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Hello John
Could you please advice me how to calculate interest basis. I need your support regarding to the application of LIBOR & interest basis.Specially how to approach in exam questions & the approaching in determine interest rates.
Thank in advance for your support.The basis is the different between the futures price and LIBOR restated in the same way as futures (i.e. 100 minus LIBOR).
The relevance of it is that the basis will get smaller the closer we get to the ‘end’ of the future. For example, if we are trading in a March future, the basis will fall gradually to zero on 31 March. We assume always that it falls linearly (although in practice it may not).For more explanation, and for examples calculating it and dealing with it, you should watch the free lecture on interest rate futures.
Dear Moffat. If remaining life of basis is 2 months and outstanding basis is 0.17 for example….please clarify wt does this mean theoretically? Does it mean that the future had to close 2 months later e.g in june and we sold it earlier so there is a slight risk of imperfect hedge?
We always finish the futures deal on the date that the loan starts.
The hedge would only work perfectly if both LIBOR and the futures price moved by exactly the same amount. They don’t move by the same amount because the difference between the two (the basis) changes – it falls to zero over the life of the future. Therefore futures will never give a perfect hedge (although we can predict the outcome because we can predict the change in the basis assuming it falls linearly).
You really need to watch the free lectures on interest rate risk (and the lock-in rate) for a full explanation.
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