Stir euronet

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Those wishing either to trade futures and options contracts on Exchanges within the Euronext Group, or to offer and sell them to others should establish the
regulatory position in the relevant jurisdiction before doing so.
Euronext.liffe refers to the combined derivatives operations of Euronext and LIFFE. It comprises:
Euronext Amsterdam Derivative Markets, which is a regulated market under Dutch Law;
G Euronext Brussels Derivatives Market, which is a regulated market under Belgian Law;
G

G Euronext Lisbon Futures and Options Market, which is a regulated market under Portuguese Law;
G LIFFE Administration and Management, which is a Recognised Investment Exchange under English Law;
G MATIF and MONEP, which are regulated markets under French Law.

All are regulated markets under the European Union’s Investment Services Directive.
Euronext NV
PO Box 19163
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The Netherlands
Tel +31 (0)20 550 4444
.

Contents

G G 1 Introduction
G 1

G Euronext, LIFFE and Euronext.liffe 2

G 2 Introduction to understanding Short Term Interest Rate (STIR)
G
futures 3
G

G Definitions 3

G G 3 The wholesale cash money markets
G 4

G Introduction 4

G Understanding money market risk management 4

G G 4 The Inter-bank (or “Depo”) market
G 7

G Domestic and Eurocurrencies 8

G The importance of LIBOR and EURIBOR benchmark fixings 8

G Calculating simple interest on loans and deposits 10

G Conclusion – The inter-bank market 12

G G 5 STIR futures
G 13

G What defines a futures contract? 13

G Why trade STIR futures contracts on Euronext.liffe 13

G What has made STIR futures so successful? 14

G What is a STIR future? 14

G STIRs as “Contracts for difference” 19

G G 6 Price movements of STIR futures contracts
G 20

G Buying, or selling, STIR futures? 20

G The pricing mechanism of STIR futures 22

G The basis 24

G Conclusion 25

Contents continued overleaf

G G 7 Trading with STIR futures
G 26

G Using STIR futures contracts as a hedge 26

G Hedging where dates don’t match i.e. to non-Euronext.liffe
settlement dates 28

G Trading the futures curve using ‘calendar spreads’ 31

G G 8 Pricing swaps using STIR futures -Interest Rate Swaps
G 33

G Interest Rate Swaps 33

G The relationship between STIR futures and short dated IRS’s 34

G Using the STIR futures strip to determine the price of a one year
swap rate 34

G G 9 STIR options – an introduction
G 38

G What is an option? 38

G The advantages of buying and selling options 39

G De-coding the market jargon 40

G G 10 Trading with STIR options
G 43

G Trading examples 43

G Exercising an option 44

G Limitations of using options – the calculation of the
break-even rate 45

G Option valuation 45

G G 11 One year Mid-Curve options
G 52

G G G Contacts Inside back cover

Introduction to trading STIRs 1

G G
G Introduction
1

In today’s financial markets, uncertainty and
volatility are ever present, especially in the
interest rate markets. Increasingly, treasurers,
fund managers and others active in the world’s
financial markets are advised to consider cost
effective methods of managing their exposure Additionally, and not to be overlooked, bank
to sharp moves in those financial markets. treasury managers and fund managers can
benefit from less restrictive regulatory
Managing risk constraints pertaining to capital requirements
Treasurers, fund managers and other market when trading exchange-traded futures and
participants have a number of choices available options contracts.
to them to help them manage their interest rate
exposure. Either by using exchange-traded Comprehensive portfolio
products, like futures and options contracts, or Euronext.liffe offers one of the most
over-the-counter (OTC) products, such as comprehensive portfolios of Short Term Interest
swaps, Forward Rate Agreements (FRAs), caps Rate (STIR) futures contracts in the world
and floors together with the underlying cash covering the European market. Indeed,
markets themselves. Indeed, successful players in Euronext.liffe, with its flagship contract, the
today’s volatile markets will employ the full range Three Month Euro (EURIBOR) Futures
of available risk management and trading Contract, has over 99% market share in the
strategies. trading of Euro denominated STIR contracts.

Exchange traded futures and options contracts Trading STIRs
offer market participants not only a high degree This brochure has been developed by
of versatility in their use, but also significant Euronext.liffe in conjunction with Resource City,
advantages as strategic instruments, especially a leading provider of educational material to
when complemented by OTC derivative and capital market participants.The brochure has
cash market financial instruments. Indeed, when been designed to provide an overview of the use
used effectively, exchange-traded futures and and application of Short Term Interest Rate
options contracts, in conjunction with cash futures and options contracts, as well as giving
market and OTC derivative instruments can specific worked trading examples.
enhance returns, reduce risks and manage
interest rate risks with greater certainty, This publication has been written to be
precision and economy. accessible to all levels of market participant, and
as such assumes no prior financial knowledge on
behalf of the readers.Therefore, the publication
can either be read through progressively in
order to gain an overview of today’s STIR
market, or used selectively in order to gain
specific insights into certain aspects of the use
of STIRs or the actual trading of STIRs.

This publication does not offer advice on how
or whether to trade STIR futures and options
contracts on the LIFFE market and is provided
for informational purposes only.

2 Introduction to trading STIRs

G Euronext, LIFFE and Euronext.liffe
Euronext was formed by the merger of the
Amsterdam, Brussels and Paris cash and
derivatives exchanges in September 2000.The
Euronext Group has since grown further, adding
BVLP (the Portuguese cash and derivatives
exchange) and LIFFE (The London International
Financial Futures and Options Exchange).The
derivatives business of Euronext and LIFFE have
been being combined under the Euronext.liffe
umbrella with the migration of all of Euronext’s
derivatives markets to LIFFE CONNECT®, the
most sophisticated electronic derivatives trading
platform in the world.

