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Need help in buying interest rate hedge on Libor index


cheapguy
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Appreciate if you knowledgeable members can tell me how to do this.

 

Issue:

This is for regarding hedging the rising interest rates based on 12-month LIBOR index

I have residential property loans which become floating in end of 2010 and mid 2011.

Once they are floating they are based on 12month LIBOR +2.25%

 

Current 1year Libor is 1.98.

 

If there is lot of inflation in the future (between the next 2-6 years, i.e. mid 2011-mid 2015), the libor will go up.

Let us say I want to buy a hedge for  libor being greater than 6% for the years mid2011-mid2015, how can I do this.

 

Treat these numbers and  dates approximate and can be adjusted to the nearest settlement dates and rates.

The loan amount is about $1million.

 

What is the minimum amount for which i can buy these interest rate futures.

 

The sole goal is to protect myself from unexpectedly high interest rates, not to speculate on the direction of the interest rates. So buying insurance against inflation.

 

(There are other things like making the loan fixed for 30yr, but don't need 30yr fixed.Protection needed only until 2015.)

 

Thankyou

cheapguy

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Hi cheapguy,

 

The most simplest way is to probably ask your bank to see if you can refinance your loan to a fixed interest rate.

That's my advice. Otherwise you might bite off more than you can chew by trying to manage margin positions in the fixed income markets.

 

Other than that you'll have to resort to fixed income strategies.

 

There is no specific interest rate futures contracts that track the 12-month US LIBOR rates, however the closest interest rate futures contract would be the 30-day Fed Funds Rate Interest rate futures contract or the 1-month US Libor futures contract. The relationship is stronger long term however; even now, short term LIBOR rates vs. long term LIBOR rates vs. Fed Funds rate are different:

 

USD Libor 

1-month 3-month 6-month 12-month

0.45           1.24 1.75          2.04

 

Fed Funds rate = 0.25

 

http://i163.photobucket.com/albums/t314/ripleyx/Finance/12musliborvfedfundsrate.jpg

 

Be warned however, the relationship isn't always clear cut in the short term as you can see in the latter stages of 2008 when we had the credit crunch blowups in full swing, since LIBOR is based on the inter-bank borrowing rates and not the Fed Reserve rate directly.

 

So you should talk to your broker and ask about interest rate futures, and see the 30-DAY FEDERAL FUNDS INTEREST RATE futures contract specifications:

 

30-Day Federal Funds Futures

- Trade Unit = $5 million

- Settle Method = Cash Settled

- Point Size = $10.417 per 1/4 of one basis point starting on the Monday of the first full week in the expiration month (1/4 of 1/100 of one percent of $5 million on a 30-day basis rounded up to the nearest cent) $20.835 per 1/2 of one basis point ( 1/2 of 1/100 of one percent of $5 million on a 30-day basis rounded up to the nearest cent)

 

--> be warned with re point size, as 1 point size = $10.417 for every 0.000025 bp move up or down ... so if short term rates fall even more for some random reason, you might get a margin call.

 

Current initial margin requirements for CBOT 30 DAY FED FUND FUTURES contracts are approx. $1,688 max. depending on whether you are a specialist or not. So you will probably be entering into 1 contract at $5M and maintaining the margin requirements from there on (correct me if I am wrong).

 

As you're betting on the fed funds rate rising you will be shorting the fed funds rate interest rate contract, which means you will be selling it and hoping that the price will go down and then settling at a lower price to close out the hedge (no delivery/cash settlement).

 

So current quotes on the CME are:

http://i163.photobucket.com/albums/t314/ripleyx/Finance/quotes-1.jpg

 

Notice how the market is already pricing in a rate rise the latter end of 2010; i.e. you get the implied fed funds rate by taking the quote for say, Nov 2010 = 98.265, and going 100 - 98.265 = 1.735%. So the market as of this moment, is betting that the Federal Reserve will raise the Fed Funds rate to 1.735% by Nov 2010.

 

So right now, the implied rate is 100 - 99.7575 = 0.2425% ... which is correct (i.e. current yield on short term treasuries/fed funds rate).

 

Now, your problem is that there no contracts that go all the way out to 2011-2015, and it also become very illiquid as you get longer dated ... so that's the hard part.

 

That is the best way IMO. You can try options, or ETFs that are short treasuries too.

 

You should talk to your broker for more info or visit the Chicago Merc Exchange website: http://www.cmegroup.com

Good luck.

 

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