Question

Explain why an Interest Rate Swap (assume LIBOR as the floating rate) with quarterly settlement (assume 90 days per quarter) can be viewed as a strip of Eurodollar futures contracts. (Note: A strip is a sequence of ED futures with successive expirations) Note:

This question is worth 10 marks.

Answer 1

Interest rate swap is basically a swap wherein a party agrees to pay fix rate in return of floating rate and vice versa.

For example : if an investor agrees to enter into fixed interest rate swap with 5% and notional value of $100,000, he is obligated to pay fix 5% interest rate and will receive floating rate ( in our case it is LIBOR) at settlement. Settlement can be annually, semi annually, quarterly etc. If it is quarterly settlement, net payment is made every quarter. So if after 1 quarter, LIBOR is say 6%, investor will receive net 1% of the notional amount. Similarly, other way around, other investor will have to pay net 1%.

Future strip is basically a series of sequence of futures contracts for consecutive months traded as a single transaction. It helps investors to lock in the rate for that time period.

Now assume that Euro dollar future contact is for 3 years which can be divided into 3 Euro strips with 4 consecutive contracts and each will last for 3 months.

If you closely look at the payoff for swap and euro dollar strip, it is the same. If you have locked the rate in strip and future rate rises, you will recieve net payment.

So both are alike.