In this brochure:
“Euronext.liffe” refers to the combined
derivatives operations of Euronext and
G

LIFFE, comprising the Euronext derivatives
markets in Amsterdam, Brussels, Paris and
Lisbon, and the LIFFE market in London; and
the “LIFFE market” refers to the UK
Recognised Investment Exchange which is
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administered by LIFFE Administration and
Management (a UK company), and which
forms part of Euronext.liffe.

For further information about Euronext.liffe’s
STIR products, please email stirs@liffe.com.


G G
G Introduction to understanding Short Term Interest Rate
2
(STIR) futures

Introduced in 1982, the LIFFE market’s STIR
contracts have seen strong and steady growth
ever since, maturing into one of the leading
derivative product portfolios of any exchange.
Indeed, such has been the success of these
contracts, Euronext.liffe has captured over 99% It is also appropriate at this point, to define what
market share of short term euro derivatives with a futures contract is:
its flagship contract, the Three Month Euro
(EURIBOR) futures contract. Definition of a futures contract
A futures contract is a legally binding
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Please see Euronext.liffe’s Short Term Interest agreement, concerned with the buying, or
Rate Brochure for further details on selling, of a standardised product, at a fixed
Euronext.liffe’s STIR product portfolio. price, for cash settlement (or physical
delivery1) on a given future date
G Definitions
In order to understand STIRs fully, it is important In the case of STIR futures, the “standardised
to understand some initial definitions, specifically, product” is short-term interest rates, (which
what a derivative is and from where it derives. will also be expanded on further in the futures
section of this text).
Definition of a derivative
As the name suggests, a derivative product is Therefore, having defined STIRs as both
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the term applied to any product that derives “derivatives” of the underlying cash money
from another product, usually (but not markets, and more specifically “futures
always) the underlying cash markets. contracts” on short-term interest rates, we can
now turn our attention to understanding what a
STIRs, as derivative products, derive from the money market product actually is.This will aid
underlying cash money markets, which will be your understanding of STIR futures contracts
examined in more detail shortly. and help put them into context.

1
STIR contracts are all cash-settled, there is no physical delivery, unlike the bond futures contracts.


G G
G The wholesale cash money markets
3

G Introduction
Each country’s own domestic money market is
an “OTC” (over-the-counter2) wholesale market,
trading in two main areas:

1. Unsecured cash – the so-called Investment Houses, Fund Managers, large/medium
“inter-bank”, or “Depo”, market (we will sized Corporations and Governments3.
focus more closely on the “depo” market in
the next section, as it is closely related to A “Wholesale” market is distinct from a “Retail”
the STIR market), and; market, in that the wholesale markets are usually
concerned with transactions for large sums of
2. Secured cash – the so-called cash-based money, i.e. in excess of say £500,000 (or the
securities, or “tradeable paper” market e.g. foreign currency equivalent).Whereas “Retail”
Treasury Bills, Certificates of Deposit (CDs), generally refers to the day-to-day transactions
Commercial Paper (CP), Bankers of the general public, in the form of deposits,
acceptances (BAs), Floating Rate Notes personal loans, mortgages etc.
(FRNs) and of increasing importance, the
so-called “repo” (sale and repurchase Although there is no official definition of what
agreement) market. constitutes a “money market” product:

All of the above OTC deals are done largely over The majority of all financial instruments traded
the telephone (either directly between the two in the money markets will have ‘a maturity’
counterparties concerned, or via money of one year, or less.
brokers) or, increasingly, via computerised
electronic broking systems. Although some money market instruments can
have longer maturities, (CDs for example can
Collectively these markets are referred to as the have maturities of up to 5 years), this length of
“cash” markets, because real sums of money term is normally the area where the so-called
will actually be debited and credited to “Capital Markets”, which specialise in medium
respective accounts. However, the most and long term transactions, take over.
important thing to remember about them is that,
because they trade OTC (rather than trading as G Understanding money market risk
a standardised contract, on a regulated exchange, management
such as the LIFFE market), there is real All money market products are concerned with
counterparty risk to consider. two of the three main types of risk:

“Counterparty risk” refers to the risk that Interest rate risk; and
either counterparty could actually default on the Counterparty (or credit) risk.
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deal and thereby leave the other counterparty
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exposed. (The third main type of risk is Foreign Exchange
(FX), or Currency Risk.)
The main market “players” in these wholesale
cash money markets are: International and
Domestic Banks, Building Societies (UK),

2
An over-the-counter or OTC market is where the two counterparties concerned strike a deal where all aspects are
negotiable.The two parties will therefore agree such things as currency, amount, period and price.
3
Only tradeable paper, not Inter-bank, as Governments will not deal “unsecured”.


Interest rate risk
What can interest rates do? Well, they can go up,
go down, or stay the same. Nobody knows for
certain what is going to happen next, which is
why this risk has to be managed.
For example, assume that a dealer lends money
The level of interest rates in any domestic at say, 5% for a three-month period.Then, the
market is determined by numerous factors. following day, interest rates for the three-month
For example, supply and demand, government period move up to say, 5.25%. If the dealer had
monetary policy4, the current economic climate, waited one more day, he could have lent at this
the strength or weakness of the currency etc. higher rate, ie received more interest on the loan.
The markets can be volatile and therefore, alter
quite frequently.Any action taken based upon Therefore, as a lender, one always wants to
actual, or possible, interest rate movement is lend as expensively as possible. (In banking
known as managing interest rate risk.The terminology, lending funds is also known as
management of interest rate risk in the short- ‘creating an asset’, ie it is your assets that you
term cash money markets is dependent upon are lending).
whether one is a borrower, or a lender, of funds.
Counterparty, or credit risk
However, a lender of funds in the cash money
markets also incurs another major risk –
The borrower
If you are a borrower of funds (i.e. create
liabilities), then your risk is that if interest rates counterparty, or credit risk.This is the risk that
subsequently come down, you could have waited the funds that have been lent, will not be re-paid
and borrowed at a lower (ie cheaper) rate! by the borrower. It is for this reason that all
banks (and other financial institutions that
For example, assume that a dealer borrows participate in the wholesale money markets),
money at say, 5% for a three-month period.Then, have very strict lending guidelines set in place.
the following day, interest rates for the three-
These include:
month period move down to say, 4.75%. If the
to whom they can lend money;
dealer had waited one more day, he could have
the amount they can lend; and
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borrowed at this lower rate, ie paid less interest
the period of the loan.
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on the loan.
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These guidelines are normally known as “credit
Therefore, a borrower of funds always wants
limits”. Such limits will be set up by a bank’s
to borrow as cheaply as possible. (In banking
credit department, whose sole purpose it is
terminology, borrowing funds is also known as
to assess and monitor the ability of existing
creating a liability, ie you are liable to pay the
(and potential) counterparties, to repay money
money back).
borrowed from the bank.
The lender
If you are a lender of funds, (ie create assets),
Money market products as “On balance

