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TO GET STARTED TRADING CME INTEREST RATE PRODUCTS
Interest rates, which loosely can be defined as the price of money, affect the liveli-
hoods of individuals and businesses each and every day. The cost of a home
mortgage, the finance charge applied to a credit card balance, the amount of inter-
est received on a savings account or the coupon on a corporate bond issue are all
examples of the interest rates that influence our personal and commercial activities.
Like all goods and services, interest rates are determined by the market forces of
supply and demand; however, the federal government also can influence key interest
rates via monetary policy, that is, by adjusting them upward or downward to slow
down or stimulate the economy. Interest rate levels often are regarded as key
indicators of a country’s economic health.
The money market comprises the markets for short-term, heavily traded credit
instruments with maturities of less than one year. Money market instruments
include Treasury bills, commercial paper, bankers’ acceptances, negotiable certifi-
cates of deposit, Federal Funds, and short-term collateralized loans. While the
markets for these various instruments are distinct, their respective interest rates
reflect general credit conditions with adjustments for differences in risk and liquidity.
As the money markets have become more liquid, money managers borrow and
lend in whichever markets offer a price advantage. No longer willing to leave
balances as unproductive, non-interest-earning demand deposits, corporations
today are making more aggressive use of cash management techniques. Cash
market participants primarily use the CME’s interest rate products for pricing
and hedging their money market positions.
CME INTEREST RATE
3
T H E C M E - S I M E X M U T UA L
O F F S E T S YS T E M ( M O S )
CONTRACT MONTH SYMBOLS able to liquidate or offset your original HEDGING WITH surer projects that cash flows will
January F July N
position and realize a gain. If you are I N T E R E S T R AT E F U T U R E S require a $1 million bank loan on
wrong, however, your trade will result Interest rate futures can be used to December 16. The contractual loan
February G August Q
in a loss. hedge against an existing or future rate will be 1% over the three-month
March H September U
The design of most CME interest interest rate risk. This is accom- Eurodollar (LIBOR) rate on that
April J October V
rate futures contracts features a min- plished by maintaining a futures date. LIBOR is currently at 5.56%.
May K November X
imum price move, or “tick” of 0.01. position that will generate profits to The December Eurodollar futures,
June M December Z
Gains or losses, therefore, are calcu- cover (or offset) the losses associated which can be used to lock in the for-
lated simply by determining the with an adverse move in interest ward borrowing rate, are trading at
rates. It is important to note that a
7
94.24, implying a forward Eurodollar extending the duration of the loan. or vice versa. When using futures month funds at 5.75%, but has to roll
rate of 5.76% (100.00 – 94.24). By sell- Liability managers can achieve the contracts as part of a swaps transac- over this funding in three successive
ing one December Eurodollar futures same effects by doing the opposite, tion, it is important to note that quarters. If he does not lock in a fund-
contract, the corporate treasurer i.e., selling futures to lengthen their futures cover single interest periods ing rate and interest rates rise, the
ensures a borrowing rate of 6.76% for liabilities and buying futures to only, whereas swaps are multi-period loan could prove to be unprofitable.
