HOW ARE STIR FUTURES PRICED?

As one would expect, STIR futures are priced from the underlying cash inter-bank money markets from which they derive. Prior to the introduction of STIRs (and FRAs –Forward Rate Agreements that trade in the OTC market) a dealer in the cash markets could easily find himself with so-called ‘mis-matched’ positions.

For example, suppose a dealer in the inter-bank market had lent six-month cash and then found that he could only borrow for the first three months at an acceptable rate. He thereby created for himself an exposure, ‘borrowing requirement’, relating to a three-month period, but starting in three months’ time i.e. ‘forward/forward’. The term ‘forward/forward’, therefore literally means an exposure starting on a forward date, for a further period of time. It was because of the headaches associated with running these ‘mis-matched’ positions that dealers soon devised a market for dealing ‘forward/forward’.

By using a simple mathematical formula, known as the ‘forward/forward formula’, they were able to calculate the interest rate they would need to obtain for the forward period, in order to ensure that they did not lose money on the cash transaction as a whole. Furthermore, since futures are concerned with the implied value of interest rates for a given period, this so called ‘forward/forward formula’ can also be applied to the pricing of STIR futures. An example of the Forward/Forward Formula is available in the resource section.