Free Interest Rate

Tutorial
Malcolm Baker – founder
Interest Rate
Fundamentals
Long Term Interest Rates refer to the Interest Rates of
derivatives with a Residual maturity of 7 years or more. In the
Over-The-Counter (OTC) Bond Markets Bonds trade out to 50
years.

These are not the Interest Rates at which the bonds were issued rather
the interest rates implied by the prices at which these (Government
and Corporate) Bonds are being traded in the financial markets.

Some of the Most actively traded Long Term Interest Rates:

Bunds – German Govt Bonds with a maturity circa 10 years

UST 10 year Notes – US Govt Bonds with a Maturity of circa 7 ½ years
Gilt 10 year – UK Govt Bonds with a maturity circa 10 years
CGB – Canadian Govt Bonds with a maturity circa 10 years
JGB – Japanese Govt Bonds with a maturity circa 10 years
The Price Yield Relationship for Bonds

Interest Rate Risk, is the risk that interest Risk will rise, thereby decreasing the
value of a bond. The Price of a bond is inversely related to movements in interest
rates. In general, the relationship between price and yield is Convex. In other
words, the sensitivity of the bond price to changes in interest rates varies on the
level of interest rates.

Below you have a chart illustrating the price-yield relationship for two bonds with
the same 5% coupon rate, but different maturities (3years versus 30 years).
Note that the bond with the 3 year maturity is more linear, while the bond with
the 30-year maturity is more convex. Generally, bonds with longer maturities
(beyond 7 years) are more convex, while short-term bonds exhibit little
convexity.
The Price Yield Relationship for Bonds

The Below Chart illustrates the price-yield relationship for two bonds with the
same 10-year maturity, but different coupons (10% versus 5%). The bond with
the larger coupon is more convex than the bond with the smaller coupon.
Generally, bonds with higher coupons have greater convexity.

The price-yield relationship is curvilinear because the coupons paid to the bond
holder over the life of the bond are reinvested, earning interest on interest.
Intuitively, the magnitude of the compounded interest depends positively on the
size of the coupons and the period of time for which the coupons are reinvested.
The Price Yield Relationship for Bonds – continued

The previous two slides show how convexity is larger at both very low yields and
very high yields. As such, convexity varies depending on the magnitude of the
change in interest rates.

By implication, highly convex bonds are more valuable in volatile interest rate
environments. In this scenario of higher volatility the market charges a higher
premium for convexity in the form of a higher price and lower yield.
The Price Yield Relationship for Bonds – Duration.

Duration is a summary measure of maturity, coupon and yield effects that is used to approximate
interest rate risk. A bond with larger coupon and yield has lower duration, while a bond with a longer
maturity has higher duration. Bonds with lower duration are less sensitive to change in yield, while
bonds with higher duration are more sensitive to changes in yield.

Duration Strategies versus Convexity Strategies.

Duration strategies attempt to capitalize on expected increases/decreases in interest rates, while

convexity strategies are based on changes in volatility. A position in a long bond (long) is long
duration and long convexity (i.e. long volatility).

Duration approximates interest rate sensitivity. Hence, increase duration if interest rates are expected
to fall, and reduce duration when interest rates are expected to rise. Longer duration bonds have
lower coupons and longer maturities.

Convexity is highly valued during periods of highly volatile interest rates. Hence, shift to bonds with
higher convexity if interest rate volatility is expected to rise, and shift to bonds with lower convexity
when interest rate volatility is expected to fall. Highly convex bonds tend to have maturities beyond
10 years.

When uncertain about the direction of interest rate movements (or you agree with market
expectations), maintain a neutral duration position relative to the targeted benchmark.
Yield Curve Risk: The Yield – Maturity relationship.

The yield Curve – also known as the term structure of interest rates – illustrates the
relationship between the yield and maturity of bonds with the same credit quality. There
are four classic yield curve shapes:

I) Rising (normal): Yields rise continuously, with some reduction in the rate of increase
at longer maturities.
II) Falling (Inverted): Yields decline over the entire maturity range.
III) Flat: Yields are unaffected by maturity.
IV) Humped: yields initially rise, but then peak and decline.
Yield Curve Risk: The Yield – Maturity relationship.

The shape of the yield curve has important implications for the performance of a bond portfolio.
Yield curve risk is the risk that an unanticipated shift in the yield curve will reduce the value of the
bond portfolio. Exposure to yield curve risk depends on the spacing of the maturity of bonds within a
portfolio. Before considering different types of yield curve shifts and their effect on the performance
of a bond portfolio, it is useful to see how the shape of the yield curve can affect performance of a
single bond.
Curve Risk implications for Traders.

Yield Curve strategies involve taking positions in bonds of varying maturities in order to capitalize on
expected changes in the shape of the yield curve.

One Can Observe:

I) If the yield curve is expected to flatten, longer duration strategies should outperform shorter
duration strategies.
II) If the yield curve is expected to steepen, shorter duration strategies should outperform longer
duration strategies.
III) Longer duration bonds take advantage of a positively sloped yield curve.
Other sources of Risks for Bonds.

What else can affect the value of a bond?

I) Credit Risk (also known as default, downgrade or spread risk)

II) Event Risk
III) Exchange Rate Risk
IV) Inflation Risk
V) Liquidity Risk
VI) Political and Legal Risk
VII) Reinvestment Risk
Other Risks for Bonds

Credit risk - Relevant for all bonds. US Treasuries (UST) and German Bunds (Bunds) used to be 100 %
exempt from credit risk, but since 2008 global Financial Crisis and the 2010 European Crisis market
practitioners view these bonds to display a slight credit Risk. Still UST and Bunds are the Benchmark
Bond that analysts look at for gauge the health of the global Economy. In the Event Of Credit Risks,
the Market Buys UST and Bunds as Safe haven.

Event Risk – For corporate Bonds the likely causes of such risk are Natural disasters, industrial
Accidents, Takeovers or corporate restructurings. For Sovereign government debt these are extreme
flight to quality episodes, such as war, dramatic economic shocks or changes in government policy.

Inflation Risk – Except for Inflation linked bonds or floating rate bonds. This is the risk that
unanticipated inflation will erode the value of the bond cash flows.

Liquidity Risk – The Primary measure of liquidity risk is the size of the bid-ask spread. Illiquid bonds
have wide bid ask spreads. Generally, Bunds and UST will not exhibit liquidity concerns.
Interest Rate Futures

A Futures contract represents an obligation to buy (or sell) an asset at a specific price on
a specific date in the future. The seller of a bond futures contract has the obligation to
deliver to the buyer of the futures contract at the settlement date the underlying bond
with a prespecified period remaining to maturity and face value. In selecting the issue to
be delivered, the seller of the futures contract will select from all the deliverable issues
the one that is the cheapest to deliver. As such, the buyer of the bond futures contract
can never be sure exactly which bond will be delivered.

The Pricing of Bond Futures.

The theoretical price of a bond future is equal to the cash price of the underlying bond
plus the cost of carry. In reality the actual price is lower than the theoretical price
because of the delivery options afforded to the seller of the futures contract. The price
of the futures contract moves with the price of the underlying asset.
Uses of Bond Futures.

I) To speculate on the movement of Interest Rates

II) To control the interest rate risk of a portfolio (i.e. manage duration)
III) To create synthetic securities to enhance yield
IV) The hedge price risk incurred from normal business operations.
V) End user does not have access to the underlying OTC Bond Markets

Types of End users in the Bond Markets.

I) Investment & Regional Banks

II) Asset Managers
III) Pension Funds
IV) Hedge Funds
V) Proprietary Trading Companies/CTAs
VI) High frequency Traders
VII) Central Banks
Interest Rate Swaps (IRS)

In an IRS two parties agree to exchange periodic interest payments. The most common
arrangement is the “plain vanilla” swap, where one party agrees to pay the other party
fixed interest payments (at a spread over Treasuries or another benchmark government
yield) in return for floating payments based on a reference rate (usually 6-month London
Interbank offered Rate – LIBOR) the Fixed rate payer (i.e. the payer of fixed) is long the
swap and benefits if interest rates rise. Conversely, the floating rate payer (i.e. the
receiver of fixed) is short the swap and benefits if interest rates fall.

The Swap Rate = PV (floating payments)-PV (Fixed payments)

Swap Spreads

The swap spread is the interest rate differential between the swap rate and the
government benchmark yield of the same maturity.

Swap Spread = IRS rate – Government Benchmark yield.

Key Economic Data
Key Central Bank Policies.

European Central Bank (ECB) – The Primary objective of the ECB’s Monetary Policy is to
maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over
the medium term.

UK Monetary Policy Committee (MPC) – The Primary objective of the MPC is to enable
the UK inflation target to be met.

Swiss National Bank (SNB) – Its sole responsibility is to define Price Stability and use the
tools at its fingers to ensure this target is met.

Federal Reserve (US Fed) – Its obligations are to Maximize Employment, Stabilize Prices
and Moderate Long Term interest Rates.