then your risk is that if interest rates
sheet” transactions
A bank will account for all such transactions
subsequently go up, you could have waited and mentioned above, on what is known as its
lent at a higher (ie more expensive) rate. balance sheet, which is split into assets and
liabilities.

4
Monetary policy in the Euro-in region is managed by the ECB (European Central Bank), rather than being the responsibility of
each individual government.


Operations such as cash loans (assets) and
deposits (liabilities) that actually involve a
physical payment (and consequent risk) are
therefore termed “On-balance sheet” exposures.

Having “On balance sheet” exposures dictates
that a Bank is required, by the Bank for
International Settlements (BIS), via its Capital
Adequacy Directive (CAD), and local regulatory
authorities, to set aside, for no return, a
proportion of its capital, in case of
non-repayment and doubtful debts.

This is an important aspect of all money market
trading, as it can make “On balance sheet”
trading expensive to conduct.

This major drawback is one of the main reasons
why the use of STIR futures (which are termed
“Off balance sheet,”) have grown rapidly as an
alternative and more cost effective, interest rate
risk management tool.

In the section “STIR Futures”, the reason as to
why STIR Futures are termed as “Off balance
sheet” products and the benefits thereof will be
explained in detail.


G G
G The Inter-bank (or “Depo”) market
4

The significance of the so-called “inter-bank” or
“Depo” market is that it is the underlying cash
market from which STIR futures derive.

It is therefore necessary to look at the inter-bank
market in greater detail.The inter-bank market Trading periods
(in market jargon terms, often referred to as the Figure 1 (above) illustrates Sterling (£) inter-bank
“Deposit” or ‘Depo’ market), is a wholesale OTC cash rates for certain fixed periods of time. For
market. It is the part of the money markets that illustration purposes, assume that it is published
is concerned with the borrowing, or lending, of by a London bank that is active in the sterling
large sums of cash (ie at least £500,000 or foreign inter-bank cash market.The fixed periods are
currency equivalent), totally unsecured, for marked in bold.
certain ﬁxed periods of time.
O/N: “Overnight” ie cash lent/borrowed for
As the name suggests, the interest rates quoted a one-day period, from today until
are known as “inter-bank” rates, simply because tomorrow6
they represent the best rates at which the major T/N: “Tom/Next” ie cash lent/borrowed for a
banks, and other large financial institutions (but one-day period, but from tomorrow until
not Governments5), are prepared to deal. the next day7
All currencies that trade in the international 1 wk “One week” ie cash lent/borrowed for a
money markets have an inter-bank cash market: 7-day period
2 wk “Two weeks” ie cash lent/borrowed for
Example a 14-day period
A typical set of rates, as given below, illustrates 1 mth “One month” ie cash lent/borrowed for
the Sterling (GBP) inter-bank cash rates one calendar month
applicable, for the various periods concerned: 2 mth etc.

Figure 1: Sterling inter-bank rates You will note that there are two interest rates
quoted for each period.This style of quote is
known as a “two-way” price, representing the
Period Offer Bid
O/N 4.70 4.60 interest rates at which a market maker (ie the
4.65 4.55 bank making the price) is prepared to lend, or
borrow, money in the inter-bank market.
T/N
1 wk 5.00 4.75
2 wk 5.00 4.75 The highest rate in an inter-bank two-way quote,
5.00 4.75 is always the rate at which a market-maker (bank)
would be prepared to lend cash for the period
1 mth
5.00 4.75
concerned.This rate is known as the “offer”.
2 mth
3 mth 5.00* 4.75
6 mth 5.25 5.00 Similarly:
5.50 5.25
The lowest rate in an Inter-bank two-way quote,
9mth
12mth 5.75 5.50 is always the rate at which a market-maker (bank)
* the significance of the three-month offered rate will be would be prepared to borrow cash for the
explained shortly
period concerned.This rate is known as the “bid.”
5
Governments do not normally deal “unsecured”.
6
If today was a Friday, then “Overnight” would actually mean from today until Monday ie a three-day period.
7
Similarly, if today was a Friday, then “Tom/Next” would mean from Monday until Tuesday.The markets do not trade on weekends, or
Bank Holidays.


A market-maker’s offer is naturally at a higher
rate of interest than his bid, as lending high and
borrowing low is how a market-maker in the
inter-bank market expects to make a profit!

Example: Eurocurrencies
Assume a market-maker quotes the three-month The definition of a eurocurrency is any
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Inter-bank price on the rates given above.This currency that is held outside its country of
means he would be willing to: origin.

