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Hi Sir,
Could you please advise:
If a company considering a loan in future and hope to lock up risk, it can buy some IFR contracts, but can’t understand what ACTUALLY it is buying? is it buying the RATE? how come a loan’s interest rate can be bought? Also why IFA are generally sold in a exchange (such as CME) not in a bank?Because I have no any experience on futures contract, so can not understand what actually companies are buying or selling. Please explain briefly.
Strictly an interest rate future is the right to buy or sell an interest bearing asset (e.g. Treasury Bills) at a fixed price on a future date. As interest rates go up, the price of the future goes down (so interest of 2% is equivalent to a price of 100 – 2 = 98; and interest of 3% is equivalent to a futures price of 100 – 3 = 97), and vice versa.
However, because of the fixed dates, futures are used for betting/gambling on the movement of interest rates. You buy or sell a future on one day, and then complete the deal on a later date (if you start the deal by buying, then you sell later; if you start the deal by selling then you buy later). The change in the price of the future over the deal is the profit or loss made.
Many people who trade in futures do it purely as a gamble – if they manage to predict the movement in interest rates correctly they can make big profits. However the financial manager should only use them to hedge against the risk of interest rate movements on a loan they intend to take (or a deposit they intend to make).
Have you watched my lecture on this (and on currency futures, where the principle is very much the same) ?
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