TO GET STARTED TRADING CME INTEREST RATE PRODUCTS ® TO GET STARTED TRADING CME INTEREST RATE PRODUCTS Since the introduction of financial futures at the Chicago Mercantile Exchange in 1972, the importance of futures in transferring financial risk has been proven by the explosive growth in the market. The vast array of CME interest rate prod- ucts allows professionals to manage interest rate risks ranging from one day to ten years. Interest rates, which loosely can be defined as the price of money, affect the liveli- hoods of individuals and businesses each and every day. The cost of a home mortgage, the finance charge applied to a credit card balance, the amount of inter- est received on a savings account or the coupon on a corporate bond issue are all examples of the interest rates that influence our personal and commercial activities. Like all goods and services, interest rates are determined by the market forces of supply and demand; however, the federal government also can influence key interest rates via monetary policy, that is, by adjusting them upward or downward to slow down or stimulate the economy. Interest rate levels often are regarded as key indicators of a country’s economic health. The money market comprises the markets for short-term, heavily traded credit instruments with maturities of less than one year. Money market instruments include Treasury bills, commercial paper, bankers’ acceptances, negotiable certifi- cates of deposit, Federal Funds, and short-term collateralized loans. While the markets for these various instruments are distinct, their respective interest rates reflect general credit conditions with adjustments for differences in risk and liquidity. As the money markets have become more liquid, money managers borrow and lend in whichever markets offer a price advantage. No longer willing to leave balances as unproductive, non-interest-earning demand deposits, corporations today are making more aggressive use of cash management techniques. Cash market participants primarily use the CME’s interest rate products for pricing and hedging their money market positions. CME INTEREST RATE The CME lists a variety of contracts The CME’s Eurodollar time on short-term US and foreign interest deposit futures contract reflects rates. Here’s a brief description of the the London Interbank Offered Rate markets on which the CME products (LIBOR) for a three-month, $1 mil- are based: lion offshore deposit. A total of 40 quarterly futures contracts, spanning THREE-MONTH EURODOLLARS ten years, plus the two nearest serial Eurodollars are simply US dollars on (non-quarterly) months are listed at deposit in commercial banks outside all times. Eurodollar futures are the of the United States. The Eurodollar cornerstone of the Exchange’s inter- market has burgeoned over the past est rate quadrant and are the most 30 years as the dollar has become a liquid exchange-traded contracts in world currency. Eurodollar deposits the world when measured in terms play a major role in the international of open interest. capital market. The interbank market for immediate (spot) and forward ONE-MONTH LIBOR delivery of offshore dollars is deep and LIBOR is a reference rate for dealing liquid, giving banks the ability to fund in Eurodollar time deposits between dollar loans to foreign importers with- commercial banks in the London out incurring currency exchange risks. Interbank Market. LIBOR often is Eurodollar deposits are direct the benchmark rate for commercial obligations of the commercial banks loans, mortgages, and floating rate accepting the deposits. They are not debt issues. The CME’s LIBOR con- guaranteed by any government. tract is analogous to the Eurodollar Although they represent low-risk contract, but represents one-month investments, Eurodollar deposits are LIBOR on a $3 million deposit. The not risk-free. Exchange currently lists twelve con- secutive monthly LIBOR futures at any given time. 3 THE CME-SIMEX MUTUAL OFFSET SYSTEM (MOS) In 1984, the Chicago Mercantile Exchange, in partnership with the Singapore International Monetary 13-WEEK TREASURY BILLS contracts traded on the Singapore 91-DAY CETES* Exchange, pioneered an innovative As direct obligations of the US International Monetary Exchange (MEXICAN TREASURY BILLS) approach to futures trading known as government,Treasury bills are consid- (SIMEX). Via the Mutual Offset Certificados de la Tesoreria de the Mutual Offset System (MOS). ered risk-free debt instruments and System with SIMEX, open positions la Federacion, commonly referred Through the MOS, contracts opened provide the foundation for the money may be held either in Chicago or to as Cetes, are government-issued, on one exchange can be liquidated or markets because of their unique Singapore. Like the SIMEX, the CME short-term discount instruments held at the other. The CME-SIMEX safety and liquidity. Because of their currently lists twelve quarterly Euroyen that