LEND cash (unsecured) for three months For example, USD deposits traded in the UK
at 5%, (LIBOR)8 ie his offer, and, money markets are known as “eurodollar”
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BORROW cash (unsecured) at 4.75%, deposits, Similarly, sterling traded outside of the
ie his bid. UK would be referred to as “eurosterling” etc.
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The difference between the market-maker’s offer It is therefore very important not to confuse the
and his bid, is known as the “dealing spread”. term “eurocurrency” with the term “euro.”

Note: Since this is an inter-bank market, any The “euro” is the name given to the unit of
other non-bank participants, e.g. large currency created in January 1999 by the
Corporates, may well have to pay a “margin European Central Bank.Whereas,
over” to borrow funds. For example, for three “eurocurrency” is the generic term given to any
months say 5.00% plus 1⁄4 % margin = 5.25%. currency that is held (or being traded) outside
The size of the margin added to the offered rate, its country of origin.
for non-bank players, depends on the credit
worthiness of the institution concerned. Technically therefore, the euro would not be
Similarly, a Corporate wishing to place money on termed a eurocurrency, unless it is being traded
deposit may only be quoted, say 4.50% (ie bid outside the euro zone.
side minus 1⁄4 %).
G The importance of LIBOR and EURIBOR
G Domestic and Eurocurrencies benchmark fixings
The inter-bank markets for the various
currencies that trade in the international money LIBOR
markets come in two forms: Referring to the Sterling Inter-bank rate sheet
illustrated (Figure 1), you will note that there is
Domestic an asterisk* by the three-month offered rate,
The definition of a domestic currency is one which is also printed in bold.This is to alert you
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that is held in its country of origin. to the importance of this rate, with regard the
STIR futures markets. In order to understand the
For example, sterling (GBP) is the domestic concept of STIR futures, it is important to
currency of the UK money markets.Whereas, understand the significance of this three-month
the euro is the domestic currency of the offered rate.
(currently) 12 countries which collectively make
up the eurozone (ie Germany, France, Italy,
Austria, Spain, Portugal, Belgium, Netherlands,
Luxembourg, Finland, Ireland and Greece).

8
The concept of LIBOR will be covered shortly.


At 11am each day, in London, an “official fixing”
of a whole range of “LIBOR” rates, for a variety
of currencies, takes place under British Bankers
Association (BBA) rules, for any currency “fixing”
in London. For example, for the major currencies
“fixing” in London, the BBA will publish an based financial transactions (such as STIR futures
overnight, one week and two week fixing as well contracts), can be made).
as 12 monthly fixings out to one year.
It is important to realise therefore, that the
LIBOR stands for “London Inter-bank word ‘LIBOR’ actually refers to the fixing of any
Offered Rate”. currencies traded in London and agreeing to
abide by a BBA LIBOR fixing.
The fixings are determined as follows:
It is also possible to have an official USD LIBOR
At just before 11am, a group of 16 London banks fixing (ie US Dollar inter-bank rates “fixed” in
submit their offered rates for a variety of the Inter- London), or a CHF LIBOR fixing (ie Swiss franc
bank periods mentioned above, in order to allow rates “fixed” in London). Similarly, it is possible to
an official “ﬁxing” of this period to take place. have a Yen LIBOR fixing (ie Yen rates fixed in
London), or even a “euro-LIBOR” fixing (ie euro
For example, when setting the official three- rates fixed in London – see notes below on
month Sterling (or currency code GBP, or “EURIBOR”).
symbol £) LIBOR rate, the four highest and the
four lowest rates submitted are discarded. The importance of the three month
Subsequently, the official three-month GBP LIBOR rate
LIBOR rate is then ‘fixed’ at 11am, by establishing It is the three month fixing that has most
the mean average of the remaining eight banks’ significance for the STIR market, as this is
offered quotes. essentially the “underlying cash product” that the
STIR futures contracts derive from.
It is this official three-month LIBOR (or
EURIBOR – see below) “fixing” that is the For example with regard to Euronext.liffe’s STIR
most significant to us here, as this is also the futures contracts, LIBOR is the reference rate
“underlying product” that the STIR futures used for the Three Month Sterling (Short Sterling)
contracts are based on. Interest Rate futures contract (£ LIBOR), and the
Three Month Euro Swiss Franc (Euroswiss)
For example, when someone trades a STIR Interest Rate futures contract (CHF LIBOR).
futures contract, they are trading what they think
this official three month LIBOR (or EURIBOR – Other countries have their own official interest
see below) fixing rate will be for the currency rate fixings for domestic and eurocurrencies, and
concerned, on a given future date. (However, this these are used in similar circumstances, for
does not mean that the “offered side” of the example:
three-month inter-bank rate will remain at this
level for the rest of the day’s trading. Rather, this SIBOR: Singapore Inter-bank Offered Rate
official fixing rate at 11am is merely used as a
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TIBOR:Tokyo Inter-bank Offered Rate9
“reference rate” or “benchmark”, against which
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the pricing, or settlement, of a variety of LIBOR-

9
With reference to the STIR contracts, the yen denominated futures contract is settled against the TIBOR fixing.


EURIBOR
The initial struggle for supremacy concerning
a “euro reference rate” needs to be mentioned
here.When the euro was first introduced as
a single currency, in January 1999, it was assumed
that the main “fixing” centre would be in Simple interest =
London, ie a LIBOR rate for the euro (the “euro- Actual No. of days in period
Principal Amount x % Rate x
LIBOR rate” as mentioned above). However, this Actual No. of days in year
has not been the case.
Using the data in Figure 1, on a market-maker’s
three month quote of “5.25 – 5.00” for the three
For a variety of reasons, the main centre for the
month period, on a principal amount of say
fixing of euro benchmark interest rates has now
£500,000, the amount of interest to be paid
established itself in Brussels, where a panel of 49
(or received), at the end of the period (ie at
banks, calculate their own official benchmark
maturity), can be calculated as follows:
interest rates for the euro.The majority of the
panel are from Euro-in countries, but also
include, for example, the UK, which is a member
of the European Union, but is not a participant in
the euro itself.