the three-month period beginning shorten them. instruments. To hedge between The three quarterly re-funding
December 16. This rate reflects the The use of futures may be an futures and swaps then, it is neces- dates fall shortly before the next
bank’s 1% spread above the rate attractive alternative when physical sary to transact a strip, i.e., a three Eurodollar futures contract
implied by the futures contract. restructuring is not possible; for coordinated purchase or sale of a expirations in March, June, and
example, term deposits cannot be series of futures contracts with September. At the time the loan is
Modifying Maturities bought back prior to their maturity successive expiration dates. For a made, the price of each contract is
With either assets or liabilities, dates. It also may be less expensive detailed description of using 94.12, 93.95, and 93.80, corresponding
hedging can serve as an alternative to to use futures because transaction Eurodollars to construct interest to yields of 5.88%, 6.05%, and 6.20%,
restructuring the portfolio in the cash costs may be lower than those in rate swaps, see the CME strategy respectively. Coupled with the initial
markets. Asset managers can cash markets, or liquidity conditions paper titled “Comparing Eurodollar funding rate of 5.75%, the bank could
lengthen the effective maturity of in the cash market would result in Strips to Interest Rate Swaps.” lock in a cost of funds for the year
short-term investment assets by buy- substantial market penalties. equal to 6.11%.*
ing futures contracts, or shorten the Locking in a Funding Rate The banker knows that the
effective maturity by selling futures. Swapping Fixed and Floating Rates Consider the case of a bank that money needed to fund the loan can
Assume a lender places $1 million in Many swaps dealers incorporate funds itself with three-month be locked in for a year at approxi-
a three-month time deposit at 5% in CME interest rate futures into their Eurodollar Time Deposits at LIBOR. mately 6.11% in the futures market.
September. After some time, the portfolios to hedge and/or arbitrage Let’s assume this bank has a customer This rate can be used as a basis for
lender believes that rates will decline their money market swaps. One of who wants a one-year, fixed-rate loan quoting the fixed rate to the cus-
in the coming months and wants to the most common uses of Eurodollar of $10 million, with interest to be paid tomer. Generally speaking, the rate
extend the duration of the loan out to futures is to convert a floating inter- quarterly. At the time of the loan quoted will cover hedging expenses
six months. At this time, the lender est rate exposure to a fixed rate, disbursement the banker raises three- and allow a profit margin.
can purchase a December Eurodollar
*
futures contract, thereby synthetically
[ (( 91 91 91
)
1 + .0575 x 360 ) x ( 1 + .0588 x 360 ) x ( 1 + .0605 x 360 ) x ( 1 + .0620 x 360 ) - 1 x 360 ≈ 6.11%
91 364
]
8 9
contracts would be liquidated in The unhedged interest expense however, the actual funding over the
June; and September contracts over the four quarters would have term of the loan was, on average, one
would be liquidated in September. been 6.89%, substantially higher, in and one-third basis points lower than
In this scenario, the banker is able fact, than the hedged expense. It the futures liquidation rates. Put
to re-fund at 7.00%, 7.15%, and 7.35% should be recognized that effective another way, these basis adjustments
for the respective quarters. The futures hedges materially lock in an positively affected the performance.
corresponding futures are liquidated interest rate, precluding both advan- The minimal difference between
at 92.98 (7.02%), 92.80 (7.20%), and tage and loss from rate movement. the target rate and the effective
92.66 (7.33%). The overall results Had interest rates moved lower over funding rate can be attributed to the
are shown below. the life of the hedge, the bank would fact that the re-funding dates were
have incurred an opportunity cost quite close but not identical to the
QUARTERLY EURODEPOSIT COSTS roughly equal to the difference futures expiration dates. If the
Qtr 1: $10 million x .0575 x 91/360 = $145,347 between the effective (hedged) rate respective dates were further apart,
Qtr 2: $10 million x .0700 x 91/360 = $176,944 and the lower rate which could have the funding rates and the futures
Qtr 3: $10 million x .0715 x 91/360 = $180,736 been realized by forgoing the use rates would not necessarily converge
If the loan is made and the risk Qtr 4: $10 million x .0735 x 91/360 = $185,792 of futures. as closely as those used in the above
is hedged in the futures market, the $688,819 (6.89%) Recall that the banker had example.
