Market Maker?
not a car
dealer
•He is looking for fair
market equilibrium
•He is
Who is the Market Maker?
ads
transparency to the
• With his pricing he
market
• For a market maker it’s all about
demand and supply
The bottom line
• Trading options is a very
demanding job. You are
supposed to:
•Deal with the unknown
• Make
split-second decision
The bottom line
•Keep
tight spreads
•Keep the
market happy
•Keep your
happy
sales staff
The bottom line
• Keep your
risk manager
• Keep your
boss happy
happy
•Keep the money
coming in
How we do it
•Continuous
two-way prices
•Strict delta, vega and theta
limits
•Each position is
dynamically hedged
How we do it
•Initial hedge via futures then
we lock in the value of the option via a
combination of spreads
• The natural
order flow is
sufficient to absorb most of the
hedge activity
How we do it
•Tightness of spreads
heavily dependant on size
•We watch out for
directional players
How we do it
• We pay attention to
“distressed
options” i.e. options that have
moved
uncharacteristically away
from fair value
How we do it
•We watch out for spreads
that can turn very quickly
close to maturity if near to
at-the-money strike
prices
Interest Rates Options
General hedging categories
Type of exposure
Strategy
Short-term debt issuer
Buys puts on short-term IR future
Short-term investor
Buys calls on short-term IR future
Medium-term debt issuer
Buy series of puts on short-term
IR future
Medium-term debt investor
Buys series of calls on short-term
IR future
Long-term debt issuer
Buys puts on long-term IR (Bonds)
Long-term debt investor
Buys call on long term IR (Bonds)
A typical trade
• Market participants with
aims
different
•Speculator forecasts a rate hike
probability-based
trade on an expectation
• He enters a
A typical trade
•Hedger: wants to hedge exposure
against rate hike
eliminate the
risk of an expectation
• He wants to
A typical trade
• What do they do:
• Speculator - buys
• Hedger -
ladder
buys call spread
A typical trade – In practice
• Euribor cash rate: 3.50 %
• Euribor March 07 Future: 96.09 (implied rate 3.91)
• Indicative option prices
Ask
–
–
–
–
March
March
March
March
07
07
07
07
Euribor
Euribor
Euribor
Euribor
96.000
96.250
96.500
96.750
call
call
call
call
Bid
0.11 0.12
0.015 0.020
0.050 0.070
0.000 0.001
A typical trade – In practice
• Speculator buys ladder:
– Buys 1 March 07 Euribor 96.250 call
– Sells 1 March 07 Euribor 96.500 call
– Sells 1 March 07 Euribor 96.750 call
1000
500
0
95.5
-500
-1000
-1500
95.75
96
96.25
96.5 96.75
97
97.25
97.5
A typical trade – In practice
• Hedger sell call spreads
– Buys 1 March 07 Euribor 96.250 call
– Sells 1 March 07 Euribor 96.000 call
1000
500
0
95.5 95.75
-500
-1000
-1500
96
96.25
96.5 96.75
97
97.25
A typical trade – In practice
•LCM:
– Sells 2 March 07 Euribor 96.250 call
– Buys 1 March 07 Euribor 96.200 call
– Buys 1 March 07 Euribor 96.500 call
– Buys 1 March 07 Euribor 96.750 call
1700
1200
700
200
-300 95.5
-800
95.75
96
96.25
96.5 96.75
97
97.25
97.5
Considerations
• No
pull to par but drift
•Mean reversion of
volatility
and rates
Considerations
•Price options off an
underlying future or fwd
instrument
•Use
implied volatility
Summary
•Futures trading
– A word on pricing
– Basic strategies
Pricing an Interest Rate Future (1)
The price quotation of a 3 month
interest rate future is 100 minus the
(expected) future 3 month interest
rate, and the interest rate is quoted on
a per annum basis
3rd Wed
Today
of Dec
Dec future
=100 - 3.57
= 96.43
3m rate = 3.57%
Pricing an Interest Rate Future (2)
As time passes the Jun contract price will
fluctuate according to changing expectations
3rd Wed
of Dec
3m rate = 3.57%
This demonstrates
convergence
Dec future
= 100 - 3.57
= 96.43
Calculation of Forward Rates
in the Money Market (1)
These can be calculated from EURIBOR
rates
0
91 days
3m =3.6%
6m =3.7%
9m =3.8%
3m
90 days
3f6=?
6m
92 days
6f9=?
9m
Calculation of Forward Rates
in the Money Market (2)
(1+0.036 x 91/360) (1+3f6 x 90/360) = (1+0.037 x 181/360)
3f6
3f6
=
1+ 0.037 x 181/360
1+ 0.036 x 91/360
= 3.767%
-1
360
x
90
Calculation of Forward Rates
in the Money Market (3)
0
91 days
3m =3.6%
6m =3.7%
9m =3.8%
3m
90 days
6m
92 days
3f6=3.77%
6f9=?
9m
Calculation of Forward Rates
in the Money Market (4)
(1+0.037 x181/360) (1+6f9 x 92/360) = (1+0.038 x 273/360)
1+ 0.038 x 273/360
360
-1 x
6f9 =
1+ 0.037 x 181/360
92
6f9
3.9237%
Calculation of Forward Rates
in the Money Market (5)
0
91 days
3m =3.6%
6m =3.7%
9m =3.8%
3m
90 days
6m
92 days
3f6=3.77%
6f9=3.92%
9m
Hedging with Interest
Rate Futures (1)
Co. needs to borrow €20,000,000 for three months
starting in the future on the delivery date of the
Dec 3m € interest rate future (15/06)
Matching delivery date
Matching period
15/09
3m borrowing
No. of futures = €20,000,000 = 20
€1,000,000
15/03
Hedging with Interest
Rate Futures (2)
Co. needs to borrow €20,000,000 for six months
starting in the future on the delivery date of the
Dec 3m € interest rate future (15/12)
Matching delivery date
Period being hedged
Non-matching
period
15/12
15/03
6m borrowing
No. of futures = €20,000,000 x 6m = 40
€1,000,000 3m
Period covered by future
15/06
Hedging with Interest
Rate Futures (3)
The previous slide showed that we needed to sell
40 contracts.
The question now is which contracts should we sell?
There are two possibilities
1. Sell 40 Dec futures
Stack Hedge
2. Sell 20 Dec and 20 Mar futures
Strip Hedge
Calculating the Strip Rate
If a strip hedge is utilised, the expected
rate (the strip rate) achieved can
be calculated as follows
 
