EURIBOR contract

As with bond options, each of these options contracts are exercisable into one contract in the underlying futures, also traded on the same exchange. The detailed specifications for EURIBOR STIR options are given in Exhibit 17.11, with those for the other currencies being very similar. However, as the EURIBOR contracts are the most liquid, we will concentrate on these for the remainder of this section. 

To provide an idea of which of the EURIBOR contracts are liquid. Exhibit 17.12 shows the trading volumes on 7 March 2003 for the 10 expiry months available on that date. As with the bond options discussed earlier, the March 2003 options are exercisable into the March 2003 futures contract, the April through June 2003 options are exercisable into the June 2003 future, and the remaining options are exercisable into the future expiring in the same month. 

During 2002 Bund GC traded in a range around 2-10 basis points below EURIBOR in the short dates, while on occasion trading in specials went down to 90 basis points below the GC rate. As in other markets, there are a number of reasons why government stocks become special in the German market however, the primary factor is the extent of its deliverability into the Bund futures contract. For illustration we show, in Exhibit 10.23, the spread below GC for repo in the DBR... 

Understanding how a STIR option works can be a little convoluted, so let s start by recapping the definition of the EURIBOR futures contract itself. 

The EURIBOR futures contract provides the buyer with the theoretical commitment to place 1 million on deposit at a fixed interest rate for a nominal 90-day period starting on the futures expiry date, the third Wednesday of the delivery month. The fixed interest rate is not quoted directly, but is defined as 100 minus the quoted futures price. So if an investor buys a future at a price of 97, he or she is theoretically committed to deposit 1 million at 3% for 90 days. We have twice used the word theoretically because, in practice, these futures contracts are always cash settled, which means that buyers and sellers effectively pay or receive the difference between ... 

So if an investor bnys one EURIBOR futnres contract at 97.000, implying a 3% rate of interest, and the contracts expire at 97.500, implying a 2.5% interest rate, the investor receives... 

Now that we understand how the EURIBOR futures contract works, let s think about options on these futures. Suppose an investor buys one STIR call option struck at 97.75 on the June 2003 futures contract, which is trading also at 97.750. The option is quoted at a price (premium) of 0.100. This means ... 

Euronext-LIFFE s 3-month EURIBOR futures option, traded on the Chicago Mercantile Exchange, is an actively traded short-term interest rate option that enjoys high trading volume. If these options are exercised, the buyer and the seller of the option take positions in an underlying 3-month EURIBOR futures contract. The futures contract is cash-settled and the final price at delivery is equal to 100 minus the 3-month LIBOR. 

Consider the hypothetical interest rate swap nsed earlier to illustrate a swap. Let s look at party X s position. Party X has agreed to pay 10% and receive 6-month EURIBOR. More specifically, assuming a 50 million notional amount, X has agreed to buy a commodity called 6-month EURIBOR for 2.5 million. This is effectively a 6-month forward contract where X agrees to pay 2.5 million in exchange for deliv-... 

As explained earlier in this chapter, a swap position can be interpreted as a package of forward/futures contracts or a package of cash flows from buying and selling cash market instruments. It is the former interpretation that will be used as the basis for valuing a swap. In the case of a EURIBOR-based swap, the appropriate futures contract is the 3-month EURIBOR futures contract. For this reason, we will briefly describe this important contract. 

The EURIBOR futures contract trades on LIFFE. Each contract has a 1,000,000 notional value and is traded on an index price basis. The index price basis in which the contract is quoted is equal to 100 minus the annualized EURIBOR futures rate. For example, a EURIBOR futures price of 98.00 means a 3-month EURIBOR futures rate of 2% (100 - 98). 

The EURIBOR futures contract is a cash settlement contract and trades with expiration months of March, June, September, and December, up to five years in the future. In addition, the four nearest serial contract months are listed. For example, on 30 June 2003, there were 24 listed EURIBOR futures contracts listed. For the year 2003, the contract expiration months included July, August, September, October, November, and December. In the years 2004-2007, the expiration months were March, June, September, and December. Finally, the expiration months listed for 2008 were March and June. 

The EURIBOR futures contract allows a market participant to lock in a 3-month rate on an investment or a 3-month borrowing rate. The 3-month rate begins in the month that the contract settles. For example, an investor on 30 June 2003 purchased a contract that settles on 15 September 2003 and the EURIBOR futures rate is 1.3%, the investor has locked in the rate of 1.3% on a 3-month investment beginning 15 September 2003. 

Now let s return to our objective of determining the future floating-rate payments. These payments can be locked in over the life of the swap using the EURIBOR futures contract. We will show how these floating-rate payments are computed using this contract. 

January of year 1) to project what 3-month EURIBOR will be on 1 April of year 1 One possibility is the EURIBOR futures market. There is a 3-month EURIBOR futures contract for settlement on 30 June of year 1. That fntures contract will have the market s expectation of what 3-month EURIBOR on 1 April of year 1 is. For example, if the futures price for the 3-month EURIBOR fntures contract that settles on 30 June of year... 

Now that we know how to calcnlate the payments for the fixed rate and floating-rate sides of a swap, where the reference rate is 3-month EURIBOR given (1) the cnrrent valne for 3-month EURIBOR (2) the expected 3-month EURIBOR from the EURIBOR futures contract and (3) the assnmed swap rate, we can demonstrate how to compnte the swap rate. 

We will refer to the present value of 1 to be received in period t as the forward discount factor. In our calculations involving swaps, we will compute the forward discount factor for a period using the forward rates. These are the same forward rates that are used to compute the floating-rate payments—those obtained from the EURIBOR futures contract. We must make just one more adjustment. We must adjust the forward rates used in the formula for the number of days in the period (i.e., the quarter in our illustrations) in the same way that we made this adjustment to obtain the payments. Specifically, the forward rate for a period, which we will refer to as the period forward rate, is computed using the following equation ... 

Once the swap transaction is completed, changes in market interest rates will change the payments of the floating-rate side of the swap. The value of an interest rate swap is the difference between the present value of the payments of the two sides of the swap. The 3-month EURIBOR forward rates from the current EURIBOR futures contracts are used to (1) calculate the floating-rate payments and (2) determine the discount factors at which to calculate the present value of the payments. 

We consider futures 3-month EURIBOR futures contracts and find zero-coupon rates from raw data. The price of a 3-month LIBOR contract is given by 100 minus the underlying 3-month forward rate. For example, on 15 March 1999, the 3-month LIBOR rate was 3%, and... 

Investors can also use interest rate swaps for a similar purpose. These contracts exchange fixed-rate cash flows for floating-rate cash flows based on LIBOR/EURIBOR. Investors on the paying (fixed) leg of the swap reduce the duration of their portfolio, while those on the receiving (fixed) leg increase the duration of the portfolio. Since interest rate swaps are extremely liquid contracts, they are an efficient way of expressing a short-term view on interest rates. 

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