banker would sell 10 contracts for expected to lock up funding at 6.11%. This example of a one-year loan
LESS THE FUTURES PROFITS
each expiration, reflecting the fund- In fact, funds were acquired at 6.03%, funded with three-month deposits
Mar: 10 contracts x (9412-9298) x $25 = $28,500
ing need of $10 million per quarter. or approximately eight basis points illustrates a negative interest rate
Jun: 10 contracts x (9395-9280) x $25 = $28,750
Then, on the refinancing dates, the lower. This discrepancy occurred “gap”– that is, where shorter-term
Sep: 10 contracts x (9380-9266) x $25 = $28,500
banker would take in three-month because of less-than-perfect conver- liabilities are funding a longer term
Futures gain ($85,750) (0.86%)
Eurodeposits and simultaneously gence between the cash re-funding asset, and rising interest rates will
Total interest expense $603,069
liquidate the appropriate hedging rates and the futures liquidation have an adverse impact. The same
Effective rate 6.03%
contracts by buying them back. rates. If the bank had funded at basic hedging approach can be fol-
With the March refunding, the March exactly the same rate as the futures lowed to remedy an overall balance
contracts would be liquidated; June liquidation rate, the target would sheet maturity mismatch.
have been achieved. In this case,
10 11
I N T E R E S T R AT E
STRIP COLOR CODES
To expedite the execution of strip and three-year bundles are available Eurodollar packs (covering years two
Copper Ten 37-40
trades the CME offers bundles and for Euroyen futures. through ten) and two Euroyen packs
packs for Eurodollar and Euroyen Bundles are quoted on the basis of (spanning years two and three) avail-
futures. Bundles and packs are simply the net average price change of the able for trading at a given time.
“pre-packaged” series of contracts contracts in the bundle relative to
that facilitate the rapid execution of the previous day’s settlement price,
strip positions in a single transaction in increments of one-quarter (1/4) of
rather than constructing the same a basis point.
positions with individual contracts.
12
ON INTEREST RATE FUTURES
FINAL SETTLEMENT CONTRACT FINAL SETTLEMENT/DELIVERY Options on interest rate futures pro- option position by purchasing a call
P RO C E D U R E S 13-week The final settlement price will be vide the opportunity to limit losses or put, a performance bond (margin)
Treasury bills equal to 100 minus the weighted aver-
The CME’s interest rate futures are age discount rate of the 91-day T-bill while maintaining the possibility of is not required because the price
auction in the week of the third
much like Forward Rate Agreements Wednesday of the contract month.
profiting from a favorable move in paid on the option, also referred to
(FRAs) in that delivery of the face value Three-month All open positions are debited or rates. Options are analogous to an as the option premium, is the maxi-
Eurodollar credited based on the final settlement
of the contract never occurs. All CME time deposits price as determined by the British
insurance policy – the option buyer mum loss that can be incurred by a
interest rate futures are cash-settled Bankers Association Interest pays a price or premium in return long option position.
Settlement Rate for three-month dol-
upon expiration. Long and short posi- lar deposits at 11:00 a.m. London time for the right to buy (call) or sell The CME lists options on
on the contract’s last trading day. The
tions are simply marked to a final (put) a futures contract, within a Eurodollars, LIBOR, 13-week
cash market offered rate for three-
settlement price. The following table month Eurodollar time deposits (or stated period of time, at a predeter- T-bills and Euroyen (Euroyen options
LIBOR) is deducted from 100.00 to
shows the final settlement procedures determine the final settlement price. mined price known as the strike are not eligible for mutual offset).
for the CME’s interest rate contracts. One-month Settled in a manner analogous to that (or exercise) price. If the price of Quarterly and serial (non-quarterly)
LIBOR for the Eurodollars, however, the cash
market offered rate for one-month the underlying futures contract options are available for Eurodollar,
Eurodollar time deposits is deducted
never reaches a level that makes it LIBOR, Euroyen, and 13-week T-bills.
from an index of 100.00.
Three-month The final settlement price is based on profitable for the option buyer to Mid-curve options, which are short-
Euroyen time the interest rate for three-month yen
exercise his/her right, the option dated, American-style options
deposits deposits offered to prime banks in
Tokyo. This is the same final settle- expires worthless. on long-dated Eurodollar futures,
ment price used by the Singapore
International Monetary Exchange All CME interest rate options are also are listed. These options have
(SIMEX). American-style, meaning that the as their underlying instrument
One-month The final settlement price is deter-
Federal mined by subtracting from 100 the options may be exercised on or Eurodollar futures contracts one and
Funds Rate arithmetic mean of the Fed Funds before expiration. When taking an two years out. Because the options
effective overnight rates calculated
by the Federal Reserve during the are short-dated, they offer a low-pre-
period covered by the contract.
mium, high-time-decay alternative in
this segment of the yield curve.