Bank of Japan (BOJ) – Decides and implements monetary policy with the aim of
maintaining price stability.
Key Drivers of STIRs (LL)

Direct Measures of Inflation Indirect Measures (via Economic Growth)

Consumer (retail) Prices Real GDP growth

Producer (Wholesale) Prices Equity market Weakness/strength

Core Inflation (Excluding Fodd and Energy) Personal income and consumption There are many Pieces of Economic Data
available to Traders every month/Quarter.
Crude Oil and other Commodity Prices consumer confidence
The most important ones are opposite.
Labour (employment) costs Retail sales, homes sales, auto sales
LL Traders need to follow all Tier 1 UK data
Average Hourley earnings Industrial production, factory orders
through each month. These Data releases
Currency strength/weakness Capital spending by business (capex) usually come out at 0930 UK time with the
exception of BOE-MPC Meetings and Minute
Business outlook
releases. LL traders need to follow US Tier 1
Corporate earnings Data also.

Business inventories During Different Cycles, political /

Durable goods orders geopolitical turmoil's different data releases
can become more important or less
Construction activity, housing starts important. But the golden Rule is Watch
Unemployment rate Inflation data and signs Data tells you it is
increasing or failing.
Initial and continuing jobless claims

Non-Farm Payrolls

Government Budget Deficit/surplus

Trade Balance

Productivity growth
Key Economic Data.

Direct Measures of Inflation Indirect Measures (via Economic Growth)

As you can tell from the Mandates that major Central banks follow
in ensuring present and future Economic growth for their
Consumer (retail) Prices Real GDP growth Countries, maintaining Inflation is the cornerstone of a healthy
balanced Economy. Given this, Markets wisely, ensure they track
Producer (Wholesale) Prices Equity market Weakness/strength both Economic Inflation data released by the Official statistic
offices and the inflation projections the Central banks provide.
Core Inflation (Excluding Fodd and Energy) Personal income and consumption
As you can see from the opposite diagram either a Piece of
Economic Data is a direct measure of inflation or one which in
Crude Oil and other Commodity Prices consumer confidence time indirectly impacts inflation.

Labour (employment) costs Retail sales, homes sales, auto sales For STIRs traders, think Inflation, inflation, inflation…

Average Hourley earnings Industrial production, factory orders Within each bucket of either Direct or Indirect Inflation Economic
releases traders will bucket these into which are most important.
Currency strength/weakness Capital spending by business (capex)
In Reality Tier 1 Data will be the CPI, Employment, GDP,
Consumer Confidence, Retail sales, PPI, Average Hourly Earnings.
Business outlook
But Markets are extremely sensitive to All Economic Data so the
Corporate earnings Tier 1 Bucket gets filled with many more releases from time to
time.
Business inventories
The Tier 1 Data bucket Economic releases can often be that
significant their releases can completely change the direction of a
Durable goods orders
market for a significant period of time.
Construction activity, housing starts What is missing from the Opposite Economic Releases are the
Actual Central bank meetings and decision on Interest Rates and
Unemployment rate also Points in time when Central governors make Key note
speeches. Traders need to watch for these.
Initial and continuing jobless claims
Central Bank Interest rate decisions, minutes and speeches are
always well known in advance to not knock markets unawares
Non-Farm Payrolls
with surprises.

Government Budget Deficit/surplus

Trade Balance

Productivity growth
The Taylor Rule

The Taylor Rule is a formula developed by Stanford economist John Taylor. It was
designed to provide “recommendations” for how a Central Bank like the Federal Reserve
should set short term interest Rates as economic conditions change to achieve both its
short run goal for stabilising the economy and its long run goal of Inflation.

This is why GDP and CPI are so Important.

How does Economic Data impact the UK Bank Rate and ICE LIBOR futures?

LL Short Sterling Futures are highly sensitive to Key Economic Data

Releases from the UK Statistics offices (ONS). All Traders need to know in
advance what is coming out (Have a Current UK Figure Sheet to hand).
You will need to know;

a) What is the market estimation/consensus on this release?

b) What is the Range of the consensus, High/Low?
c) What was the Last Release?
d) What has been the trend in this release?
e) What happened Last time there was a significant ‘miss’ in the
Estimate to the Actual release? What products reacted the most and
by how much?
f) What Release levels will cause you to exit your current position or
enter into a new position?

There are two charts opposite, one of the Short Sterling Mar2017 (in
price) and one of the UK PMI Manufacturing Survey (a strong indicator of
the health of the Economy). The UK PMI would be your Indicator and the
LL Mar2017 the traded asset. We do not trade Outrights at OSTC, in this
example it is to show you the impact of Economic release on one of the LL
futures. Knowing in which business cycle you are in will enable you to
know how this impacts the spreads we trade.

Although not a linear relationship, you can see clearly a strong Inverse
relationship/correlation between the UK PMI Manufacturing Survey and
the markets prediction on future 3 month LIBOR Rates.

Although, UK PMI is just one Piece of Economic Data out of 10 that are
really important to the UK BOE-MPC in setting future Interest Rates, it
demonstrates how sensitive LL futures are to these Pieces of data. The
theory is that weaker Manufacturing that we can witness from the falling
UK PMI from 58 to 50 from 2013 to 2016, demonstrates a weakness in the
UK economy. As each Release in this 3 years is known by the markets the
LL futures start to trade higher (i.e. Market predicting the at BOE-MPC will
start lowering Interest Rates to stimulate the flagging economy)
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data?

Preparing for the Data.

1 Hour Prior to the US Jobs data. Non Farm Payrolls and Unemployment
Data. The US economy is the Largest by far and as such if there is a
dramatic slowdown or increased growth this will impact all global
Markets

Opposite you have 2 charts of the Upcoming US Employment Data for the
Major Global Markets to analyse.

The top Chart is Non Farm Payrolls Data. A higher number for this release
is highly positive for the US Economy, conversely a lower number is
adversely negative.

The Bottom chart is the Actual Unemployment Rate, this is a measure of

how much Unemployment there is across the US Economy, as opposed to
the Employment in Non Farm part of the Economy.

So the Trend you can see is of an improving US Economy in the jobs

markets. This would imply more money in circulation and more spending
and potential (not always) for Wage Growth.

This brings us back to the conundrum for Central Banks, they have to
balance Inflation. So signs of Economic Indicators that can ultimately
drive up Inflation will concern the Central banks into potentially
withdrawing stimulus and potentially Raising Interest Rates.

Although one Economic release ultimately will not drive the Central bank
into rushing to change policy, the Financial Markets will begin to make
changes to the probability of future changes in interest Rates.

So conclusion one will be the trend is for improved or sustained Job

Growth, traders will be watching for an acceleration of this or a reversal
of this trend in Job Growth.
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data?

Preparing for the Data.

1 Hour Prior to the US Jobs data. Non Farm Payrolls

and Unemployment Data. The US economy is the
Largest by far and as such if there is a dramatic
slowdown or increased growth this will impact all
global Markets.

Despite the Smartest people on the planet(Bank

analysts/Economists) analysing the Upcoming data
from all technical, mathematical models the actual
precise number is very hard to predict.

Most Economists predictions are not supposed to

predict the exact release number but more the
direction of the economic Release. I.e. Is it going to be
inflationary or not inflationary for the Economy and
ultimately this will decide how the market should trade
in the period afterwards.

Opposite chart shows two variables. The Blue chart is

the Actual release of US NFP and then Orange line is
the Economists prediction of the upcoming Release.

As you can see about half the time the number is

accurate and the other half the Consensus prediction is
about as useful as a chocolate Tea pot.
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data?

Preparing for the Data.

Actual Expectation Revision

1 Hour Prior to the US Jobs data. Non Farm Payrolls

and Unemployment Data. The US economy is the
Largest by far and as such if there is a dramatic
slowdown or increased growth this will impact all
global Markets.

Unfortunately for the market the Government statistics

offices often release several Economic Releases at
exactly the same time. As you can imagine, often each
of the Economic releases can have equal / opposite
impacts on the expectations for inflation. Equally you
can have two highly Inflationary or non-inflationary
pieces of data released at exactly the same time
doubling the impact on the markets.

Most often the Financial Markets will focus on just one

economic release as the most market impactful.

For Each Economic release you have the Market

Expectation. Market analysts will watch carefully the
actual release and the revision to last months release.
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data?

Preparing for the Data.

Actual Expectation Revision

1 Hour Prior to the US Jobs data. Non Farm Payrolls and Unemployment Data. The US economy is the Largest by far and as such if there is a dramatic slowdown or
increased growth this will impact all global Markets.

Market Players will look at the expected 180,000 prediction of the US NFP and make the following predictions on how this will impact the LL Futures.

A NFP release of > 300,000 LL Sep17 sell down to 99.68 from Baseline 99.72
A NFP release between 249,000 and 299,000 LL Sep17 sell down to 99.71 from Baseline 99.72
A NFP release between 191,000 and 249,000 LL Sep17 sell down to 99.70 from Baseline 99.72
A NFP release between 170,000 and 190,000 LL Sep17 no price change from Baseline 99.72
A NFP release between 169,000 and 129,000 LL Sep17 Buy up to 99.73/99.74 from Baseline 99.72
A NFP release of < 100,000 LL Sep17 buy up to 99.75 from Baseline 99.72
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data? Defining the Baseline.

1 Hour Prior to the US Jobs data. Non Farm Payrolls and

Unemployment Data. The US economy is the Largest by far
and as such if there is a dramatic slowdown or increased
growth this will impact all global Markets.

Opposite is a look at the Short Sterling Outright futures 1

hour Prior to, arguably, the Biggest Non Central bank
Economic Data of the Month for all global Markets. Traders
will ‘stack’ the CLOB with orders as they are confident of
the Next few minutes price action.