This reference rate is known as the European
Bankers Federation (EBF) “EURIBOR” rate.
*See notes below on Value Dates & Day Basis.
Strictly speaking it should be referred to as the
‘euro-EURIBOR rate’, but because the euro is Hence, in a) above, as a market user:
the only currency being fixed under this new If you were a borrower of funds and dealt at
EBF benchmark reference rate, it is only ever the market maker’s offer of 5.001%, you would
referred to as the “EURIBOR” rate. borrow (“go long”) £500,000 at the outset.
You would also repay the principal plus interest
EURIBOR stands for “Euro Inter-bank (ie £500,000.00 + £6,232.88) at the end of the
Offered Rate”. fixed period (in this case 91 days later).

In b) above, as a market user:
If you were a lender of funds and dealt at the
G Calculating simple interest on loans

market maker’s bid of 4.75%, you would lend
and deposits
In order to fully understand where “minimum
tick size movements” on Euronext.liffe’s STIR (“go short”) £500,000 at the outset.You would
futures contracts come from, it is important to also receive principal plus interest (ie £500,000 +
understand the calculation of interest paid, or £5,921.23) at the end of the fixed period (in this
received, in the inter-bank markets.The amount case also 91 days later).
of interest to be paid, or received, on a loan or
deposit, is calculated at the start of the fixed A dealer making a two-way price and dealing on
period to which it relates, but is paid at the end both sides simultaneously would therefore make
(known as “in arrears”). It is calculated using the a profit of £311.64.
following simple interest formula:


Value dates & day basis
Sterling (GBP), as the UK’s Domestic currency,
normally deals ‘value today’, ie out of today,
calculating the Actual number of days in the
deposit period and dividing by a 365 day basis
(known as Bond basis).This would be written This would be referred to as “T (trade) + 2 (two
as “Actual/365”. business days forward)”, ie out of Wednesday
11th May, (also known as “out of spot”) and with
Whereas: an end date, or maturity date, of 11th August (ie
same date but exactly three calendar months
Most eurocurrencies deal ‘value spot’ (ie two later, providing it is a good business day). Hence,
business days forward), calculating the Actual in this case the trade date (9th May) and the
number of days in the deposit period, but value date (11th May) are clearly not the same!
dividing by a 360 day basis (known as Money
Market basis).This would be written as This is because most eurocurrencies trade “out
“Actual/360”. of spot”, not “out of today”.

Example actual/365 (£) The actual number of days in the deposit period
If today is Monday, 9th May, 2005, then a would then be calculated (in this case 11th May –
calculation for a Sterling deposit, for say a 11th August 2005 = 92 days) and would then be
three month period, would have a value date of divided by the Day Basis applicable to euros ie
6th May ie the same day on which the trade 360 days.
was enacted.
The actual number of days in a deposit
This is referred to as “T (trade) + 0 (no days)” period
and an end date, or maturity date, of 9th August It is important to realise that, in the inter-bank
(ie same date, but exactly three calendar months markets, the actual number of days in any given
later, providing it is a good business day). Hence deposit period can vary, according to the actual
in this case, the trade date and value date are the dates in question.
same, and Sterling is said to trade “out of today”
or “value today”. Hence a three month run will not always be
exactly a quarter of a year ie 91, or 90 days,
The actual number of days in the deposit period but is normally somewhere between say 89 – 93
would then be calculated (in this case 9th May – days. Shorter, or longer, periods are likely to
9th August, 2005 = 92 days) and would then be occur where a weekend, or Bank holiday period
divided by the Day Basis applicable to Sterling ie is concerned.This is because the start date
365 days. (value date) and end date (maturity date) can
only be on ‘good’ business days.
However, this is not the case with
eurocurrencies (ie euros, Swiss Francs,Yen etc. For example, assume a Sterling three month
trading in London). transaction where the actual dates are 2nd Feb –
2nd May 2005. Using a calendar, you will see that
Example actual/360 (€,CHF,Yen) 2nd Feb is a Wednesday. However, 2nd May was a
If one were doing the same calculation as given Bank Holiday in the UK, therefore standard
above, but for say euros, then the value date market practice is to go forward to the next
would be two business days forward from the good business day ie Tuesday 3rd. (The only
trade date of Monday, 9th May. exception to this would be if, by going forward, it


put you into the next calendar month. In that
case you would go backwards, to the previous
good business day).The actual number of days
would therefore be 2nd Feb – 3rd May = 90
days.
G Conclusion – The inter-bank market
By contrast, a euro three month transaction The inter-bank market is the most basic of all
where the actual dates are say 5th April – 5th money market products. It is concerned with the
July, 2005, would give rise to an actual number borrowing or lending of cash, totally unsecured,
of days of 91 days. for fixed periods of time. Moreover, because
money actually changes hands, there is real
Using the correct day base counterparty risk to consider.
Having established the actual number of days,
one must also remember that the Day Base can Banks, and other financial institutions, that deal in
vary, according to the currency being used. the Wholesale Cash Money Markets, thereby
Hence, in the Sterling example given above, the create what are known as “On Balance Sheet”
93 (Actual) days, would then be divided by the exposures, having to set aside a proportion of
Sterling Day Base of 365.Whereas, with the euro their exposure, as provision for bad and doubtful
calculation, this would be 91 (Actual) days, debt.This makes On Balance Sheet transactions
divided by the euro Day Base of 360. expensive to conduct.

