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Introduction to Interest Rate Futures

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  1. Introduction to Interest Rate Futures Lin Chih-chuan Internal Affairs, Vice President of Futures Club, National Taiwan University Department of International Business All Rights Reserved by the author The Information on this file may not be reproduced, republished or mirrored without permissions

  2. Interest Rate • Definition: The cost of loan. • Yield to Maturity (IRR) and Current Yield • Rate of Return vs. Interest Rate • Real Interest Rate vs. Nominal Interest Rate

  3. Yield to Maturity Curve--Term Structure • Pure Expectations TheoryForward Interest Rate = Expected Future Spot Rate • Market Segmentation Theory • Liquidity Preference Theory Forward Interest Rate > Expected Future Spot Rate

  4. Loanable-Funds Theory • Interest rate is the price that make the supply and demand of fund be equal.

  5. Factors that Affect Interest Rate • Policy of Central BankFiscal Policy and Monetary Policy Target: Internal and External Equilibrium • Supply and Demand of Monetary Market • Economic Index e.g: GNP, CPI, Rate of Unemployment…

  6. Risk Type of Interest Rate • Price Risk, for example:discount (zero-coupon) bond • Reinvestment Rate Risk, for example: coupon bond • Almost all financial instruments are affected by changing of interest rate

  7. What’s Interest Rate Futures • Forward contracts for hedging against interest rate fluctuations. • e.g: GNMA (Government National Mortgage Association), U.S. Treasury Bill,十年期政府公債期貨(Taiwan) • Main Function: 1.Hegde 2.Hint about the future price 3.Accelerate liquidity of Real Goods 4.Absorbe fund of speculating

  8. Background of Interest Rate Futures • First Contract of Interest Rate Futures: GNMA by CBOT (Chicago Board of Trade) in 1975 • Cause: 1.Policy 2.Prosperous bond market in U.S. 3.Need of hedge by bonds holders

  9. Interest Rate Futures Of Taiwan (from Jan., 2004)

  10. Strategies of Interest Rate Futures • Substitution of Bond • Cross Hedge with Public Bond • Macro Hedge • Long Trade • Short Trade • (Yield Curve) • (Spread)

  11. Merit and Defect of Interest Rate Futures • Risk Transferring • Low Transaction Cost • High Liquidity • Low Risk of Deficit • Standard Contract Merit Defect • A Paradise of Speculators • Diversification Is Not Enough • Undividable Contract • Imperfect Function of Hedge

  12. Reference • TAIEX, http://www.taifex.com.tw/ • CBOT, http://www.cbot.com/ • Frederic S. Mishkin, The Economics of Money, Banking, and Financial Markets 7th edition, Addison Wesley • Bodie, Kane and Marcus, Essentials of Investments, 5th edition, McGrawHill