The Markets are very smart at understanding volatility and

how it can impact the markets, volume and trading ranges
of LL futures.

Major economic data releases can impact the Central

banks thoughts on future Interest Rate decisions, as such
the probability of volatility can increase. As a Major Event
Like US NFP (despite not being a UK economic Release)
causes uncertainty of the next movement in price, so
traders will delete their orders until they confident again
and probability is back in their favour,
Tier 1 Data.

What happens prior to the release of a Tier 1 Piece of economic Data? Defining the Baseline.

1 Hour Prior to the US Jobs data. Non Farm Payrolls and

Unemployment Data. The US economy is the Largest by far
and as such if there is a dramatic slowdown or increased
growth this will impact all global Markets.

A function of expected forthcoming volatility is liquidity

drying up in most global Markets for short period of time.
You can see from the opposite Diagram from stellar of the
Short Sterling (LL) futures., there is a huge reduction from
50,000 lots on the bid and ask prices to nearly 1,000 lots or
less from the previous slide 1 hour prior to the upcoming
event.
This reduction in Liquidity in the market only exacerbates
any potential shock from the forthcoming Economic
Release.

Depending how impactful the upcoming event could be

will depend how much liquidity pulls from the market
CLOB.

For the upcoming release we are going to look at the

Sep17 LL Future. Its current VWAP price is 99.726 and last
traded price is 99.73. This implies that the ICE GBP 3 month
LIBOR is currently expected to fix at 0.27 Basis Points. This
current Price is what is described as the Baseline Price we
will use for our analysis.

The previous slides analysis of the upcoming Data is usually

fully automated by Major Players. This analysis allows each
player to know in advance what they will do as there is a
very small amount of times between receiving the Release
data and the market reaction.
Tier 1 Data.

What happens after the release of a Tier 1 Piece of economic Data?

Post the Data Release.

Actual Expectation Revision

1 Hour Prior to the US Jobs data. Non Farm Payrolls and Unemployment Data. The US economy is the Largest by far and as such if there is a dramatic slowdown or
increased growth this will impact all global Markets.

Market Players will look at the expected 180,000 prediction of the US NFP and make the following predictions on how this will impact the LL Futures.
Actual Release LL Sep 17 Price
A NFP release of > 300,000 LL Sep17 sell down to 99.68 from Baseline 99.725 avg
A NFP release between 249,000 and 299,000 LL Sep17 sell down to 99.71 from Baseline 99.725 avg
A NFP release between 191,000 and 249,000 LL Sep17 sell down to 99.70 from Baseline 99.725 avg
A NFP release between 170,000 and 190,000 LL Sep17 no price change from Baseline 99.725 avg
A NFP release between 169,000 and 129,000 LL Sep17 Buy up to 99.73/99.74 from Baseline 99.725 avg 151,000 99.735 avg
A NFP release of < 100,000 LL Sep17 buy up to 99.75 from Baseline 99.725 avg
Tier 1 Data.

What happens post to the release of a Tier 1 Piece of economic Data?

1 Hour Post US NFP Release.

The Weaker than expected US NFP has caused the

Financial Markets to think the US economy is not as
Strong as previously thought. We see global Interest Rate
Futures trade higher ( lower expected future interest
Rates ) and LL Sep17 trade 1 tick higher.
Other Drivers of
Interest Rate Markets
Other drivers of Interest Rate markets

Upcoming Elections – If there is a chance of significant shift in Economic Policy of a

future new government the Market in its approach to the Bond Market, will become
very nervous and watch carefully all Political research and surveys. A recent example of
where Markets were transfixed by these was the recent Brexit referendum in the UK.

Budget Blowouts are Bond Bearish – Fiscally loose governments, like seen in Southern
Europe in the early 2010’s can cause horrific Bond stress and cause huge falls in bond
prices as confidence wanes and thus huge rises in the Government Bond prices.

Political Crisis - Will undoubtedly cause a bond crisis in the domestic Country. Recent
Crisis in Europe in 2010 caused much contagion to other developed Economies.
A trader's Strategy template

I) Fundamentals:
A) Growth (direction, pace)
B) Inflation (pace, variability)
C) Demographics (trend)
II) Politics:
A) Monetary policy changes
B) Fiscal policy changes
C) Geopolitical considerations
II) Behaviour:
A) Risk Appetite (volatile)
B) Sentiment
C) Momentum

II) Technical Factors:

A) Flows (Market Position)
B) Seasonals
C) Issuance vs transient demand

II) Quantitative Indicators:

A) Rich versus Cheap
B) Extreme versus normal valuations

Every trader should understand where the Economy is right now and look to
understand most or all of the trends and factors above.
Fundamentals

How do the Swap, Bond, STIR, FRA, OTC, Futures Markets interact?
What is a Bond Future?

We can broadly define a Bond Future as;

A physically deliverable futures contract.

An underlying (government) bond, that matches the deliverable criteria, must either be delivered on a given date (Eurex) or during a given time
window (CME).

Expiry dates are quarterly in March, June, September and December, but may be on the 10th of the month (Eurex) or during the month (CME).

The prices are quoted with reference to a ‘standard’ bond contract with a defined yield to maturity of 6% (CME and Eurex) or 4% (ICE).

The Tick value of a bond future is the smallest price increment possible multiplied by the face value. For Eurex Bond Futures (which are quoted
in Decimals and quoted with a 0.01% increments), this makes life straight forward, being the tick Value EUR 10, apart from Shatz (2year
contracts) which can move in 0.005% increments and hence have a EUR 5 tick value. For CME, it varies with the futures contract, from $7.8125 to
$31.25.

The Actual invoice price of the deliverable bond is calculated using a Conversion Factor.

Conversion factors can be complex, suffice to say that because bond futures are not based on a single underlying bond issue, but rather a basket
of eligible (“deliverable”) bonds, there is always a bond that makes more economic sense than others to deliver. Therefore, the market assumes
that any contract seller will always deliver this “cheapest to deliver” bond in the event of delivery.

Think of it this way, if you are trading Coffee and you had to deliver Coffee to the Buyer at the Warehouse, and you had a choice between various
different grades and cost of Coffee, you would always deliver the cheapest grade of Coffee within the acceptable grades per the contract
specifications . Bond Deliveries are much the same.

This link gives a concise approach to calculating a conversion Factor on Eurex.

http://www.eurexchange.com/exchange-en/market-data/clearing-data/deliverable-bonds-and-conversion-factors/Deliverable-Bonds-and-
Conversion-Factors/173146

Size wise, Bond futures are simply huge trading a notional daily volume of $12 trillion per day.
What is an interest rate swap?

An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set
period of time. Swaps are derivative contracts and trade over-the-counter.

The most commonly traded and most liquid interest rate swaps are known as “vanilla” swaps, which exchange fixed-rate payments for
floating-rate payments based on LIBOR (London Inter-Bank Offered Rate), which is the interest rate high-credit quality banks charge
one another for short-term financing. LIBOR is the benchmark for floating short-term interest rates and is set daily. Although there are
other types of interest rate swaps, such as those that trade one floating rate for another, vanilla swaps comprise the vast majority of
the market.

What is the swap rate?

The “swap rate” is the fixed interest rate that the receiver demands in
exchange for the uncertainty of having to pay the short-term LIBOR
(floating) rate over time. At any given time, the market’s forecast of
what LIBOR will be in the future is reflected in the forward LIBOR
curve.

At the time of the swap agreement, the total value of the swap’s fixed
rate flows will be equal to the value of expected floating rate
payments implied by the forward LIBOR curve. As forward
expectations for LIBOR change, so will the fixed rate that investors
demand to enter into new swaps. Swaps are typically quoted in this
fixed rate, or alternatively in the “swap spread,” which is the difference
between the swap rate and the equivalent local government bond
yield for the same maturity.
What is the Swap Curve?

The plot of swap rates across all available maturities is known as

the swap curve, as shown in the chart below. Because swap rates
incorporate a snapshot of the forward expectations for LIBOR, as
well as the market’s perception of other factors such as liquidity,
supply and demand dynamics, and the credit quality of the banks,
the swap curve is an extremely important interest rate
benchmark.
Although the swap curve is typically similar in shape to the
equivalent sovereign yield curve, swaps can trade higher or
lower than sovereign yields with corresponding maturities. The
difference between the two is the “swap spread”, which is shown
in the chart below. Historically the spread tended to be positive
across maturities, reflecting the higher credit risk of banks versus
sovereigns. However, other factors, including liquidity, and supply
and demand dynamics, mean that in the U.S. today the swap
spread is negative at longer maturities

Because the swap curve reflects both LIBOR expectations and

bank credit, it is a powerful indicator of conditions in the fixed
income markets. In certain cases, the swap curve has supplanted
the Treasury curve as the primary benchmark for pricing and
trading corporate bonds, loans and mortgages.

Theoretically, Swap Rates trade higher to that of the Treasury

Rate. Although, that theory is blown apart with the US Swap
Spread curve opposite. Balance sheet pressures and Ultra low
Rates have pushed the US Swap spreads strongly negative for a
long period of time.
Mechanics and Definitions of Swap Spreads

Trading strategy; to take a view on the difference in rates between an Interest Rate Swap and a Government Bond.