Hence in summary, with regard the currencies The main users of the inter-bank markets, are
that have a Euronext.liffe STIR futures contract therefore those with a physical cash requirement.
based upon them: For example, Banks, Building Societies (UK), Fund
Managers or large Corporations, who ﬁnd
Currency Value Date Day themselves with excess funds, either overnight
Basis (O/N) or for a “ﬁxed” term (ie up to 12 months),
or in need of such funds.
Sterling Same as Trade date, hence 365
“T + 0”
They can use the wholesale cash money markets,
€, CHF,Yen Trade date + two business 360 in order to gain access to other participants, and
days, hence “T + 2” so match their funding requirements.

However, those with a desire only to manage
interest rate risk (ie without a physical cash
requirement) can access a more prudent and
cost effective route: Futures!


G G
G STIR futures
5

G What defines a futures contract?
Unlike the OTC Inter-bank markets, from which
they derive, all of Euronext.liffe’s STIR futures
contracts are traded electronically (via LIFFE
CONNECT®) on a regulated exchange.
Central Marketplace
STIR future contracts are defined as: With exchange traded futures (and options),
G

A legally binding agreement, concerned with the buyers and sellers enjoy immediate access to
buying, or selling, of a standardised amount of a a central marketplace, where a large number
given short term interest rate product, at a fixed of competing buyers and sellers can transact
price, for cash settlement on a given future date. their business, via the LIFFE CONNECT®
electronic trading system.
STIR futures contracts derive from the cash
inter-bank markets, previously mentioned, since Price transparency
they are concerned with the trading of the Euronext.liffe’s electronic trading platform,
G

implied value of three month LIBOR (£ and LIFFE CONNECT®, provides continuous and
CHF) EURIBOR (€) or TIBOR (Yen), but from competitive price discovery and global
a given future date. dissemination of price information. In
essence “price discovery” means that the
G Why trade STIR futures contracts on best bid and best offer in any given contract,
Euronext.liffe? is always displayed on the trading screen and
Trading interest rate risk using Euronext.liffe’s “global dissemination of price information”
STIRs has many advantages, including: means that computer terminals are
distributed to a world-wide audience!
Liquidity
Exchange traded futures (and options) are Together, these two aspects make it possible
G

standardised contracts.They provide a for traders (no matter how big, or how
uniformity of specification and quality, which small) to compete on equal terms and
enhances market liquidity and efficiency. In facilitate the timing of trading decisions, as
theory, it is possible to have a futures quickly and accurately as possible.
contract on any product, but strong user
demand is what produces liquidity. Central Clearing
Unlike the OTC markets, the LIFFE market’s
G

“Liquidity” refers to the depth of the futures and options contracts benefit from a
market, ie a large number of buyers central clearing counterparty, known as
and sellers creating substance to the LCH.Clearnet.This means that counterparty
marketplace, allowing for a free flow risk is considerably reduced.
of transactions at any given price.
Upon matching and registration of purchases
Liquidity is therefore the essential factor for and sales, LCH.Clearnet, (which is
the survival of any futures contract. independent of the Exchange), becomes the
Euronext.liffe is dominant in STIR futures effective buyer to every seller, and seller to
contracts, as well as having strong bond, every buyer. Hence LCH.Clearnet becomes
swap and equity product portfolios, with its the guarantor of all futures (and options)
biggest, and most liquid contract, being the trades to so-called Clearing Member firms.
Three Month Euro (EURIBOR) Interest Rate
futures contract.


LCH.Clearnet thereby ensures the integrity
of the Exchange’s contracts, by calling on
Member Firms, for so-called Initial Margin (ie
funds placed with LCH.Clearnet at the time
that a new position is taken), and Variation
margin (ie additional funds placed with or settlement. By trading STIR futures, a trader
withdrawn from LCH.Clearnet, where a will utilise less of a Bank’s capital10 than
position is showing an open loss or gain), on would be the case with ‘On-Balance Sheet’
all positions. For further details on the transactions, such as ‘cash’.
margining system used by the LIFFE market,
London SPAN® version 4, please see 3. Counterparty risk is standardised in
www.euronext.com. the Futures markets.This is due to the
combination of the margining system unique
Regulated market to the Futures Exchange and the role of the
The LIFFE market is a Recognised clearing house (LCH), standing as
G

Investment Exchange (RIE) under the UK counterparty to every trade. Consequently,
Financial Services Act.As such the LIFFE ‘counterparty risk’ (which is prevalent in the
market is required to ensure that all business cash markets) is all but eliminated.
is conducted in an orderly manner and that
the Exchange affords proper protection to G What is a STIR future?
investors. STIRS are short-term interest rate derivatives,
that derive from the underlying three-month
G What has made STIR futures so successful? LIBOR,TIBOR or EURIBOR rate traded in the
STIR futures contracts have been so successful OTC Cash Money Markets.
and have expanded so rapidly, simply because
they offer something that the underlying OTC The Short Term Interest Rate (STIR) Futures
cash markets alone cannot offer. Chiefly there Contracts currently traded on Euronext.liffe, are
are three reasons: as follows:

1. They enable traders to trade for a future Contract Underlying product
value date, thereby allowing them the Three Month Euro Three month €
opportunity to hedge (ie cover, or protect) a (EURIBOR) Interest EURIBOR fixing rate
forward interest rate exposure and hence Rate futures contract
remove some of the uncertainty associated
Three Month Sterling Three month £ LIBOR
with interest rate risk management.
(Short Sterling) Interest fixing rate
(Speculators on the other hand, are on the
Rate futures contract
other side of the fence.They are instrumental
in providing the liquidity that is needed for Three Month Euro Three month CHF
futures exchanges to succeed, by speculating Swiss Franc (Euroswiss) LIBOR fixing rate
(ie taking risk) on future price movements!) Interest Rate futures
contract
2. They are termed ‘Off-Balance Sheet’ Three Month Euroyen Three month Yen
products.They do not involve the physical (TIBOR) Interest Rate TIBOR fixing rate
risk of the underlying transaction amount
(unlike the Cash Money Markets), but are in
the main based on ‘contract for difference’

