Interest Rate Futures

21 November 2006

Outline of Presentation

• Managing Interest rate Risk

• Identifying market Expectations

• Using Charts

• Market Price Dynamics

• MosPrime

Concept of interest rate risk

• Fixing of the interest rate on an Asset or Liability

• What is my exposure?

• How do I measure it? => BPV

Instruments hedging short term interest rate risk

Available instruments:

- Cash instruments: Money Market and FX swaps

- Non-cash Derivatives: OTC and Interest Rate Futures

• Money Market Instruments:– Allow for the perfect interest rate hedge– Dates and notionals can be tailored– But, credit line intensive

• FX Swaps:– Exchange of notional between two currencies for the

duration of the transaction – Allows for the perfect interest rate hedge in two currencies– Dates and notionals can be tailored– And use less credit lines than Money Market instruments.

Cash instruments

• Uneven swaps–T0

–T1

• Even swaps–T0

–T1

Cash instruments: FX swaps

Bank A Bank B

Bank A Bank B

USD Notional

USD Notional + interest

Bank A Bank B

Bank A Bank B

USD Notional

USD Notional

EUR Notional

EUR Notional + (EUR interest – EUR

equivalent of USD interest)

EUR Notional

EUR Notional + interest

Where derivative instruments are available, it is usually more efficient to separate cash and interest rate risk management:

This allows to take the preferred hedging decision for each exposure.

For example, it may be preferable to hedge a disbursement on a 3 month loan with overnight funding (Cash management) and a DERIVATIVE instrument (interest rate risk management).

i.e. we can take a curve view

Cash not always optimum to hedge the interest rate risk

Derivatives

Over The Counter: Forward Rate Agreements (FRA)

A FRA is an agreement about the future level of interest rates. Compensation is paid by one party to the other to the extent that on the interest fixing date, market interest rates deviate from the agreed rate.

Derivatives• Benefits of FRAs:

• No cash involved (except at settlement): allows to separate cash management from interest rate risk management

• Dates and Notionals flexible (within limitations) => more flexible than Futures

• No basis risk (as opposed to Futures)

• Drawbacks of FRAs: • Not perfect hedge (but if FRA dates close to those of the risk to be

hedged, residual curve risk can be minimised)• Credit risk• ISDA legal agreement needed with every counterparty• Pricing may not be transparent for non standard dates• Legal and tax considerations in Russia?

Exchange traded derivatives:

Interest rate futures prices are defined as 100 – Interbank offered rate.

Derivatives

Exchange traded derivatives:

–Benefits of Futures: • No cash involved (except for margin): allows to separate cash management from interest rate risk management• Counterparty is the Exchange + initial margin + daily margin calls => reduced credit risk• Fewer Legal Agreements needed (with the Broker and Clearer only) • Transparent pricing• Brokerage fees cheaper than on OTC derivatives• Fast and simple execution

–Drawbacks of Futures:• Not perfect hedge• Basis risk with the cash risk (converging to 0 towards Future settlement date => no real risk if Futures held to settlement date)

Derivatives

FRAs vs. Futures:

In principle, a Forward and a Futures price have the same payoff

Derivatives

FRAs vs. Futures:

However,

• The margining can create a price bias, if there is a non-zero correlation between moves in the asset (Futures) price and movements in the interest rates

• Margin in-flows need to be reinvested• Margin calls out need to be funded

• The cash-settlement value of a FRA is discounted at the settlement price over the fixing period

Derivatives

DerivativesFRAs vs. Futures: the basis

Summary table of the different Instruments

• According to information provided to the EBRD by market participants

In hard currencies In Russia (*)

No Residual interest rate risk

No Basis risk

No Notional exchange

Easy Execution

Transparent pricing

Not Credit line intensive

No legal issues

No Tax issues

Money market , if standard dates (in

general)

FX swap , if standard dates (in

general)

NDF , if standard dates

FRA , if standard dates

Futures ? Reduced?

Example: BPV impact of the different instruments

BPV

Book risk Risk implied by hedging instruments

Maturity bucket

Interest Rate

3 month 300 million loan to be hedged

Money Market FX Swap NDF

Buy 1*4 FRA

on 300mn starting

on 11/12/6

Sell 300 Dec. Future

settling on 18/12/06

               

1D 5.28        

1W 5.30          

1M 5.32   -2,559 -2,396

2M 5.36    -748

3M 5.37 -7,759 7,759 7,759 7,759

4M 5.38   9,803 8,022

 5M      2,549

TOTAL   -7,759 7,759 7,759 7,759 7211 7,416

MM and FX swap imply a perfect hedge in BPV terms. However, BPV analysis ignores transaction costs, which can only be recovered by taking some risk.

=> no risk = no loss, but also no gain!