Any interest rate swap will make or lose money as rates go up or down. But what if an investor does not have an
opinion on whether rates will go up or down? Perhaps, they think that the credit-worthiness of the financial
industry will change relative to sovereign debt? Maybe our investor thinks that markets are poised for a Flight to
Quality, or that other investors want to avoid Libor-based instruments and the lack of liquidity in associated swaps.
In this case, they can transact a Spread over.
Consider an investor who believes that 10 year Interest Rate Swaps will move differently to 10 year Government Bond yields. They
would be well served to enter into a Spread over trade. If they think 10 year Interest Rate Swap rates will go up by more (or go up
faster) than the yield on a 10 year Government Bond, then they should pay the fixed rate on a 10 year swap and buy the 10 year
Government Bond. If they think 10 year Interest Rate Swap rates will go down more (or go up slower) than 10 year Government Bond
yields, then they should receive on a 10 year swap and sell the 10 year Government Bond.

This strategy highlights a very important feature of Spread over

trading. These trading strategies rely on relative moves between two
markets. In the case of a 10 year swap versus a 10 year bond, if interest rates
on the two instruments moved exactly in tandem, then we would not make
or lose money (assuming cost of carry and the shape of the curves are
consistent across the two markets).
Eonias, Sonias and OIS – Risk free Term Structure

The “risk-free” term structure of interest rates is a key input to the pricing of derivatives. It is used for defining the expected growth rates of
asset prices in a risk-neutral world and for determining the discount rate for expected payoffs in this world. Before 2007, derivatives dealers
used LIBOR, the short-term borrowing rate of AA-rated financial institutions, as a proxy for the risk-free rate. The most widely traded
derivative is a swap where LIBOR is exchanged for a fixed rate. One of the attractions of using LIBOR as the risk-free rate was that the
valuation of this product was straightforward because the reference interest rate was the same as the discount rate.

The use of LIBOR to value derivatives was called into question by the credit crisis that started in mid-2007. Banks became increasingly
reluctant to lend to each other because of credit concerns. As a result, LIBOR quotes started to rise. The TED spread, which is the spread
between three-month U.S. dollar LIBOR and the three-month U.S. Treasury rate, is less than 50 basis points in normal market conditions.
Between October 2007 and May 2009, it was rarely lower than 100 basis points and peaked at over 450 basis points in October 2008.

Most derivatives dealers now use interest rates based on overnight indexed swap (OIS) rates rather than LIBOR when valuing collateralized
derivatives.

Overnight Indexed Swaps

Overnight indexed swaps are interest rate swaps in which a fixed rate of interest is exchanged for a floating rate that is the geometric mean of
a daily overnight rate. The calculation of the payment on the floating side is designed to replicate the aggregate interest that would be earned
from rolling over a sequence daily loans at the overnight rate. In U.S. dollars, the overnight rate used is the effective federal funds rate. In
Euros, it is the Euro Overnight Index Average (EONIA) and, in sterling, it is the Sterling Overnight Index Average (SONIA). OIS swaps tend to
have relatively short lives (often three months or less). There are two sources of credit risk in an OIS. The first is the credit risk in overnight
federal funds borrowing which we have argued is very small. The second is the credit risk arising from a possible default by one of the swap
counterparties.

The three-month LIBOR-OIS spread is the spread between three-month LIBOR and the three-month OIS swap rate. This spread reflects the
difference between the credit risk in a three-month loan to a bank that is considered to be of acceptable credit quality and the credit risk in
continually-refreshed one-day loans to banks that are considered to be of acceptable credit quality. In normal market conditions it is about 10
basis points. However, it rose to a record 364 basis points in October 2008. By a year later, it had returned to more normal levels, but it rose
to about 30 basis points in June 2010 and to 50 basis points at the end of 2011 as a result of European sovereign debt concerns. These
statistics emphasize that LIBOR is a poor proxy for the risk-free rate in stressed market conditions.
Bundles.

ICE Futures Europe packs and bundles are recognized trading strategies that enable you to easily
execute a combination of contract months in Short-Term Interest Rate (STIR) Euribor, Sterling,
Eurodollar and Euroswiss futures contracts. This allows users to gain exposure to longer term interest
rates, without the legging risk and cost of trading the individual months.

Leg Pricing

Average Difference Change Pricing

Packs and Bundles prices will be quoted using the annualised price convention, also known as Average
Difference Change (ADC) Pricing. The tick increment to be used in the pack and bundle markets for
Three Month Sterling Futures will be:

The Exchange will use a price factor of 100 to convert the displayed screen price of a pack or bundle
into basis point tick increments. Packs and Bundles leg prices will be assigned in whole basis points
and allocated starting from the back months of the strategy and moving forwards. For example: a user
submits a price of 2.75, which is then converted to 0.0275 ticks by dividing the price by the price
factor (2.75/100). This tick price can then be assigned to each individual leg price.
What does a Listed Interest Swap look Like?

There are USD and Euro denominated Swap Futures with very similar contract specs, below I
have focused on the GBP denominated version. They are designed to give the holder (buyer or
seller of the swap) exactly the same economic cash flow as to holding a notionally equivalent
Interest Rate swap in the OTC Market.

ERIS GBP LIBOR Interest Rate Future

£100,000 notional principal whose value is based upon the difference between a stream of
semi-annual fixed interest payments and a stream of quarterly or semi-annual floating interest
payments based on 3 or 6 month GBP LIBOR, over a term to maturity.

Tenors available: 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 30 years

1 Contract = 1 lot = £100,000 face value

Trading conventions - Buy = Pay Fixed & Sell = Receive Fixed

Quarterly IMM Dates (3rd Wednesday of each March, June, September, December) (e.g. 2YR
Tenor may read “Mar 18, 2015” or “Mar 15”) Up to 8 consecutive future Effective Dates
tradable at one time

The last day on which the Contract can be traded is the Holiday Calendar business day
preceding the Maturity Date. On the Last Trading Day trading will cease at 6:00 PM London
Time.

Net Present Value (“NPV”) per Contract will be used for trade execution. NPV is expressed in
per contract terms for the Buyer (Pay Fixed). Each Future negotiated in NPV terms has an
implicit Futures-Style Price of:

Trade Price = 100 + Anegotiated +Bt – Ct

Where Anegotiated is the NPV per Contract agreed upon between the counterparties (divided by
1,000 to normalise units to 100 face amounts), Bt is the value of the historical fixed and floating
amounts, and Ct is the PAI†† at time t

The B and C components are calculated once daily and applied by IFEU, and are not subject to
negotiation by the counterparties.
All the Interest Rate Markets discussed prior are linked intrinsically to one another.

Bootstrapping, interpolation and extrapolation are used commonly in the Interest Rate markets to plot yield curves. We don’t need to dive
into the math of these approaches, we just need to know this is how the Financial Engineers plot yield curves on a day to day basis.

Between each of the derivatives listed there is a Strong traded ‘basis’ product which ties all our Interest Rate curves together.

As the only key difference between an Interest Rate Swap and a Government bond with equal start dates and Maturity dates will be the
Credit Difference, it is no surprise the price difference will be very small and to the most part, the prices of the two instruments, will remain
tightly linked to one another. This strong ‘bond’ between these two instruments holds for all the tenors up and down the yield curve, 2yr,
3yr, 5yr, 10yr and 30yr.

Given Interest Rate Swaps are a string of Forward LIBOR Rates one would expect, and be right, that a 2 year EUR Interest Rate swap (a
string of 4 consecutive 6m EURIBOR rates) will resemble closely a string of 8 Euribor Futures (2 year bundle). There is a basis, which is
pretty constant, between 3Month and 6Month Euribor or Libor Rates, this is called the 3s*6s Basis.

IMM Dated Forward Rate Agreements or FRAs are the Over-the-Counter STIR essentially. The ONLY differences are the FRA is quoted in
Yield Terms and the STIR is quoted in terms of price (100-Yield) and that a FRA is quoted with another counterparty/Bank and a STIR is
traded in the Clearing House of an Exchange.

Bond Markets
Swap Spread Basis

OIS/Eonia/
Interest Rate
Sonia/Fed Swap Markets
Funds

1s/3s Eonia – Euribor Basis 3s*6s Basis and Convexity

FRAs STIRs
All the Interest Rate Markets discussed prior are linked intrinsically to one another, yet the curve shapes remain very similar.

The 2 year EUR Interest Rate Swap’s price discovery/direction is 97.5 % correlated on average to that of the 2year Shatz Future. To further
illustrate this tight ‘bond’ between these derivatives I have created two (intraday) charts below. The left hand chart shows the intraday price
movement of the actual Swap spread between the two derivatives. This shows a stable relationship between the two ‘different’ but highly
connected markets. The right hand chart illustrates the intraday price movements of the actual 2 products that create the 2 year EUR swap
spread, i.e. the 2year German Govt Bond (benchmark 2 year in Europe for 2 years) and the 2 year EUR Interest Rate Swap. It is no surprise that
the two derivatives are 97.5% correlated as you can see their close relationship in the chart, as one product trades higher so does the other
product.

Banks are the major users of Interest Rate Swaps and usually are the Major Market Makers to their clients (Hedge Funds and Asset Managers) Liquidity in both is
very high and these Major players will use both markets to hedge open positions when they need. If a Bank is requested to quote a large trade in the 2 year EUR
IRS from a client and then the client trades with him, he will use all the Tools he has in front of him to hedge the immediate ‘outright risk’ of the Interest Rate
swap. He will / could hedge all the risk in the 2yr Govt bond Future or a combination of both products. The Banks will then ‘warehouse this Basis Risk’ between
the two derivatives, much preferring this basis risk to outright exposure of the IRS.
Long Term Trends can drive Swap Spreads in one direction or another to form a Long Term Trend.

