Question

Know how a firm can hedge its interest rate risk on a short-term fixed or variable rate bank loan or on a fixed or variable rate short-term investment using the interest rate futures market. Be able to explain how there is a gain or loss if a firm with a variable rate bank loan expects interest rates to rise and attempts to hedge this expected interest rate risk in the interest rate futures market.

Answer 1

Interest rate futures react opposite to the perception of the interest rates as the underlying in these futures are mostly the government treasuries.

The futures are available in various periods taking an eg. of the US treasury yield you could take a bet on a 30 year yield, 10 year yield, 5 year yield or even a 2 year yield.

The interest rates futures are available in certain contracts which represent a certain number of teh treasury security.

So basically we can place a bet to buy(long) or desire to sell(short) a futures contract. If the interest rates are perceived to rise then the interest future price would decrease.

Due to the duration of how bonds work, when the interest rates go up, the treasury bond price falls down so we would want tot buy a futures contract that would short the US treasuries in order to capitalize the perception of the increasing interest rates.

As per the market perception, the treasury securities would see a decline in the value and this would be captured oppositely as mentioned above and would see the short interest rate futures price increasing.