Example: BPV risk

Example: Scenario

   

INPUTS

                     

  Central Bank Rate Increases            

  Date Scen1 Scen2 Scen3            

  02-Nov-06 0.25 0.25 0.25     ####  

  07-Dec-06 0.00 0 0   Forward (M) 3  

  04-Jan-07 0.25 0.25 0   Fwd Interval (M) 1  

  08-Feb-07 0.00 0 0            

  01-Mar-07 0.25 0 0            

  05-Apr-07 0.00 0 0   EONIA EBFSSW1W Index 3.36  

  03-May-07 0.00 0 0            

  07-Jun-07 0.00 0 0            

  05-Jul-07 0.00 0 0            

  02-Aug-07 0.00 0 0            

  06-Sep-07 0.00 0 0            

  04-Oct-07 0.00 0 0          

  01-Nov-07 0.00 0 0            

  06-Dec-07 0.00 0 0            

  03-Jan-08 0.00 0 0            

  07-Feb-08 0.00 0 0            

  06-Mar-08 0.00 0 0            

  03-Apr-08 0.00 0 0            

                     

 

Example: Scenario

    MARKET MODEL

Contract   Fut Dlv Dt First Px Last Yld Ytm Mid Scen1 Scen2 Scen3

ERZ6 Comdty   18/12/2006 96.280 3.720 96.076 96.125 96.329

ERH7 Comdty   19/03/2007 96.115 3.885 95.819 96.071 96.323

ERM7 Comdty 18/06/2007 96.070 3.930 95.834 96.086 96.339

ERU7 Comdty   17/09/2007 96.070 3.930 95.829 96.081 96.333

ERZ7 Comdty   17/12/2007 96.085 3.915 95.827 96.079 96.332

ERH8 Comdty   17/03/2008 96.120 3.880 95.825 96.077 96.329

ERM8 Comdty 16/06/2008 96.130 3.870 95.822 96.075 96.327

ERU8 Comdty   15/09/2008 96.135 3.865 95.819 96.072 96.324

ERZ8 Comdty   15/12/2008 96.115 3.885 95.816 96.068 96.321

ERH9 Comdty   16/03/2009 96.120 3.880 95.812 96.065 96.317

ERM9 Comdty 15/06/2009 96.105 3.895 95.808 96.061 96.313

ERU9 Comdty   14/09/2009 96.090 3.910 95.804 96.056 96.308

ERZ9 Comdty   14/12/2009 96.070 3.930 95.799 96.051 96.303

ERH0 Comdty   15/03/2010 96.060 3.940 95.794 96.046 96.298

ERM0 Comdty 14/06/2010 96.030 3.970 95.788 96.040 96.293

ERU0 Comdty   13/09/2010 96.010 3.990 95.782 96.034 96.286

ERZ0 Comdty   13/12/2010 95.975 4.025 95.775 96.027 96.279

• Heterogeneous expectations

• Speculators: critical to provision of liquidity

• A special kind of speculator: the Black Box

What drives price action?

MosPrime: Origins

In April 2005, a new Rouble money-market reference rate was launched in the Russian market - the Moscow Prime Offered Rate (MosPrime Rate) - under the auspices of the National Foreign Exchange Association (NFEA).

MosPrime: Description• MosPrime is the yield for money-market time

deposits offered by first tier banks in the Russian market to financial institutions of comparable credit standing.

• MosPrime is calculated daily for 1, 2, 3 and 6 month tenors provided by eight Contributor Banks.

• MosPrime calculation procedure is based on international standards: the arithmetic average of quoted rates after rejecting the highest and the lowest offers.

MosPrime: Contributing Banks

• A minimum of six banks contribute reference rates, and are selected on the basis of reputation, credit standing, scale of activity and experience in the Russian money-market.

• NFEA’s Board reviews the contributors’ list at least once a year. There is no restriction on the recurring inclusion of a bank in the list.

• Currently the list of contributing banks consists of:

ABN Amro Bank, ZAO Citibank, ZAOGazprombank, CJSC International Moscow Bank, ZAO Raiffeisenbank Austria, ZAOSberbank, OJSCBank for Foreign Trade (VTB), OJSC WestLB Vostok, ZAO

MosPrime: Bilateral Loans

• EBRD has arranged RUB 30 billion of MosPrime-linked corporate and municipalcorporate and municipal loans.

• MosPrime is used for long term mortgage mortgage lendinglending, with one bank reporting 746 such loans in September 2006.

• MosPrime is used by a number of banks in their

corporate loan programmes, as well as for internal benchmarkinginternal benchmarking.

MosPrime: Bonds

• EBRD’s inaugural RUB bond (RUB 5bn 5yr), May 2005, was the first MosPrime-linked issue.

• To date, EBRD has issued three such RUB 5-year Floating Rate Notes totalling RUB 17.5 billion, for which a coupon will be set at 3 month MosPrime on every calendar month of the year.

MosPrime: Derivatives•In May 2006 MosPrime-linked futures were

launched on MICEX.

•Banks are quoting RUB interest rate swaps using MosPrime as the index for the floating leg.

Expected legal changes, clarifying enforceability of swap transactions in Russian courts should expedite this activity, and allow the hedging of interest rate risk.

MosPrime: Additional Information

•NFEA undertakes to disclose MosPrime on a daily basis via its website, special Reuters pages and mass media. http://www.nva.ru

•Contributor Banks undertake to lend to the other panel banks at their MosPrime quotation rate, and to accept deposits from them at no more than 50 basis points below that rate.

•Contributor Bank’s have agreed to lend to EBRD at their MosPrime quotation rate and accept deposits at no more than 50 basis points below it on the dates of bond coupon fixings.

EBRD tests the validity of the rates quoted, and monitors the panel of Contributor Banks to ensure the credibility of the MosPrime rate.

MosPrime: Additional Information

Mosprime quotations for 0/n, 1 week, 2 weeks will be officially launched in January 2007

Technical start date 15 December 2006