Despite this long term trend in the ‘basis’ between the two derivatives the intraday price action, of the component
legs of the basis, are highly correlated to one another and one we must watch.

Despite large fiscal deficits in the US, UK and Germany, government bond supply implies tighter spreads however the flight to quality from
Eurozone crisis and Central Bank bond buying have pushed swap spreads wider (higher, as illustrated in the 2 year chart of the EUR 2 year
Swap spread above). This widening is exacerbated as the panel of Euribor banks is made up of banks from the whole Eurozone as well as a
handful of non-Eurozone banks.

While the current Longer term drivers of the 2 European Swap spreads have been driven by the initial uncertainty around the partial
repayment of the 3 year LTRO and continued pressure from the European crisis, expectations of European interbank stress are contained by
the ECB’s actions and should keep a lid on further widening in this spread.

These longer term drivers of Swap spreads are very subtle or appear not present in the microstructure of the Euribor and Shatz futures, yet
underneath they are part of a strong current that we should understand at the very least.
Interest Rate Swaps, STIRs and Bond curve shapes.

Despite this long term trend in the ‘basis’ between the two derivatives the intraday price action, of the component
legs of the basis, are highly correlated to one another and one we must watch.

To highlight the symbiosis between the Shatz-Bund (bond spread - blue) and EUR 2yr-10yr (IRS spread - orange), I have overlaid a 60 minute
chart of each above.

Statistically these two spreads are 79% correlated in their price action.

There is not a Perfect correlation for a few reasons;

a) Supply and Demand. These markets have different players making different trades at different times for different reasons.
b) Liquidity.
c) Slight difference in Duration. Bund is 9 years Approx. in Maturity and the 10 yr. EUR IRS start value spot and not Dec 2016 when the
Bund start date is.
Price action of 2 year Shatz, 2 year EUR IRS and 2year Euribor Bundle.

Despite this long term trend in the ‘basis’ between the two derivatives the intraday price action, of the component
legs of the basis, are highly correlated to one another and one we must watch.
Price action of 5 year Bobl, 5 year EUR IRS and 5 year Euribor Bundle.

Despite this long term trend in the ‘basis’ between the two derivatives the intraday price action, of the component
legs of the basis, are highly correlated to one another and one we must watch.
Price action of 10 year Bund future and the 10 year EUR IRS.

Despite this long term trend in the ‘basis’ between the two derivatives the intraday price action, of the component
legs of the basis, are highly correlated to one another and one we must watch.
Short Term Interest
Rates
What is a Short-Term Interest Rate Future (STIR)?

STIRs are very liquid instruments. They are one of the most important tools for managing interest rate risk.

We can broadly define a Short-Term Interest Rate future as:

• A cash settled futures contract (i.e. there is no delivery of an underlying asset)

• Settlement in cash occurs on the value date of the reference interest rate.
• Expiry dates are generally on International Monetary Market dates
(the third Wednesday of March, June, September and December). Australian Bills and
New Zealand Bills are notable exceptions. So-called monthly “serial” contracts also exist,
typically expiring on the third Wednesday of a non-benchmark month.
• For “T+2” currencies, (such as USD and EUR), the relevant fixing date for the reference
interest rate is the Monday before the third Wednesday. For “same-day” currencies (such as GBP and CAD
plus other Commonwealth currencies), the relevant fixing date is the third Wednesday itself.
• The price is quoted as 100 minus a reference interest rate.
• The reference interest rate is a 3 month tenor.
• The face value of the contract is normally 1,000,000 of local currency (in JPY it is 100m).
• A move of 1 “tick” or 0.01 on the price of the contract is therefore equal to 25 of local currency. This is simply #
the non-discounted value of a 1 basis point move in interest rates for three months:

0.01% * 1,000,000 * 90/360 = 25

The contracts are quoted as “100 minus interest rate” so that the price of the contract mirrors the
properties of a bond – price up, yield down and vice versa.

That’s so that us simple traders don’t get too confused when trading between different instruments!
STIRs at ICE Futures Europe

When ICE bought NYSE Euronext in 2012/2013, they also gained control of the LIFFE derivatives exchange in London. LIFFE is
an acronym for the London International Financial Futures Exchange. The STIR contracts traded on LIFFE are:

• Euribors, known as ‘Bors. These contracts cash settle at 100 minus the 3 month Euribor fixing. (see slide 48)
• Short Sterling. These contracts cash settle at 100 minus the 3 month GBP Libor fixing. (see slide 47)
• EuroSwissy. These contracts cash settle at 100 minus the 3 month CHF Libor fixing. (see slide 49)

And for completeness sake, the other notable STIRs around the globe are:

• Eurodollars, traded at CME. These contracts cash settle at 100 minus the 3 month USD Libor fixing. (see slide 50)
• Euroyen vs TIBOR, traded at SGX and TFX. These contracts cash settle at 100 minus the 3 month JPY Tibor fixing on
a notional of JPY100m.
• Aussie Bills, traded at ASX. These contracts are deliverable! Quoted as 100 minus the 3 month AUD BBSW fixing.
• Kiwi Bills, traded at ASX. These contracts cash settle at 100 minus the 3 month NZD BKBM fixing.
CME Eurodollar volumes are huge

You cannot get away from this fact as soon as you look at the data. Below is the percentage market share of the
STIR market by currency (last 12 months):

• The chart shows USD-equivalent notional volume traded each day in Eurodollars (USD), Euribors (EUR),
Short Sterling (GBP) and Euroswissy (CHF), expressed in percentage of total traded.
• The blue bars, representing USD notional traded dominate.
• As a rule of thumb, CME Eurodollars make up 70-75% of STIR trading on any given trading day.
Euribor volumes are surprisingly small

Ask any trader, and they will confidently assert that Euribors are liquid and Short Sterling is a pig to trade due to a
lack of liquidity. I was therefore surprised when I analysed recent volumes for the European STIR contracts:

A few notes on the Chart below;

a) Volume and Liquidity is important but does not guarantee or confirm whether a Particular
product can be a profitable product to trade.
b) The below Volume breakdown clearly shows a increase in Liquidity/volume in Short Sterling in
the last 4 months relative to the previous 2 months. This is mainly because of Volatility / Uncertainty around the
Brexit ( UK vote on EU referendum ) vote and outcome In June 2016.
c) Volume will pick up in Euribor and Euroswissy Futures if there is Economic news to impact
Interest Rates.
d) Negative Interest Rates / Low Interest Rate Policy by Central Bank is very damaging for Volumes
and Volatility in STIRs.
BREXIT affected volumes

One of the motivations to include ICE STIR volumes now is to monitor events in GBP markets. June saw elevated
volumes in Short Sterling as a result of the referendum:

• Volumes, in USD-notional equivalents, traded per day for Euribors (EUR), Short Sterling (GBP) and Euroswissy (CHF) for June
2016.
• Volumes in Short Sterling (in Red) have overtaken Euribors on 11 trading days in June!
• This might be a fleeting phenomenon, but anyone running risk in these products should be aware of these market
changes.
STIRs and FRAs

FRAs are essentially an OTC version of a STIR future. Less Liquidity (as you can see from the Volume comparison on
slide 49) but far more granularity in Maturity Dates.

An FRA is a contract in which the underlying rate is simply an interest payment, not a bond or time deposit, made in dollars, euribor
or any other currency at a rate that is appropriate for that currency. A forward rate agreement is a forward contact on a short-term
interest rate, usually LIBOR, in which cash flow obligations at maturity are calculated on a notional amount and based on the
difference between a predetermined forward rate and the market rate prevailing on that date. The settlement date of an FRA is the
date on which cash flow obligations are determined.

• The structure is the same for all currencies.

• FRAs mature in a certain number of days and are based on a rate that applies to an instrument maturing in a certain
number of days, measured from the maturity of the FRA.
•The structure is as follows: The short party or dealer and the long party or end-user will agree on an interest rate, a time
interval and a "hypothetical" contract amount. The end-user benefits if rates increase (she has locked-in a lower rate with the
dealer). Because the end-user is long, the dealer must be short the interest rate and will benefit if rates decrease.
•The contact covers a notional amount but only interest rate payments on that amount are considered.
•It is important to note that even though the FRA may settle in fewer days than the underlying rate (i.e. the number of days
to maturity in the underlying instrument), the rate that the dealer quotes has to be evaluated in relation to the underlying
rate.
•Because there are two-day figures in the quotes, participants have come up with a system of quotes such as 3 x 9, which
means the contract expires in three months and in six months, or the nine months from the formation of the contract,
interest will be paid on the underlying Eurodollar time deposit upon which the contract's rate is based.
•Other examples include 1 x 3 with the contract expiring in one month based on a 60-day LIBOR, or 6 x 12, which means the
contract expires in six months based on the underlying rate of a 180 day LIBOR.
•Usually based on exact months such as 30 day LIBOR or 60 day LIBOR not 37 days and 134 day LIBOR. If a client wants to
tailor an FRA, it is likely that a dealer will do it for the client. When this occurs, it is considered to bean off-the-run contract
•The best way to see it is through an example, which we will cover in the next section.
STIRs and FRAs

FRAs are essentially an OTC version of a STIR future. Less Liquidity (as you can see from the Volume comparison)
but far more granularity in Maturity Dates.
• Aggregated weekly notional amounts of STIR futures (Euribors, Short Sterling and Euroswissy) vs FRAs (EUR,
GBP and CHF).
• On average, FRA notional traded makes up around 20% of total short-term interest rate risk.
• This is a much higher percentage than I anticipated. In futures markets there is a lot of risk recycling by
liquidity providers, which inflates volumes for a given change in open interest.
• FRA volumes are far more likely to be down to risk management of large swaps desks – akin to
“compressing” short dated interest rate risk of swaps with FRAs.
Fed Funds Futures

The Fed Funds futures contract price represents the market opinion of the average daily fed funds effective rate as
calculated and reported by the Federal Reserve Bank of New York for a given calendar month. It is designed to
capture the market’s need for an instrument that reflects Federal Reserve monetary policy. Because the Fed Fund
futures contract is based on the daily fed funds effective rate for a given month, it tends to be highly correlated
with other short-term interest rates and is useful for managing the risk associated with changing credit costs for
virtually any short-term cash instrument. Fed Funds futures can be used either speculatively to anticipate changes
in monetary policy or more conservatively to hedge inventory financing risk across many different markets.