Day in 6mth period 
 
1   rstr ip 
360

 
 
Day sinDecPeriod   
Day sinMarPeriod 
1

r
Dec


1

r
Mar






 
360
360
  

 
Hedging with Interest
Rate Futures (4)
Co needs to borrow €20,000,000 for three months
starting in the future on 15/01. The delivery date of
the Dec 3m £ interest rate future is 15/12
Non-matching delivery date
Matching period
15/12 15/01
15/03
3m borrowing
No. of futures = €20,000,000 x 3m = 20
€1,000,000
3m
Let’s say we choose to sell 20 Mar contracts
Hedging with Interest
Rate Futures (5)
The basic hedge must now be adjusted
to reflect the mismatch in dates.
As a borrower, using a later dated contract
will expose the hedger to a flattening yield
curve, whilst using an earlier dated contract
will expose the hedger to a steepening yield
curve
Yield Curve Exposure - Steepening
Longer-dated
rates rise more
Shorter-dated
rates rise less
The forward rates will rise relative to near rates,
i.e. the further futures contract will fall MORE
Yield Curve Exposure - Flattening
Longer-dated
rates fall more
Shorter-dated
rates fall less
The forward rates will fall relative to near rates,
i.e. the further futures contract will rise MORE
Hedging with Interest
Rate Futures (6)
To protect against yield curve risk we should
execute an appropriate number of
futures intra-market spread trades
Long spread - buy nearer dated, sell later dated will be profitable if the yield curve steepens
Short spread - sell nearer dated, buy later dated
- will be profitable if the yield curve flattens
Hedging with Interest
Rate Futures (7)
A hedger protecting against an increase in
interest rates will have sold futures as the basic
hedge.
If, because of mismatching dates, they are using
later dated contracts, they need to additionally
execute an appropriate number of short spreads.
Hedging with Interest
Rate Futures (8)
No. of
Basic
=
x
spreads
number
Time between start of exposure
period and future’s delivery date
Future’s contract
length
15/12 15/01
15/03
3m borrowing
2
No. of spreads = 20 x
= 13.33
3
2 months
Hedging with Interest
Rate Futures (9)
Sell 2.67 Dec/Mar spreads
Summary
Dec
Basic
Mar
-20
Spreads
-13.33
+13.33
Total
-13.33
-6.67
Rounded to -13
-7
i.e. still short 20 contracts net total
Hedging with Interest
Rate Futures (10)
Alternatively: sell 20 Mar futures and additionally
Sell 13.33 Mar/Jun spreads
Summary
Mar
Basic
-20
Spreads
-13.33
+13.33
Total
-33.33
+13.33
Rounded to -33
Jun
+13
i.e. still short 20 contracts net total
Hedging with Interest
Rate Futures (11)
Another alternative would be to do the basic
hedge by selling 20 Dec futures
As this is using earlier dated contracts,
the short hedger will now have to do a
number of long spread trades
15/12
15/01
15/03
3m borrowing
1
No. of spreads = 20 x
= 6.66
3
1 month
Hedging with Interest
Rate Futures (12)
Summary
Dec
Basic
-20
Spreads
+6.67
-6.67
Total
-13.33
-6.67
Rounded to
-13
Mar
-7
Note that after the basic hedge has been adjusted
with spreads to cover the yield curve risk, the
answer comes to the same whether we start with
Dec or Mar contracts as the basic hedge
Calculating the Strip Rate for
Non-Matching Periods (1)
A company needs to hedge for a 6-month period
starting on 20 Jan. What is the anticipated strip
rate if the following futures prices apply?
Dec (15/12) 94.45
Mar (20/03) 94.62
Jun (19/06) 94.14
Calculating the Strip Rate for
Non-Matching Periods (2)
Futures prices:
20/01
15/12
Dec 94.45
Mar 94.62
20/04
20/03
Jun 94.14
20/07
19/06
( 5.55% x 59/360 + 5.38% x 91/360 + 5.86% x 31/360 ) x 360/181
= 5.5176%
Summary
•What makes a market?
– Product development as an
integrated process
– A fine balancing act
What makes a market
•A
liquid underlying
•Diversity
•Easy
of players
access to liquidity
What makes a market
•Technology sophisticated
–
trading platform
• Product
range
•Margining efficient usage of
–
collateral
What makes a market
•Simple contract design
•Reasonable exchange fees
•Transparency
What makes a market
well capitalized
clearing house
•The upshot: no need
for credit lines
•A
Product development
• Exchange traded product development is
users needs and
filling gaps in the offering
about meeting
• It takes deep
understanding of
your client base
• It implies
hard choices
Product development
• It requires
• It takes
focus
time
•Exchanges cannot do it alone
anymore
Product development
•Market participants
