Hedging - Implications For Financial Markets

Implications For Financial Markets
Short-term interest rate futures contracts, such as fed funds futures, and long-term interest rate futures contracts, such as treasury note contracts, can both be used to hedge risks associated with rises and falls in interest rates.

A bank that offers variable-rate mortgages can use short-term interest rate futures to hedge the risk that the yield on these assets will decline due to a drop in interest rates. By buying short-term interest-rate futures, the bank can effectively convert these variable-rate assets to fixed-rate assets.

An insurance company with a conservative portfolio of T-notes can sell T-note futures to hedge against the risk of long-term interest rates rising, which would cause the value of the Treasury note portfolio to decline.

The basis does not come into play here in terms of the costs of physical storage and handling. Still, interest rates themselves are a component of the basis.

This relationship is called the "implied repo rate," a proxy for the interest rate on repurchase agreements. A "repurchase agreement," or "repo," is a contract through which the seller buys a security back from the buyer at a specified price on a designated future date. It is essentially a short-term loan in which an interest-bearing security – like the one underlying a futures contract – is used as collateral. The implied repo rate, then, is the interest rate that the seller of a futures contract can earn by buying an issue and then delivering it at the settlement date.

Loosely speaking, a high implied repo rate suggests high futures prices.

In contrast to the basis, the implied repo rate tends to remain the same through the delivery date, rather than approach zero.

Hedging Calculations
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