FINA2322ABC Tutorial 3
THE UNIVERSITY OF HONG KONG
HKU BUSINESS SCHOOL
FINA2322EFG – DERIVATIVES
FIRST SEMESTER, 2023-2024
Tutorial 6 –Forward Rate Agreements and Interest Rate Futures
✓ Summary of different forms of interest rates
Relationship:
1 1
𝑃0 (0, 𝑇) = 𝑇 = 𝑟𝑇
= 𝑒 −𝑟𝑇
(1 + 𝑟0 (0, 𝑇)) 𝑒
[1 + 𝑟0 (0, 𝑇)]𝑇 𝑃0 (0, 𝑡)
1 + 𝑟0 (𝑡, 𝑇) = =
[1 + 𝑟0 (0, 𝑡)]𝑡 𝑃0 (0, 𝑇)
𝐵0 (0, 𝑇, 𝑐, 𝑛) = ∑ 𝑐𝑃0 (0, 𝑡𝑖 ) + 𝑃0 (0, 𝑇)
𝑖=1
1 − 𝑃0 (0, 𝑇)
𝑐=
∑𝑛𝑖=1 𝑃0 (0, 𝑡𝑖 ) why c like this?
FINA2322ABC Tutorial 3
✓ Forward rate agreement (FRA)
• A guaranteed rate for lending/borrowing
• For long positions:
Settlement in arrears (at maturity): (spot rate – FRA rate) * notional principal
Settlement at initiation: (spot rate – FRA rate) * notional principal / (1+ spot rate)
2
FINA2322ABC Tutorial 3
Tutorial Exercise
Question 1 (Forward Rate Agreement)
Suppose that in order to hedge interest rate risk on your borrowing, you enter into an FRA
that will guarantee a 6% effective annual interest rate for 1 year on $500,000. On the date
you borrow the $500,000, the actual interest rate is 5%. Determine the dollar settlement of
the FRA assuming
(a) Settlement occurs on the date the loan is repaid.
(b) Settlement occurs on the date the loan is initiated.
3
FINA2322ABC Tutorial 3
Question 2
Given the Zero-coupon bond prices as follow:
Days to Bond Prices
Maturity
90 0.99009
180 0.97943
270 0.96525
360 0.95238
Suppose you are studying an FRA which fix the lending/borrowing rate on $10m for a 90-
day loan commencing on day 270.
Suppose the market FRA is 1.2% at time 0, suggest how you can capture an arbitrage
profit from FRA.
4
FINA2322ABC Tutorial 3
✓ Eurodollar Futures Contract
• Eurodollar are deposits denominated in USD at banks outside US.
• The Eurodollar futures contract refers to the futures contract based upon these
deposits, traded at the Chicago Mercantile Exchange (CME)
• It is derivatives on the interest rates (e.g. 3 month LIBOR)
• Price of Eurodollar futures give you the interest rate
→ Price = 100 – annualized 3-mth LIBOR
• A long position on a Eurodollar futures maturing in 1 year, has a price of 94,
means that you can lend 1 year later, for 3 months, with a rate of 6% p.a. (i.e.
effective rate in 3 months is 1.5%).
• Long position in the contract means that you gain when interest rate falls, lose
when interest rate are high → Used by lender
Short position in the contract means that you lose when interest rate falls, gain
when interest rate are high → Used by borrower
• Gain / losses are marked to market
• Payoff (Long position)
= (Locked-in 3-month LIBOR – spot 3-month LIBOR(p.a.)) / 4 * Size
= (Spot Eurodollar futures price – Locked-in Eurodollar futures price)% / 4 * Size
