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If the BPP textbook is available to you, please look at the chapter about interest rate derivatives: The question “Interest rate futures” in section 3.
The answer use June future – LIBOR to get basis at time “now”, which I understand. But why divide this basis by 4 months since it is a three month future.
Now is 1st March and the company needs to borrow from June, so this is also a three month period which match the length of the future. So where does this 4 months come from?
I don’t understand the sentence in the answer “This basis represents four months from beginning of december to end of march”
Tianxiao, please state your question clearly. I guess there are two similar issues in the above question.
Example. Now is 1st March and the Co need to borrow at the beginning of June. Your company decide to hedge by interest rate Future and the most suitable one is June Future.
1st Mar: you sell June Future and occur basic
the basic will evenly reduce to 0 until maturity date – 30 June, not on 1 June. Therefore, the basic will be expected to straight line reduced during 4 month.Trangtubin: Please do not answer in this forum – it is the Ask the Tutor Forum, and you are not the tutor. Answer questions in the open P4 forum instead 🙂
Tianxiao: The statement “3 month futures” only relates to the way that the gain or loss on futures is calculated (it is calculated as though it was three months interest). It has nothing to do with how long the loan is. If the loan itself is for longer or shorter than 3 months then we need to adjust the number of futures contracts that we deal in.
You really need to watch the free lectures on interest rate risk on here, because I cannot type out the whole lecture 🙂Mr. Moffat
Example:
Now is 1st March, the company wants to borrow money from 1st June to 1st September
and it sells a three month June Future on 1st March.On 1st March, June future is 3.9, LIBOR is 3.5.
So when we calculate Basis,we get 3.9-3.5=0.4 on 1st March. But why we then devide 0.4 by 4 months instead of 3? The future is a three month future right? The answer says “This basis represents four months from begining of Dec to end of March”, I just don’t get it. I thought the future is from 1st March to 1st June with 3 months life.
And btw the loan is also 3-month length so I really don’t know where dose this 4 months come from.
If you have typed it correctly, then the answer has written the wrong months, but has got the correct arithmetic.
We sell the future on 1 March when the basis is 0.4.
It is a June future and so the basis will fall linearly to zero by the end of the future which is 30 June, which is 4 months away from 1 March. So the basis will fall by 0.4/4 = 0.1 each month.
We close the futures deal on the date that the loan starts, which is 1 June, and therefore it will be three months from now, or 1 month before the end of the futures. So the basis will have fallen by 3 months x 0.1, and the basis remaining at 1 June will be 1 month x 0.1 = 0.1.
The fact that they are 3 month futures has nothing at all do with this part – it does not mean the future ends in 3 months (this future ends on 30 June because it is a June future). 3 month future simply relates to how any gain or loss is calculated and nothing else. Also, the length of the loan has nothing at all to do with this part either.
As I wrote before, you really should watch the free lectures on futures where I explain all this in detail with examples.
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