are denominated and paid in link effectively extends the trading risk-free nature, changes in the yield contracts, covering three years. Mexican pesos. The Cetes market hours of both exchanges beyond on T-bills reflect “pure” interest rate is considered the benchmark for their operating hours, allowing movements. Four quarterly T-bill ONE-MONTH FEDERAL FUNDS short-term interest rates in Mexico. traders to manage their overnight futures contracts are available for Federal Funds are funds in excess of Like US Treasury bills, Cetes are risk. This agreement, the first inter- trading at any given time. reserve requirements held by member issued in a variety of maturities, national futures trading link of its banks of the Federal Reserve System, with 28-day and 91-day maturity kind, is available for both Eurodollar EUROYEN transferable between those banks issues the most common. and Euroyen futures. Analogous to Eurodollars, Euroyen within one business day. Because the For a more detailed description of are Japanese yen deposits outside reserve accounts banks maintain at 28-DAY TIIE MOS, please consult the brochure Japan. Like the dollar, the Japanese the Fed are not interest-bearing, sell- (MEXICAN INTEREST RATE) titled CME/SIMEX Mutual Offset yen is globally traded on a 24-hour-a- ing Fed Funds allows institutions to The Tasa de Interés Interbancario de System:The World’s Most Successful day basis. The CME’s Euroyen futures earn a positive return on balances that Equilibrio, or TIIE,is a benchmark Trading Link. are fully fungible with the Euroyen might otherwise lie idle. The most interbank interest rate that repre- common Fed Funds transaction is an sents the price at which Mexican overnight, unsecured loan between banks are willing to borrow from or two banks. lend to the Bank of Mexico (the coun- The CME lists twelve consecutive try’s central bank). The TIIE is an Fed Funds futures, the same as LIBOR, equilibrium or market-clearing rate. with a new month added on the first business day following expiration of the front-month contract. INTEREST RATE FUTURES INTEREST RATE CONTRACT MONTHS Eurodollar, LIBOR,TIIE, Fed Funds and T-bill contracts are listed for all calendar months. Cetes and Euroyen contracts are on a March quarterly INTEREST RATE number of ticks moved, multiplied properly constructed futures hedge cycle–March, June, September and FUTURES BASICS by the value of the tick. For the first can also generate losses that will off- December. A contract month identi- All CME interest rate futures con- four quarterly and two serial set the effects of a beneficial interest fies the month and year in which the tracts are traded using a price index, Eurodollar and T-bill contracts,as rate move. In addition, because futures or options contract ceases to which is derived by subtracting the well as all LIBOR contracts, the mini- futures are quoted in terms of price exist. It is also known as the “deliv- futures’ interest rate from 100.00. For mum tick is .005, or $12.50. Thus a rather than interest rate, futures ery month.” This procedure ensures instance, an interest rate of 5.00 per- price move of from 95.005 to 95.01 exhibit an inverse relationship that the futures price converges with cent translates to an index price of for example, would mean a $12.50 between rates and price. A borrower the cash market price. However, the 95.00 (100.00 – 5.00 = 95.00). Given gain for the long position and a would sell futures to protect against vast majority of market participants this price index construction, if inter- $12.50 loss for the short position. an interest rate rise, i.e., to profit from close out their positions before expi- est rates rise, the price of the contract For the Euroyen contract and the a decrease in the futures price, and a ration by establishing new positions falls and vice versa. Therefore, to Mexican interest rates, the treat- lender would buy futures to hedge in the next month or rolling their profit from declining interest rates, ment is analogous, but the gains and against an interest rate decline or positions forward. In fact, only a very you would buy the futures contract losses are realized in Japanese yen capitalize on an increase in the futures small percentage of futures transac- (go long); to profit from a rise in inter- and Mexican pesos, respectively. price. Consider these examples: tions reach delivery. est rates, you would sell the contract That is, each 0.01 price move gives a (go short). In either case, if your view ¥2,500 or MP 50 result. Hedging a Forward Borrowing Rate turns out to be correct, you will be In late September a corporate trea- CONTRACT MONTH SYMBOLS able to liquidate or offset your original HEDGING WITH surer projects that cash flows will position and realize a gain. If you are require a $1 million bank loan on January F July N INTEREST RATE FUTURES wrong, however,your trade will result Interest rate futures can be used to December 16.