cannot do it alone
• It takes a
partnership
• It’s a crowded market you are
fighting for attention
Product development
• It is a
• The
phased approach
priority is in creating a healthy
underlying market
success is a mix of
ingredients
• The
Product development
•Incentives
•Visibility
•Relevance
Product development
• Ask the question:
Who needs it
most?
Product development
choose the
path of least
resistance!
• Above all
A delicate balancing act
Product development
+
Market Structure
+
Marketing
=
Successful
Product
A delicate balancing act
• Market structure is
key
•Order driven book
•Designated Market Makers and
Liquidity Providers with
contractual obligations
Product development - Marketing
•Best form of marketing?
Education!
Marketing
• Identify who has
more to gain
from using these products and in
return can
• Be
provide support
pervasive
Marketing
• Create a
community of
users
• Educate,
educate,
educate
Marketing
• Enrol people who will
champion
your product
• Be
open minded
•One on one
Marketing
•Seminars
•Sponsored
articles
•More seminars
Marketing - Communication
• Be
committed
• Be
passionate
• Be
uncompromising
• Make it
relevant
Summary
•MOSIBOR / MOSPRIME
– Underlying market
– Futures contracts: what
market structure
– The virtuous circle:
liquidity breeds liquidity
MOSIBOR/MOSPRIME - Key considerations
• Underlying market still relatively
small
•Promote the underlying market
actively
• Market it to
issuers – supra and
corporate
• Improve overall
visibility
MOSIBOR/MOSPRIME – Market Structure
•Clarify legal status of Exchange
Traded Derivatives contracts is Russia
•Order-driven based on
pro-rata algorithm, with priority given to
the first order at
best price
MOSIBOR/MOSPRIME – Market Structure
• Introduce a Designated Market
scheme with
incentives
Maker (DMM)
wholesale
facilities
• Introduce
MOSIBOR/MOSPRIME - Key considerations
• Work with brokers and parties that
provide
flow
• Make data
freely available
• Continue to improve the technology – STIRS are
sophisticated products!
The benefits of central markets
•Natural venue where
counterparts can be found
• Price
discovery
•Transparency
• Liquidity reduces spreads and
cost
execution
The benefits of central markets
• Market depth
risk
reduces execution
“sticky” - easy to
• Liquidity is
access, difficult to move
• Exchanges
liquidity
invest in developing
Liquidity breeds liquidity
•The virtuous circle
Liquidity breeds liquidity
• Individual Liquidity Provider
(ILP)
• Euribor Futures Contract STIR Liquidity
Provider (SLP)
• Short Sterling Futures Contract
• Eurodollar Futures Contract
(SLP)
(SLP)
• New Market Participant – (NMP)
Liquidity breeds liquidity
• Individual Liquidity Provider (ILP)
•Lower
exchange fees for
individual
proprietary traders
• Focus on developing liquidity on the
months
back
•Proven consistency in supporting order flow
in long-dated contracts
Liquidity breeds liquidity
• Euribor Futures Contract STIR Liquidity
Provider (SLP)
•Volume based discounts for
proprietary traders – firms and individuals
•Proven consistency in facilitating pricediscovery and injecting liquidity
Liquidity breeds liquidity
• Market makers
• Incentives
love incentives
reward them for adding
value and putting capital at risk
• They have to
work hard for them
Liquidity breeds liquidity
right balance
• Requires the
of
incentives and fair market structure
• In Euribor the exchange offers liquidity
different
market participants
provision schemes aimed at
result is a vibrant
• The
market
and tight
Disclaimer
The material and information set out in this presentation is not intended to be an offer to buy or sell
any derivatives. Any expression of opinion is based on sources believed to be reasonably reliable but
is not guaranteed as to accuracy or completeness.
The material and information herein is general and for informational purposes only. The derivative
market comprises volatility and considerable risks. To the maximum extent permitted by law no
responsibility or liability can be accepted by Liquid Capital Securities Limited, any company or
employee within its group for any action taken as a result of the information contained in this
presentation. You are requested to seek specific advice when dealing with specific circumstances.
Liquid Capital Securities is regulated by the UK Financial Services Authority.