Key Product Specifications;

a) Notional Face Value of $5,000,000 for one month calculated on a 30-day basis at a rate
equal to the average daily Fed funds effective rate for the delivery month.
b) 100 minus the average daily Fed Funds effective rate for the delivery month.
c) Nearest month: one-quarter of one basis point (0.0025), or $10.4175 per contract. All other
contract months: one-half of one basis point (0.005), or $20.835 per contract.
d) 36 consecutive Monthly contracts listed (3years)
e) Last business day of the delivery month. Trading in expiring contracts closes at 4:00 p.m.,
Chicago time (CT), on the last trading day.

CME Group FedWatch Tool

The CME Group FedWatch tool lets you quickly gauge the market’s expectations of potential changes to the fed
funds target rate at upcoming FOMC meetings. Users can view the probabilities of future rate
movements for the next scheduled FOMC meeting, as well as the probabilities of rate movements for deferred
FOMC meetings.

To view the CME Group FedWatch tool, visit

cmegroup.com/fedwatch
tool, visit
CME Group FedWatch Tool

Below you have the CME Group Fed Watch tool. This computes, by upcoming Fed Fund Futures Contracts, the
current expectation (by current Market Price of Fed Funds Futures) of a change in Monetary Policy by the federal
reserve.

On the Right hand side you have the FOMC’s assessment of the future path of Interest Rates given the current
FOMC projections on Growth and Inflation. tool, visit
Short Term Interest Rates refer to the Interest Rates of derivatives with a Residual
maturity of 5 years or less. In the Over-The-Counter (OTC) Short term interest rate
markets you can trade as short as Overnight and 1 week.

These are not the Interest Rates at which the bonds were issued rather the interest rates
implied by the prices at which these (Government and Corporate) Bonds are being
traded in the financial markets.

Short Term Interest Rates Players trade are:

Euribor 3 Month Interest Rate Futures – Tracks 3 month EUR Euribor Interest Rate
Short Sterling 3 month Interest Rate – Tracks 3 Month GBP Libor Interest Rate
EuroSwiss 3 Month Interest Rate – Tracks 3 month CHF Libor Interest Rate
Eurodollar 3 month Interest Rate – Tracks 3 month USD Libor Interest Rate
Canadian 90 Day Bankers Acceptance – Tracks 90 Day CAD Bankers
Acceptance Interest Rate
ICE 3 month Short Sterling Futures (LL):

Cash Settled future based on ICE benchmark Administration limited London Interbank
Offered Rate (ICE LIBOR) rate for three months deposits.

Notional: £500,000
Quotation: 100 minus Rate of Interest
Minimum Price Movement & tick Value: 0.005 Front month £6.25
0.01 All other Contracts £12.50
Trading Hours: 07:30 AM – 18:00 PM London Time
Last Trading Day: 11:00 on the 3rd Wednesday of Delivery month
Execution algorithm: Time Based Pro-Rata matching algorithm
Settlement: Based on ICE benchmark LIBOR for 3 month Sterling deposits at 11:00 on Last Trading
Day.
Delivery Months: March, June, September, December such that there are 26 delivery months are
available for trading. In addition to this at the Front of curve there are 3 consecutive Monthly
contracts.

Related Products:

LL Calendar Spreads, LL Butterfly, LL Condors, LL Combos, LL Options.

ICE 3 month Euribor Futures (Euribor):

Cash Settled future based on EMMI EURIBOR rate for three month deposits.

Notional: EUR 1,000,000

Minimum Price Movement: 0.005
Tick Value: EUR 12.50
Quotation: 100 minus Rate of Interest
Trading Hours: 01:00 AM – 21:00 PM London Time
Last Trading Day: 10:00 on the 3rd Wednesday of Delivery month
Execution algorithm: Time Based Pro-Rata matching algorithm
Settlement: Based on the European Money Markets Institute Euribor Rate (EMMI Euribor) for three
month Euro Deposits at 11:00 Brussels time on Last Trading Day.

Related Products:

Euribor Calendar Spreads, Euribor Butterfly, Euribor Condors, Euribor Combos, Euribor Options.
ICE 3 month EuroSwiss Futures (EuroSwiss):

Cash Settled future based on Swiss Franc LIBOR rate for three month deposits.

Notional: SFr 1,000,000

Minimum Price Movement: 0.01
Tick Value: SFr 25
Quotation: 100 minus Rate of Interest
Trading Hours: 07:30 AM – 18:00 PM London Time
Last Trading Day: 11:00 Two Business days prior to the 3rd Wednesday of Delivery month
Execution algorithm: Time Based Pro-Rata matching algorithm
Settlement: Based on the ICE Benchmark Administration Limited LIBOR Rate (ICE LIBOR) for three
month Swiss Franc deposits at 11:00 London time on the Last Trading day.
Delivery Months: March, June, September, December such that there are 16 delivery months are
available for trading.

Related Products:

Euroswiss Calendar Spreads, Euroswiss Butterfly, Euroswiss Condors, Euroswiss Combos, Euroswiss
Options.
CME 3 month EuroDollar Futures (Eurodollar):

Cash Settled future based on Swiss Franc LIBOR rate for three month deposits.

Notional: $1,000,000
Minimum Price Movement: 0.0025 Very Front contract Tick Value $6.25
Minimum Price Movement: 0.005 Very Front contract Tick Value $12.50
Quotation: 100 minus Rate of Interest
Trading Hours: 17:00 PM – 16:00 PM Chicago Time (23 Hours)
Last Trading Day: 11:00 Two Business days prior to the 3rd Wednesday of Delivery month
Execution algorithm: Pro-Rata matching algorithm
Settlement: Based on the ICE Benchmark Administration Limited LIBOR Rate (ICE LIBOR) for three
month EuroDollar deposits at 11:00 London time on the Last Trading day.
Delivery Months: March, June, September, December such that there are 40 delivery months are
available for trading. In Addition to these there are four monthly contracts at the very front of the
curve.

Related Products:

Eurodollar Calendar Spreads, Eurodollar Butterfly, Eurodollar Condors, Eurodollar Combos, Eurodollar
Options.
What are Three month Short term Contracts (STIRs) ?

LL Three Month Short Sterling Futures Eurodollar Three Month Futures

What are Three month Short term Contracts (STIRs) ?

LL Three Month Short Sterling Futures

26th August 2016 Three Month ICE Libor Rate is 0.38969%.
In futures terms that Price would be 100 minus Rate =
99.61

If there was a 3month Futures expiring today then that

would be trading around 99.61 exactly as these futures
always trade at 3month LIBOR on expiry date.

STIRs are the markets prediction of Futures LIBOR Rates on

specific dates in the Future. What affects these rates are a
blend of Supply/Demand of incoming orders and the
markets perception of future economic growth and
Monetary policy.

The actual current trading price (as in 99.59 for Dec 2019)
almost never will be equal to the actual LIBOR Rate on that
expiry date. It is the current perception of where the LIBOR
would fix.

What can take away from this .jpg on LL Futures?

a) There is more liquidity (Volume/Players) in the Front

contracts i.e. SEP2016 to JUN2018 than JUN2020 to
MAR2021.
b) The current market prices indicate that the BOE/MPC
will only Raise Interest Rates by 16 Basis Points from
SEP2016 and MAR2021.
c) Given the current backdrop of Economic data and
news following Brexit Interest Rate are ‘expected’ to
go lower by 11 basis Points between SEP2016 to
MAR2018
d) The SEP2016 to SEP2017 part of the curve is ‘flatter’
than the SEP2017 to SEP2019 part of the curve.
e) The LL curve is smooth in nature.
What are STIR Calendar Spreads, Butterflies and Combos?

LL Three Month Short Sterling Futures

A STIR futures trader can utilize multiple Strategies along
the yield curve to extract alpha from the Markets in a safe
way.

In the .jpg opposite you can see a sample of the types of

common strategies STIR traders use as tools in trading the
STIRs markets every day.

