Hedging With Interest Rate Futures

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Are you apprehensive about interest rate movements? If yes, hedge yourself against adverse developments in rates and thereby you can operate your costs with an effective instrument - Interest Futures (Irf). These short term contracts are based on basal assets which are normally interest bearing securities.

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Various types of Irfs are normally exchange traded and few examples of Irfs are 13 week Treasury Bills, 3 month Eurodollars, one month Fed funds etc.

• Treasury bills are normally regarded risk free as they are backed by the United States government, any way to hedge against interest movements on these securities T-bill futures are used and they are normally available in quarterly contracts.

• Eurodollars, unrelated to Euro, are deposits in banks surface the United States which are denominated in U.S. Dollars. Such deposits do not fall under the jurisdiction of the Federal Reserve. Similarly Euroyen are deposits in Japanese Yen held surface Japan.

• Fed Funds are mandatory reserves with Federal preserve contributed by all commercial banks.

Hedging with Interest Rate Futures

The most base practice in rate futures shop to hedge positions bearing interest risk is to enter into an offsetting futures contract. One can also hedge forward borrowing rates using Irfs. Investors normally enter into a buy or sell transaction in the futures shop today, which they transact in the cash shop in future.

The size of interest rate hereafter contracts depends on exchanges and the type of contracts being traded. Price of short term interest contracts are normally based on index value (set at 100) less the interest rate. Bond based contracts secure their price from the yield on notional security.

Irfs yield many benefits to discrete players. These instruments enable primary Dealers to conduct their interest rate risk and also enhance earning capacity. Irfs further also aid in reducing transaction costs, eliminate credit and hamlet risks. Banks are benefited with Irfs in managing their repricing risk, yield curve risk and basis risk. Capital adequacy ratio can also be improved with Irfs as hedged assets need lesser capital allocation. Corporates can enhance their credit ratings as hedging enhances their 'interest coverage' and 'debt-service coverage' ratios.

Though, interest rate futures are extremely useful in the current times against interest rate movements, one must be fully aware of the discrete risks and complications complicated in its usage.

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