14 15
OPTIONS ON
E U RO D O L L A R F U T U R E S
Oct, Nov and Mar, Jun, Sep, Dec for observable. The price of an option is futures contract will be bought (in the case of
calls) or sold (in the case of puts)
two-year mid-curves shaped by the following factors:
NUMBER LISTED 6 2 8: 2 serial, 4 red quarterly, Intrinsic Value: The amount the futures price is
1. Option strike price versus the higher than a call’s strike; or the amount the
2 green quarterly
current underlying futures price: As a futures price is below a put’s strike.
LAST TRADING DAY 11:00 a.m. London time on 2:00 p.m. Chicago Time on 2:00 p.m. Chicago Time on
the second London bank the Friday preceding the 3rd the Friday preceding the 3rd rule of thumb, the closer an out-of- Time Value: The part of the option price that is
not intrinsic value
business day preceding the Wednesday of the contract Wednesday of the contract the-money option is to being at-the-
third Wednesday of the month month At-the-money: An option is said to be “at-the-
money, the higher the option price. money” when the underlying futures price is
contract month
For in-the-money options, the more equivalent to the option strike price.
SETTLEMENT/EXERCISE Cash-settled Position in front quarterly Quarterly options: Position
futures contract in the corresponding futures an option is in-the-money, the In-the-money: An option is said to be “in-the-
contract expiring either money” when the underlying futures price is
greater its value and thus, price. greater than a call option’s strike price or less
one or two years after the
than a put option’s strike price.
option expires; 2. Time to expiration: Premiums
Serial options: Position in Out-of-the-money: An option is said to be
on options with a greater time to
the next quarterly futures “out-of-the-money” when the underlying
NUMBER LISTED Two quarterly and two serial months 3. Market volatility: Generally, the
LAST TRADING DAY Friday 2:00 p.m. Chicago Time preceding the third Wednesday of the contract month greater the volatility of the underly-
SETTLEMENT/EXERCISE Position in the 5-year bundle (First 20 quarterly Eurodollar contracts)
ing futures price, the more valuable
the option.
17
To determine how much an inter- futures position, which determines a The effective floor or ceiling hedger could guarantee a minimum
est rate option premium is in dollar forward investment return for an rate provided by the option is deter- return of 5.75 percent for a cost of 12
terms, simply take the stated price, asset, the purchase of a call option mined by its strike price and the basis points. In other words, the real-
for example 1.32 points, and multiply can be substituted. The call gives the premium paid. The “strike yield” ized minimum return would be 5.63
by $2,500. In this case, the premium right to buy the futures contract at a (simply 100 minus the option strike percent as a worst case (5.75 – .12).
equals $3,300. stated price, providing a floor for a price) is adjusted to reflect the cost If the rate falls below 5.75 percent,
return on the asset while preserving of the option. For example, suppose futures prices would rise and the call
HEDGING WITH OPTIONS the opportunity for a potential profit. the following prices were observed: option would increase in value. The
19
GLOBEX® THE TRADING
GLOBEX is a network-based electronic
trading system developed by the CME
and Reuters to provide after-hours
access to exchange-traded products.