Starting from the top with the ‘naked’ outright future (long
or short) and moving down to the bottom to the 6 month
Condor, each strategy increases in potential amount of risk
associated with that strategy. We look at that as the actual
and potential volatility associated with that strategy.

What can take away from this .jpg on LL Strategy

combinations?

a) Apart from the Extended Double Fly, each of these

Strategies are actual Exchange Traded Products. This
refers to the fact there is an actual Market Price listed
so End users can trade. The Extended Double Fly needs
to be Executed manually through 2 separate
transactions.
b) Each of these strategies are 3 month ‘Curve Neutral’
(Reduced Risk)
c) Each of these strategies can be executed by trading
separate contracts to build it.
d) The most actively traded Spreads are the Calendar
Spreads then the Butterflies.
e) As STIRs Futures are prediction of the Futures Interest
Rate path by a Central Bank and predicting this is very
tough for Traders, larger gaps between expiries in the
combination deployed increase volatility and Risk. This
is because of Uncertainty.
 Microstructure Fair Value of STIR futures & spreads?

Volume Weighted Average Price (VWAP)

Top of Book refers to the Best Bid Ask Price in the Central Limit Order book (CLOB) at any time. The VWAP calculated here takes into account all the Best Bids and
offers in the CLOB and their Size and calculates the average price based on price and volume at any time. You can see this in the snapshot in the column G under AVG.

To calculate this using:

Use the Formula: =IF(B2<E2,((C2*(B2/B2)+D2*(B2/E2))/(1+B2/E2)),(C2*(E2/B2)+D2*(E2/E2))/(1+E2/B2))

In the example of LL Jun17-Sep17-Dec17 the VWAP Price is consistent with the CLOB price with a skew of 3 times the amount of orders looking to sell this
combination than buy it at the current price. In the example of LL Jun17-Sep17-Dec17 Prices created from the outrights, it is suggesting that the bid price of -0.01 is
weak and despite having 8491 lots on the bid, potentially could trade out lower.
 LL Futures, Calendar Spreads and Butterflies.
What Drives Price Discovery of the LL Futures, Calendar spreads and Butterflies?

a) Domestic Central Bank Policy – Fundamental Analysis of Current Central Bank Policy
b) Political Backdrop
c) Global Central Policy
d) Government Bond Market Prices
e) Quantitative Research and Technical research.

What can we take away from the below .jpg of Short Sterling futures prices on Central bank Policy and market Interpretation of the current and Future
Economic climate?

a) LL Futures are pricing in a Future Easing in UK interest Rates of 11 to 12 bps between SEP2016 and SEP2017, which
signifies UK economic outlook looks more weak than strong.
b) Between DEC2017 and DEC2020 the Market is expecting that the current Economic weakness will subside a little (Hence
DEC2020 is pricing in a Higher Interest Rate than DEC2017) and Economic activity would increase.
c) Despite the BOE/MPC having cut rates in August2016 the market is expecting a further easing before the current
Economic downturn subsides.
Short Sterling (LL) Sep2017, LL Sep2017-Dec2017 & LL Sep2017-Dec2017-Mar2018 Butterfly

We have four charts opposite; LL Sep2017 Future, LL Sep2017-Dec2017 Calendar

spread, LL Sep2017-Dec2017-Mar2018 Butterfly and the FTSE Future.

Analysing the ranges for the last 6 months you can determine how Volatile each
of the contracts are. We calculate this by comparing the last 6 months trading
range versus the Bid-Ask spread of each Contract:

a) LL Sep2017: Hi 99.80 Lo 99.12

Range=(99.80-99.12)*£12.50
Range=£850 or 68 Bid-Ask Spreads
b) LL Sep2017-Dec2017: Hi 0.07 Lo 0.00
Range=(0.07-0.00)*£12.50
Range=£87.50 or 7 Bid-Ask Spreads
c) LL Sep2017-Dec2017-Mar2018 Butterfly: Hi 0.02
Lo -0.01
Range=(0.02—0.01)*£12.50
Range=£37.50 or 3 Bid-Ask Spreads
d) FTSE Future: Hi 6923 Lo 5728
Range=(6923-5728)*£10
Range=£11,950 or 1195 Bid-Ask Spreads

What can take away from this .jpg on LL Futures and Strategies and the Bid-Ask
Analysis above?

a) By trading LL Futures in spreads or Combos we eliminate excessive volatility,

or Reduce Opportunity?
b) Despite Much Economic Data, UK EU Referendum in between Marc2016 and
today the Butterfly has remained in a very tight Range.
c) The LL Sep2017 Future is strongly inversely Correlated to the direction of the
Sep2017-Dec2017 Calendar Spread.
d) The LL Sep2017-Dec2017-Mar2018 Butterfly is mildly inversely Correlated to
the Direction of the LL Sep2017 Future.
e) The LL Sep2017 Future is currently positively Correlated to the direction of
the FTSE Future.
f) The FTSE future is Inversely Correlated to the direction of the LL Sep2017-
Dec2017 Calendar Spread, LL Sep2017-Dec2017-Mar2018 Butterfly
Characteristics of STIR Futures?

With a few exceptions, Central Banks will rarely act on

impulse when changing policy and direction of the
Monetary and fiscal policy of a domestic country.

A rule of thumb in determining a future path of STIR

futures is that it takes 9 to 12 months for any Economic
event today to impact the real market. Another rule of
thumb is that a Central Bank will rarely (with a few
exceptions) move Interest Rates in one direction and then
the next Interest rate move being in the other direction.
Given historical evidence of ‘paths’ of monetary Policy
change, rather than one off moves, STIR markets observe a
Smooth shape up and down the curve. Given the
complexities (almost impossible) of predicting exactly what
a 3 month LIBOR will be in 3 or 4 years time, and given the
Central bank tendency to move in a path of moves, this
makes it almost impossible for three contracts next to each
other in the future having vastly different predictions of 3
month LIBOR rate. An example can be seen with the
continuation of the gradient of the curve shape being fairly
equal up and down the LL futures curve.
Golden Rules for (STIRs) ?

LL Three Month Short Sterling Futures

What Golden Rules are there for STIR futures?

a) As Central Banks move very slowly in deciding Monetary Policy,

always wanting multiple pieces of data to confirm trends in the
underlying economy, the First STIR future (whether it be LL,
EuroSwiss or Euribor) will be the lowest volatile contract as it has
the most certainty of being fairly priced to the LIBOR rate outcome.
b) As you move further out the curve, or further into the future, you
start to see Market Sentiment moving the LL Futures. On the day
opposite there was some Gloomy news about the Economy and the
Markets started to price in the chance the BOE/MPC could be
prompted into lowering interest rates more. This Sentiment and
Market Flow buys the LL Futures. Therefore, Bad Economic News
prompting Lower implied Interest Rates pushes LL Futures Higher.
Conversely, Positive Economic Data will push Market Sentiment to
sell Lower and push implied Interest Rates Higher.
c) As Central Banks (CBs) will make monetary policy changes slowly
and not just one move, STIR curves will display a ‘traditional’ or
typical STIR move.
d) This will be Front contract flat or up small, the next 3 to 5 contracts
will rally (go up) but not be the highest point in the curve, the next 3
or 4 contracts will be the highest point in the up move and then you
will see the last few contracts be slightly lower.
e) In the example opposite, the Markets are very quick to absorb new
variables of new Economic Data or commentary from Central Banks.
So the Rationale behind the Markets’ moves is as follows. Front 1 or
2 contracts the BOE-MPC will not react and cut rates on the Gloomy
data. Contracts 3 to 7 the Market presumes the BOE-MPC will begin
to cut Rates. Contracts 8 to 15 the BOE-MPC has Moved interest
rates again lower again. Finally the back, or last 4 contracts are
lower than the highest contracts as the Market will presume the
Interest Rate cuts made will have had a positive effect on the
Economy and the BOE-MPC will start to consider unwinding the Cuts
with a hike.
f) It is highly likely none of the scenario in e) will be done by the BOE-
MPC but this is the process the market makes on every piece of
data.
g) The Economic Cycle we are in will have a large factor in where the
‘pivot point’ or Inflection point actually sits.
STIR Classic Yield Curve
Shapes and Dynamics
Rule 1.

STIR Futures prices are ONLY the Current Market perception of where Future 3 Month ICE LIBOR will be set and NOT the current LIBOR Rate.
The LL futures price action takes into account Day by Day Economic Updates to gauge where future policy will be set. As you can imagine these
are almost always wrong to where the actual rate is set as predicting such accurate points in time’s LIBOR rates is next to impossible.

Central Banks usually move, with the exception of the Bank of Japan (BOJ) and the European Central Bank (ECB), in 25 or 50 Basis Points. The
BOJ and ECB have recently started to move in 10 basis point increments.

LL futures move in 1 Basis Point increments, so very gradual/small compared to the Central Bank Policy moves.

A) LL Futures 31st August 2016. Gloomy Economic Data Pushed Market B) LL Futures 1st September 2016. UK economic activity gripped with concern over Brexit
Sentiment that the BOE-MPC would ease Interest Rates. impact, despite this, UK Manufacturing Data suggested the Economy remains strong, and up to
8 Basis points of Easing is removed from LL futures.
Rule 2.
STIR futures are very sensitive to every piece of Economic data, Central Bank release and Geopolitical news. Such that in the short space of time
between Diagram A (31st August 2016) to Diagram B (1st September 2016) the LL Futures perception of Future ICE 3 month LIBOR rates can
change from very gloomy (probability of further Interest Rate cut by the BOE-MPC) to very positive (probability of further Interest Rate Rise by
the BOE-MPC).

