LIBOR, Fed Funds, and Short-Rate Derivatives (Chapter 15, Part 1)
Book: Fixed Income Securities: Tools for Today’s Markets | Author: Bruce Tuckman & Angel Serrat | ISBN: 978-0-470-89169-8
Previous: Note and Bond Futures (Chapter 14) | Next: TED Spreads and Financial Stress (Chapter 15, Part 2)
Chapter 15 is where the book stops talking about bonds as the main character and starts treating short-term rates as their own world. Most corporate loans, swaps, and money market deals are keyed off a handful of benchmarks. LIBOR and fed funds are the big two in dollars. This first half of the chapter builds the vocabulary and the hedging tools around them.
LIBOR and How It Gets Fixed
LIBOR is not one rate. It is a family of indexes. Every business day the British Bankers Association asked banks: at what rate could you borrow funds in reasonable size just before 11 a.m. London time? For each currency and tenor they dropped the four highest and four lowest quotes and averaged the middle eight. That average is the fixing.
The three-month USD rate gets the most attention. LIBOR is quoted on actual/360 with T+2 settlement. So a three-month deposit starting July 6 runs 92 days to October 6. A lot of other rates are quoted as LIBOR plus a spread. Eurodollar futures and the floating leg of most swaps are tied to LIBOR too.
FRAs: Custom Dates, Same Idea as Futures
A Forward Rate Agreement lets you lock in a forward LIBOR rate for a specific period. Party A might agree to receive fixed at 2% on $100 million for three months settling March 14, 2012. Party B pays three-month LIBOR. The net payment is made at settlement (March 14), discounted using the same LIBOR fixing. That discounting trick is what makes the FRA rate equal the forward rate from Chapter 2.
FRAs are less liquid than Eurodollar futures but you can pick your settlement date. ED futures only expire on IMM dates four times a year.
Eurodollar Futures: Price Is Just a Quote for a Rate
Eurodollar futures hedge 90-day LIBOR deposits. The ticker is ED plus a month code plus year. EDH2 is March 2012. The contract price is 100 minus the rate in percent. A price of 98.25 means a 90-day rate of 1.75%. The price is not the price of a zero. It is a convention.
Each contract has a DV01 of $25 per basis point because the underlying notional is $1 million over 90 days. Daily settlement means gains and losses hit your account every day, not at expiration. At expiry the contract cash-settles to 100 minus 100 times three-month LIBOR. Nobody delivers an actual deposit.
Tuckman walks through hedging $100 million of future lending with 100 EDH2 contracts. In theory you lock in about $100.5 million in proceeds. In practice daily settlement messes that up. If rates jump immediately and stay there, you finance a loss at high rates or invest a gain at low rates. The asymmetry hurts.
The fix is the tail from Chapter 13. You reduce the hedge by the present value factor to the delivery date. Instead of 100 contracts you might buy 96. As delivery approaches the tail goes to zero and the hedge size rises back toward 100.
Euribor and TIBOR futures work the same way in euros and yen. TIBOR has often traded above yen LIBOR because the panel banks were perceived as riskier.
What Comes Next
The chapter then turns to TED spreads, which use ED futures as a fair-value curve for short Treasuries. That is where part 2 picks up, along with fed funds, OIS, and the LIBOR-OIS spread as a stress gauge.
My takeaway from this section: short-rate derivatives look simple until you account for daily settlement and stub periods. The tail is not optional detail. It is the difference between a hedge that works on paper and one that survives a rate spike.