All of the CME’s interest rate products,
While it is true that the 94.25- T H E WO R L D O F I N T E R E S T floor via telephone or data transmis-
with the exception of Euroyen, are
strike call provides a more attractive R AT E T R A D I N G N E V E R S L E E P S sion lines. Upon receipt, the order is
available for GLOBEX trading. CME
worst-case scenario, it does so for a At any time of the day or night time-stamped and delivered to the
members, their parents and affiliates,
larger upfront cost. The purchaser someone, somewhere, is trading trading area, or pit, by an order clerk
and CTA’s are eligible to have GLOBEX
of the 94.25-strike call pays $300 for interest rates. You can too. CME or runner. (If you’re trading on
terminals. Members and their parent/
this protection ($25 x 12 basis interest rate products are available GLOBEX, your order would be
affiliates can trade for their own
points), while the cost of the 94.50- for trading virtually 24 hours a day. entered into a GLOBEX terminal. If
account or for their customers.
strike call is only $62.50 ($25 x 2.5 Pit trading on the CME trading floor your order is matched, it is confirmed
A primary benefit of trading via
basis points). begins at 7:20 a.m. (Chicago time), to your broker and then to you. To
GLOBEX is the opportunity for pre-
To hedge floating rate liabilities, and runs until 2:00 p.m. Monday ensure fairness, the GLOBEX system
execution discussions. Potential coun-
put options present a similar set of through Friday. Once these open processes all orders based on price
terparties may discuss their intent to
choices. A short futures contract can outcry trading hours end, trading and time priority. Your broker can give
place or fill an order prior to entering
establish a forward rate of 5.76 per- resumes at 2:45 p.m. on GLOBEX® . you further GLOBEX information.)
it through a GLOBEX terminal. If the
cent; the 94.00-strike put can provide GLOBEX is the CME’s automated The trading pits are each divided
trade has not been filled within a rea-
a ceiling rate of 5.95 percent (100.00 order-entry and matching system, into a number of sections designated
sonable period of time (15 seconds for
– 94.00 – .05) for the premium of available worldwide. The GLOBEX for trading in particular contract
a futures order and 30 seconds for an
$125 ($25 x 5 basis points); and the trading session ends at 7:05 a.m. the months. No trading may occur
options order), the party with which
94.25-strike put can provide a 5.62 following business day. ( You can even outside a contract’s assigned pit, nor
the pre-execution discussion took
percent (100.00 – 94.25 – .13) ceiling trade interest rates on Sundays on is trading permitted at any time other
place can enter the opposite side.
rate for the price of $325 ($25 x 13 GLOBEX, beginning at 5:30 p.m.) than during those hours which have
CME interest rate products are
basis points). been designated by the Exchange.
traded on GLOBEX from 2:45 p.m. to
H OW A N O R D E R I S E X E C U T E D
7:05 a.m. Chicago time. On Eurodollar
Once you’ve made your trading deci- F L O O R B RO K E R
and LIBOR expiration days, traders can
sion, you would then contact your RESPONSIBILITIES
access the products exclusively through
futures broker. After you give your An individual floor broker is respon-
GLOBEX because the final settlement
broker the buy or sell order, it is sible for executing your order in the
occurs at 11:00 a.m. London time
transmitted directly to the CME trading pit. (Your brokerage firm can
(5:00 a.m. Chicago time), before the
execute it on the GLOBEX system.)
CME trading floor opens.
21
HOW A TRADE IS MADE
23
TO GET STARTED
Est vol 492,446; vol Fri 376,752; open int 2,386,860, +3,387.
All brokers in the U.S. must pass of trading) and a futures account
Volume The number of contracts traded (one side of
each trade only) for each delivery month during the trad- qualifying examinations and receive agreement outlining how the account
ing period.
a license before they are permitted is to be handled by the broker.
Open interest The accumulated total of all currently
Options outstanding contracts (one side only). Refers to unliqui- to handle customer orders. You can
2 dated purchases and sales.
EURODOLLAR (CME) -$1 million; pts of 100% check on the registration status of DEPOSIT PERFORMANCE BOND
Strike Calls-Settle Puts-Settle Strike price The price at which the buyer of a call
Price Dec Jan Feb Dec Jan Feb (put) option may choose to exercise the right to purchase your broker, or “associated person,” Before you open an account to trade
9400 0.56 0.55 . . . . 0.00 0.00 0.01 (sell) the underlying futures contract. Also known as
exercise price.
by calling the National Futures CME interest rate futures or options,
9425 0.26 0.32 0.33 0.00 0.01 0.02
9450 0.03 0.10 0.13 0.02 0.05 0.08
Put The right, but not the obligation, to sell a futures
Association at 312-781-1410. you must deposit cash or certain
9475 0.00 0.02 0.04 0.24 0.22 . . . . contract at the option’s strike price on or before the expi-
securities with your broker. The
9500 0.00 0.00 . . . . 0.49 . . . . . . . . ration date.