A) LL Futures 31st August 2016. Gloomy Economic Data Pushed Market B) LL Futures 1st September 2016. UK economic activity gripped with concern over Brexit
Sentiment that the BOE-MPC would ease Interest Rates. impact, despite this, UK Manufacturing Data suggested the Economy remains strong, and up to
8 Basis points of Easing is removed from LL futures.
Rule 3.
The 3 month ICE LIBOR rate is NOT the Bank Of England Bank Rate. The ICE LIBOR Rate is the rate at which banks will borrow from one another
in the International Money Markets. As you can imagine the UK Government has a higher credit Rating (Aaa or there about) and Interbank
Credit Rating is somewhere between A to BBB. Much like in the Real world those with Better credit Ratings can borrow money cheaper than
those with adverse Credit ratings. This means that the ICE GBP 3 month LIBOR Rate is higher than the UK Bank Rate, usually around 12 basis
points higher.

B) LL Futures 1st September 2016. UK economic activity gripped with concern over Brexit
A) LL Futures 31st August 2016. Gloomy Economic Data Pushed Market impact, despite this, UK Manufacturing Data suggested the Economy remains strong, and up to
Sentiment that the BOE-MPC would ease Interest Rates. 8 Basis points of Easing is removed from LL futures.
Rule 4.
Central Banks meet every month or two to analyse the current economic climate and plan a path of Monetary policy that can ensure the
economy meets their mandate. This mandate is devised to ensure long Term growth for the Country. Central Banks (BOE-MPC) are often
‘bombarded’ with dozens of confusing sets of economic data to analyse to determine the correct path of interest Rates. Often these interest
Rates are set to ensure Inflation remains at the correct level (not to high not to low)

Central Banks are looking at the exact same economic data that banks, Hedge Funds and Prop traders are. With this, the Market knows from
historical Evidence and mathematical probability of how certain sets of Data will impact the LL futures prices and ultimately the 3 month ICE
LIBOR Rate. Therefore, markets are quite efficient in pricing in probability changes in perception of future interest Rates. These changes are
evident in the two diagrams below.

B) LL Futures 1st September 2016. UK economic activity gripped with concern over Brexit
A) LL Futures 31st August 2016. Gloomy Economic Data Pushed Market impact, despite this, UK Manufacturing Data suggested the Economy remains strong, and up to
Sentiment that the BOE-MPC would ease Interest Rates. 8 Basis points of Easing is removed from LL futures.
Classic Curve Shape of STIR Futures (LL)
The magnitude of the economic data news will impact the propensity of changes in LL futures and where the Inflection point is located. During
the 2008 Financial crisis daily price fluctuations were over 50 basis points in LL futures.

A C

B
D

Classic Shape 1: Weak Economic Data, STIR futures (LL) go higher/Lower Interest Rates.

The Chart above depicts the Short Sterling futures moves from the start of day (Blue line) to the End of Day (Orange line), these are in Tick Increments where in the example Mar17
closed at 0.020 up on the day.

What ever causes the STIR markets to move at any point in time the STIR futures (LL) will react in a highly repetitive manner. This pattern of cause and reaction is displayed in all
STIR curves. The only difference between different STIRs will be the ‘PIVOT’ point. Above diagram shows the inflection point marked with arrow C. Usually this inflection point is
located in the future where monetary Policy can have had enough time to impact the current economic climate. Thus will need reversing with the opposite monetary policy.

A – All STIR futures curves will roll down to the current ICE 3 month LIBOR rate. With Central Banks policy changes usually 6 to 9 months in the future the very front contracts will
be least impacted by the bad Economic news and will rise very small.
B – STIR futures will start to predict from the Economic bad data, that there is higher probability of BOE-MPC cutting interest rates than before. This drives the contracts from DEC
2016 to Mar2018 to go higher (lower int rates)
C – The current LL futures inflection point. This is usually the highest Point of the LL futures Daily move where the Economic news is bad.
D – In this typical STIR Futures up move the Markets will start to predict that the LL futures should not be higher than the contracts at Point C because it believes that the economic
Data will improve with the stimulus from the Central Banks, thus increasing probability that the Central banks will reverse the Interest Rate cut with a hike.

This shape of the STIR curve will ensure you understand where each STIR future should be trading in an up move* of LL futures. As most of you will only trade as far as the 12th LL
future the General rule is Economic Data/News Weak Back contracts rise more than the front. Conversely, we see the opposite if the Economic News is good.

* An up move in LL futures is defined as where the LL futures prices are trading higher than yesterday’s settlement (closing price)
Classic Curve Shape of STIR Futures (LL)

Classic Shape 1: Very Strong Economic Data, STIR futures (LL) go lower/Higher Interest Rates.

The Chart above depicts the Short Sterling futures moves from the start of day (Blue line) to the End of Day (Orange line), these
are in Tick Increments where in the all STIR curves.

A) The Inflection point in the STIR futures (LL) curve moves much further down the curve. This inflection point in this instance
reflects where the market is increasing the probability that GBP LIBOR rates, after the Strong Economic Data, will increase
from previous levels out to Dec 2020.
B) The General rule of thumb that the further out the LL future is it will move more (up or down depending on the direction) than
the nearer in contracts up until the inflection point.
C) Thankfully, the inflection point does not jump around much. This is because Central banks will keep communicate and be
transparent on their Economic Planning/monetary policy.
Classic Curve Shapes at end or Beginning of an Economic / Business Cycle

At the beginning or end of an Economic Cycle you will expect to see a change
in Monetary Policy to either; a) Cut Interest Rates to promote Spending and
Lending in the Real Economy or b) Raise Interest Rates to reduce Lending, cool
the Economy and encourage People to Save.

Either way as the UK Bank Rate and the ICE three month Libor rates are highly
correlated to one another in their direction, the LL Futures will begin to move.

‘Bear’ refers to a downward direction in the LL futures.

‘Bull’ refers to a upward direction in the LL futures.
‘Steepening’ refers to the shape/slope of the LL futures curve when the
Further out contracts are lower than the nearer in contracts.
‘Flattening’ refers to the shape/slope of the LL futures curve when the Further
out contracts are higher than the nearer in contracts.

Remember the LL futures are prediction of the Future ICE LIBOR at each point
in time.

The Economic cycle can also be referred to the Business cycle*. To

understand what cycle we are in we need to ask ourselves the following
questions; Is the UK experiencing Strong Growth? Is the UK experiencing
Strong or weak inflation or is the UK Economic Growth likely to slow? Is the
current economic indicators showing the UK MPC is on track with its mandate
and if not what would need to be done to adjust the economy into a correct
path to meet its mandate.

Note -No-one really knows the exact point that you enter a new Business
cycle until you are months into it as you can go into a new cycle and come out
very quickly.

If the UK economy had been growing too fast and Interest Rates were too Low
for the Growth path (U.K. Bank Rate & ICE GBP LIBOR will Rise) or the UK
economy had been growing too slow and Interest Rates were too High for the
Growth path (U.K. Bank Rate & ICE GBP LIBOR will Fall) Either way UK Interest
Rates will need to be on a new Path. In these scenarios we will expect to see;

a) Scenario Need for Rate Cuts from opposite Rate path course – Bear
Steepening curve shape. 70-80% of the time in this phase the LL futures
will trade higher.

b) Scenario Need for Rate Hikes from opposite or neutral Rate path course
– Bull Flattening curve shape. 70-80% of the time in this phase the LL
futures will trade lower.
Classic Curve Shapes in the middle of an Economic / Business Cycle

‘Bear’ refers to a downward direction in the LL futures.

‘Bull’ refers to a upward direction in the LL futures.
‘Steepening’ refers to the shape/slope of the LL futures curve when the
Further out contracts are lower than the nearer in contracts.
‘Flattening’ refers to the shape/slope of the LL futures curve when the Further
out contracts are higher than the nearer in contracts.

The Middle of the Business cycle refers to the state of the Economy when a
direction of growth or weakness is experienced for a prolonged period of
time. This will be confirmed by Economic Data pointing to sustained strength
or weakness. Central Banks will talk about a path of Interest Rate Cuts or
Rises.

Even if the Economic Data is strong or weak enough to sustain a monetary

Policy path of Cutting or Raising Interest Rates for several years, LL Futures
can move up or down during this period of time. During this part of the
business cycle the markets can experience Data which does not ‘agree’ with
the current forecast by the Central Bank and Markets.

In an Interest Rate cutting Cycle where the Economy is not strong enough and
needs stimulus, the curve shape will be 70-80% of the time Bull Steepening.
This is because Interest Cuts in the next few years will improve the economic
climate and at some point in the future will be unwound by removing these
cuts and possibly Raise Interest Rates as Inflation and growth Picks up.

In an Interest Rate Raising (Hiking) Cycle where the Economy is too strong and
needs stimulus removed, the curve shape will be 70-80% of the time Bear
Flattening. This is because Interest Raises in the next few years will lower/cool
the economic climate and at some point in the future will be unwound by
removing these Hikes and possibly cutting Interest Rates as Inflation and
growth slows down.

The Inflection point of each of these curves is usually around the 5th Generic
STIR (LL) to the 12th Generic STIR (LL)
Thank you