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In my BPP practice and revision kit one of the disadvantages of interest rate futures is given as :
“Also the terms of the future may be based on LIBOR, which may not match with the basis of calculation of the interest rate being hedged. ” I don’t understand this statement. What are the terms of the future that are based on LIBOR is it the futures price or the futures interest rate? Isn’t it normal for futures interest rates to follow the LIBOR movements? And what’s the rationale behind basis of the calculation not being matched ?
Kindly explain.
There is no such thing as a futures interest rate.
The futures price is ‘equivalent’ to an interest rate (it is 100 – interest).
Futures prices do move as LIBOR moves. The problem is that the interest rate applicable to individual companies will not be LIBOR – it they are borrowing money they will be charged more than LIBOR (how much more depends on the riskiness of the company). You would usually expect the interest rate that they are charged to move up and down by the same amount as the changes in LIBOR but that does not have to be the case and if they do move differently then futures will not work exactly as we assume.
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