9525 0.00 . . . . . . . . 0.74 . . . . . . . .
Call The right, but not the obligation, to buy a futures
Est vol 148,132 Fri 70,693 calls 66,151 puts contract at the option’s strike price on or before the expi-
Op int Fri 1,078,385 calls 1,232,462 puts ration date.
24 25
CME establishes minimum initial and F I N A N C I A L S A F E G UA R D S CONCLUSION
maintenance performance bond levels OF THE CME The Chicago Mercantile Exchange is
for all products traded at the The Chicago Mercantile Exchange recognized as the world’s leading
Exchange; your broker’s require- uses sophisticated risk management marketplace for short-term interest
ments may be higher. (Buyers of and financial surveillance techniques rate futures and options. These con-
options pay the full price of the If your account falls below the to protect Exchange members and tracts serve as benchmarks for
option and are not subject to perfor- maintenance level (a set minimum customers from default on futures pricing a wide range of financial
mance bond requirements.) performance bond per outstanding and options contracts. The Exchange products. CME interest rate prod-
futures trade), your broker will con- Clearing House acts as the third party ucts offer a myriad of expirations and
M A R K I N G TO T H E M A R K E T tact you for additional funds to to every trade (the seller to every combinations covering interest rate
At the end of each trading day and replenish it to the initial level. Of buyer and the buyer to every seller), exposure from one day to ten years
all following days that your position course, if your position generates a thus ensuring the integrity of all out on the yield curve. Trading inter-
remains open, the contract value is gain, you may be able to withdraw trades. The CME is financially est rate futures and options at the
“marked-to-the-market”; your any excess funds from your account. backed by its clearing members as CME gives market participants the
account is credited or debited based well as a special Trust Fund. This most efficient, global risk manage-
on that day’s trading session. This COMMISSIONS combination provides unparalleled ment tools available today.
system gives futures trading rock- Commission costs vary according to safeguards for the protection and
solid credit standing because losses the services provided by a brokerage benefit of all CME market users. In
are not allowed to accumulate. firm. For futures and options con- the entire history of the Chicago
tracts, the commission is normally a Mercantile Exchange, there never
“roundturn” fee charged to cover the has been a default or failure result-
trades you make to open and close ing in a loss of customer funds.
each position. This is payable when
you exit the position.
26 27
.
Chicago
Chicago Mercantile Exchange Inc.
30 South Wacker Drive
Chicago, Illinois 60606-7499
1 312 930-1000
FAX: 1 312 466-4410
E-mail: info@cme.com
London
Chicago Mercantile Exchange Inc.
Pinnacle House
23-26 St. Dunstan’s Hill
London EC3R 8HN England
44 20 7623 2550
FAX: 44 20 7623 2565
Tokyo
Chicago Mercantile Exchange Inc.
Level 16, Shiroyama JT Mori Building
4-3-1 Toranomon, Minato-ku
Tokyo 105-6016 Japan
813 5403-4828
FAX: 813 5403-4646
Internet
www.cme.com
The information within this publication has been compiled by the Chicago Mercantile Exchange for general information purposes only. Although every attempt
has been made to ensure the accuracy of the information, the Chicago Mercantile Exchange assumes no responsibility for any errors or omissions. Additionally,
all examples in this publication are hypothetical fact situations, used for explanation purposes only, and should not be considered investment advice or the
results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official Chicago
Mercantile Exchange rules. Current Chicago Mercantile Exchange rules should be consulted in all cases concerning contract specifications.