10
In fact, Futures do NOT require credit risk weighting for BIS capital adequacy purposes.


Contract months
The STIR futures contracts are standardised
contracts that trade for specific so-called
“quarterly” contract months.These are:

March, June, Sep, Dec. However, this does not mean that a trader has to
keep a position until expiry. STIR futures are
Moreover, the STIR contracts actually expire (ie tradeable, which means they can be bought and
stop trading) on the third Wednesday of sold on an on-going basis, right up until the day
the contract month in question at and time of expiry, at which time the contract
11.00 a.m. (London or Brussels time depending will cease to exist!
on the contract). In practice, this means that
Short Sterling stops trading at 11.00 am (London What is meant by the serial months?
time) on the third Wednesday (ie Sterling trades In order to widen the menu of contracts
“out of today”). available for trading, so-called “serial months”
have also been introduced, such that the front
However, the Three Month Euro (EURIBOR) and three calendar months are always available for
Three Month Euro Swiss Franc (Euroswiss) trading.
futures contracts actually stop trading at 11am
Brussels time on two business days prior to the A “serial month” therefore simply refers to a
third Wednesday.This is because they trade ‘out contract month other than the standard
of spot’ (ie two working days hence.) This has quarterly futures date mentioned above.
got nothing to do with whether they are fixed
against LIBOR, or not – it is just that they are all For example:
classified as “eurocurrencies”. For example, the If it is now 1st June, 2005, then the EURIBOR
Euroswiss contract trades “out of spot”, but has contract months available for trading would be
a LIBOR fixing. as follows:

Traders of STIRs, are therefore trading June (Quarterly) ‘front’ month
(expires Monday preceding 3rd Wednesday.
G
what they think the official three-month
Cash Inter-bank LIBOR (Sterling, of June)
Euroswiss), or EURIBOR (Euro) or Tibor July (Serial month)
August (Serial month)
G
(Euroyen TIBOR) fixing rate will be on a
Then Sept (Quarterly) and subsequent
G
given future date.
quarterly months.
G

For example, September ’05 EURIBOR
Future: However, all other aspects of serial month
What do I think the official three month trading are the same.
EURIBOR (Brussels) fixing rate will be at
11.00am (Brussels time) on the Monday For example:
preceding the third Wednesday of If you traded the July ’05 EURIBOR (serial
September 2005? month) contract you would be trading:

Or, Dec ’05 Short Sterling: What do I think the official three month
What do I think the official three month LIBOR EURIBOR (Brussels) fixing rate will be at 11am
(London) ﬁxing rate will be at 11.00am (London (Brussels time) on the Monday preceding the
time) on the third Wednesday of December 2005? third Wednesday of July 2005?


Hence it is still a three month EURIBOR-based
contract, but for a different calendar month!

What are the standard contract sizes on
Euronext.liffe?
Unlike the OTC Cash Money Markets, where the For example, a dealer trading in say, the
size of each trade has to be agreed between the EURIBOR futures contract, is not risking a
two counterparties concerned, each STIR futures capital sum of €1,000,000. Rather, the nominal
“contract” is based on a nominal standard contract size is merely used to calculate the
contract size, as determined by the Exchange. minimum tick size movement that each futures
contract represents (see minimum tick size
For example: movement calculations below).
One Short Sterling contract is worth a nominal
£500,000. This is what is then used to calculate the profit,
or loss, thereby generated on any given
Therefore, if you were to trade in 20 contracts, transaction.This is an important point, because
you would be trading a nominal11 value of: it means that STIR futures are therefore termed
“Off Balance Sheet” transactions.
£500,000 x 20 = £10,000,000 worth of short
term interest rate movement. Why are STIR futures termed
“Off balance sheet”?
The contract sizes for all the STIR contracts One of the most important aspects of trading
traded on LIFFE are as follows: STIRs is that (unlike the inter-bank market), they
are termed “Off Balance Sheet” products.
Contract Unit of trading
(Nominal STIR futures are termed “Off Balance Sheet”,
contract size) because they do not involve the physical
borrowing, or lending, of the nominal underlying
Three Month Euro (EURIBOR)
contract value. Moreover, since the nominal
Interest Rate futures contract €1,000,000
capital sum is never at risk, a Bank, or other
Three Month Sterling (Short financial institution, can trade more of them
Sterling) Interest Rate futures (as opposed to trading in the Inter-bank market),
contract £500,000 without “inflating” the Balance Sheet.
Three Month Euro Swiss Franc
(Euroswiss) Interest Rate futures Because they are classified as “Off Balance
contract CHF 1,000,000 Sheet” instruments, the Capital Adequacy
requirement for STIR futures contracts, is also
Three Month Euroyen (TIBOR) greatly reduced.
Interest Rate futures contract ¥100,000,000
In essence, this means that STIRs are a more
Why are futures contracts known as cost effective tool for managing interest rate
contracts for difference? risk, than the underlying inter-bank markets, from
Futures are known as ‘contracts for difference’, which they derive.
simply because the underlying “nominal” value
of the contract is not pledged.

11
Trading a ‘nominal’ value in the STIR Futures markets is distinct from the Cash markets, where the actual underlying cash sum
is physically borrowed, or lent.


As you will see shortly, the nominal contract
value is never at risk, but is merely used to
determine two important aspects of dealing a)
the total number of contracts required and b)
the calculation of the “minimum tick size value”
for each contract. On a principal amount of say, €1,000,000, it is
now possible to calculate the amount of interest
How are the minimum tick size to be paid, or received, at the end of the fixed
movements on STIRs determined? period, ie at maturity. In this case, the difference
The tick size values for each of the STIR futures between the two amounts should represent the
contracts are based on the simple interest dealer’s profit on the transaction.
formula used for calculating interest in the
Inter-bank market.

