WHAT ARE STIRS FUTURES?

Unlike the OTC inter-bank markets from which they derive, all STIR futures contracts are traded electronically on regulated exchanges. A STIR futures contract is a legally binding agreement concerned with the buying and selling of a standardised number of short term interest rate products at a fixed price, for cash settlement on a given future date.

STIR futures contracts derive from the cash inter-bank markets, mentioned in the What Is The STIRS Market? section. The advantage of using STIR futures is that they are traded using standardised contracts, thus providing uniformity of specification and quality, which in turn enhances market liquidity and efficiency. STIRS are short term interest rate derivatives that derive from the underlying three month LIBOR, TIBOR, EURIBOR, and EURODOLLAR rate traded in the OTC money markets. STIRS have been rapidly expanding because they offer something that the OTC cash markets cannot offer, the main three being:-

• Allowing traders to trade for a future value date, therefore allowing the possibilities of hedging a forward interest rate exposure hence removing some uncertainties associated with interest rate risk management. Speculators on the other side of the coin are instrumental in providing liquidity that exchanges need by speculating on future price movements.
• Futures are termed ‘Off Balance Sheet’ products. They do not involve the physical risk of the underlying transaction amount, but are based on contract for difference settlement. Trading STIRS will utilise less of a bank’s capital than would be the case with on balance sheet transactions such as cash.
• Counterparty risk is standardised in the futures markets. This is due to the combination of the margining system unique to the futures exchange and the role of the clearinghouse standing as counterparty to every trade.

When traders enter into a STIRS contract they are trading what they think the official cash interbank fixing rate will be on a given future date, or they are speculating on intra-day price action.

How STIR Futures are 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 and works in exactly the same way, as shown below:

The Forward/Forward Formula

Where, ‘a’s the long date, b is the short date, c is the forward/forward period. The formula for calculating ‘c’ (the unknown) is therefore:

NB. If the contract to be priced is the Short Sterling contract, you must remember to replace 360 with 365 in the above formula. (All other STIR contracts are calculated using a 360-day basis.)

Since STIR Futures are based on either a LIBOR/EURIBOR/TIBOR rate, you must now determine which information would be needed to create a LIBOR/EURIBOR/TIBOR rate for the future period ‘c’.

The following diagram shows how this would be created:

Explanation

Assume a trader has borrowed cash for six months (i.e. ‘the long date’,) and only lent cash for say three months (ie ‘the short date’.) By using the forward/forward formula, the trader is able to calculate the rate at which he has effectively borrowed for the 3–6 period. This so-called forward/forward formula can be used to calculate the ‘value’ of LIBOR/EURIBOR/TIBOR from any given start date and for any given LIBOR/EURIBOR/TIBOR period, and since STIR futures are based on the value of LIBOR/EURIBOR/TIBOR, it can be used in this context.

Pricing STIR Futures off the Cash Money Market rates

All STIR futures are essentially priced off the Cash Inter-bank Money Market rates (with slight ‘Sentiment’ adjustments, as you shall see). This is because the forward/forward formula needs cash rates in the first instance to give a rough approximation of what the implied forward interest rate should be.

For example:

• = 3rd Wednesday of contract delivery month

Assume today is Tuesday 22nd March 2005 (Spot date, for calculating implied EURIBOR interest rate futures from the Cash rates, is therefore Thursday, 24th).

NB: If this were a Short Sterling example, it would trade ‘out of today’ (T + 0), not spot.

To calculate the implied or fair value, price for the June ’05 EURIBOR futures contract using the forward/forward formula:

Given:

6 month cash rates: 2.2735 – 2.1485 (use offered side i.e. “Borrow” long date) three-month cash rates: 2.1486 – 2.0236 (use bid Side i.e. “Lend” short date)

Although there are various methods of creating this rate, including creating a trading channel, this is probably the simplest method to create the implied forward/forward borrowing (ie EURIBOR) rate. This is because, if you use the “borrowing rate” for the long date (here 173 days) and then use the “lending rate” for the short date (here 83 days), you thereby create a synthetic implied rate, at which one could “borrow” the forward/forward period. Since STIRS are based on what the implied borrowing rate should be (either LIBOR/EURIBOR or TIBOR depending on the contract concerned), it can then be used in this context to create a “fair” futures price. Diagrammatically it would look like this:

For “c” use 91 days for Short Sterling (ie 1/4 of 365 days), but 90 days for all other STIR futures Contracts (i.e. 1/4 of 360 days).

Thus 90 days from 15/06/05 = 13/09/05, i.e. not always the next futures date (21/09/05).

Now, using the forward/forward formula:

= 2.49% (Implied forward/forward Borrowing Rate).

Therefore, the implied or ‘fair’ futures price for the June EURIBOR (ie three-month EURIBOR from Monday preceding 3rd Wednesday of June) should be 100 – 2.49 = 97.51. However, this is not to say that the futures price will always be trading at this exact rate.

For example:

The fair futures price might be 97.510, but the actual futures price might be trading in the Market at say 97.540.

This differential cannot be mathematically calculated, but can be attributed to “market sentiment.”

In the example above, it was only three full basis points or ‘ticks’. However, if the differential was too wide, then there could be an arbitrage opportunity (i.e. risk free profit) and cash/futures traders would quickly arbitrage between the two markets, thus closing any such gap.

THE BASIS

Sometimes referred to as ‘simple basis’, The Basis is the term given the difference between the current three-month LIBOR/EURIBOR/TIBOR rate, trading in the cash money markets and the actual futures price of the corresponding STIR contract.

For example:

• Three-month EURIBOR cash trading at: 2.1486%. Actual nearest three-month futures trading at: 2.195% (i.e. price of 97.805)
• Basis (or Simple Basis): -0.0464 (i.e. 4.6 basis points)

‘The basis’ can trade higher, or lower, over the life of the futures contract, due to the nature of supply and demand and this is known as ‘basis risk’. However, the only thing you can say with some certainty is that:

At expiry of the futures contract, the cash three month LIBOR/EURIBOR/TIBOR rate and the Exchange Delivery Settlement Price (EDSP) of the futures contract will converge (i.e. be the same) and the basis will be zero. However, a “hedger” must always be aware of “basis risk”, during the life of the contract(s) being used for hedging purposes.

At expiry of the futures contract, the cash three-month LIBOR/EURIBOR/TIBOR rate and the Exchange Delivery Settlement Price (EDSP) of the futures contract will converge (i.e. be the same) and the basis will be zero.