The minimum tick size movement varies
according to the contract concerned, but for
most contracts is referred to as “a 01”.

The value of a “01” actually means a one basis *See notes on value dates and day basis
point move, in interest rate terms, from say 4%
(ie 96.00 futures equivalent price) to 3.99% The difference between the two amounts
(96.01 futures equivalent price). represents the dealer’s profit. Hence in this
example, a dealer in the inter-bank market,
In order to understand how the futures market borrowing euros at 3.99% and lending at the
calculates the value of “an 01”, it is therefore higher rate of 4.00%, would make a profit of
important to re-visit the way in which the only €25.00.
calculation of interest is determined in the
inter-bank market, from which STIR futures However, since the inter-bank market is
are derived. “On Balance Sheet”, a certain amount of capital
would also have to be set aside, for bad and
You will recall that in the inter-bank market, doubtful debt.This means that, in practice, it is
interest is calculated “in arrears”, using the more expensive to transact, when compared
Simple Interest formula: with using “Off Balance Sheet” products, such as
STIR interest rate futures. For example, in the
Simple interest = above scenario, the cost of capital could more
Actual No. of days in period
Principal Amount x % Rate x than wipe out this tiny profit.
Actual No. of days in year

Let us now assume that a bank dealer is able to The STIR futures market, was therefore devised
borrow euro in the inter-bank market at say as an alternative “Off Balance Sheet” market, for
3.99%, for a three month period (say 90 days, trading interest rate risk, without the underlying
using actual number of days). Similarly, let us capital sum involved actually being pledged.
assume that he can also lend the same amount,
at a higher rate of interest, say, 4.00% (ie a STIR futures contracts are considered “Off
difference of “.01”) for a similar period. Balance Sheet” because all transactions are
Borrowing cheaply and lending expensively is based on a “nominal” contract size, which can
how a dealer hopes to make a profit. then be used to determine a nominal “tick size”
movement.This means that no actual capital sum


changes hands and therefore cannot be at risk.
To demonstrate how the STIR futures market
works, now let us assume that the bank dealer
does not wish to borrow or lend, but simply
wishes to take a view on interest rates, and as
such, trades one Three Month Euro (EURIBOR) price moves from say 96.00 to 96.005, then
Interest Rate futures contract. the half tick value can be similarly identified
as follows:
Let us assume that he deals simultaneously at
3.99% equivalent (ie futures price of 96.01) and
at 4.00% equivalent (ie futures price of 96.00) to
lock in a difference of “one tick” or a “01”
ie 0.01/100.We will further assume that rather
than an actual sum, a nominal €1,000,000
contract value is now applied.
Calculating basis point value or tick values
To further simplify things, with STIR futures for other STIR futures contracts
contracts, the period of time is also standardised, The other STIR futures contracts have their tick
in that it is no longer calculated based on the values calculated in a similar fashion.
actual number of days in a given three month
period, but is simply expressed as: Three Month Sterling (Short Sterling)
Interest Rate futures contract
“1/4 of a year” For example, for the Short Sterling contract, the
only difference is that the nominal contract value
(Since no actual physical borrowing or lending is is £500,000.Therefore the tick value of a “01”
going to occur, this is not a problem!) can be calculated as follows:

Hence the calculation has now been
reduced to:

Three Month Euro Swiss Franc
(Euroswiss) Interest Rate futures contract
For the Euroswiss, the tick value is similar to the
EURIBOR contract, in that the nominal contract
Therefore the value of each “01” or one tick value is of a similar denomination ie
is €25.00. CHF1,000,000.Therefore:

Hence a one tick move (up or down) in the
EURIBOR futures contract, is equivalent to
“.01%” interest rate movement in the underlying
market, but because no capital sum ever changes
hands, it is reduced to a tick value of €25.00
profit, or loss, per contract.

Note:The Three Month Euro (EURIBOR)
Interest Rate futures contract actually trades in
half ticks (.005) as well as full ticks (.01) ie if the


Three Month Euroyen (TIBOR) Interest
Rate futures contract
For the Euroyen, the tick value is larger, because
the nominal contract value is greater:

Therefore

G STIRs as “contracts for difference”
The tick values created above represent a
dealer’s actual profit, or loss on the transaction.

Consequently, such profit and loss amounts will
show up on a balance sheet, as they represent a
real ‘cash’ flow.

Hence a dealer using STIR futures contracts is
trading interest rate risk, however, without the
associated risks of On Balance Sheet
transactions, such as when trading the underlying
cash inter-bank market.The only sum that would
appear on a Bank’s balance sheet, when trading
futures contracts, is the profit or loss thereby
generated. Hence, this is why STIR futures are
also known as: “contracts for difference”


G G
G Price movements of STIR futures contracts
6

Now that we have looked at minimum tick
movements of STIR futures contracts, it is
important to see what a price movement up, or
down, actually implies, in interest rate terms.

The following diagram portrays, in pictorial style, For example:
the relationship between interest rates, and their
related STIR futures contract.This will be Step 1: Buy 5 EURIBOR contracts at 97.60,
referred to within the text of this section. Step 2: Sell 5 EURIBOR contracts at 97.70

BUYING a Future is like “lending”* at that Calculate Profit/Loss on transaction as follows:
equivalent interest rate. 5 (contracts) x 10 ticks x €25.00 per full tick
SELLING a Future is like “borrowing” at that =€1,250.00 (profit)
equivalent interest rate.
*Lending in the cash market would normally be at London Inter- Bought low and sold high, so it is a profit.

However, you also need to consider why a trader
bank Bid Rate (LIBID) or equivalent.

G Buying, or selling, STIR futures? buys, or sells, a STIR contract and what this
So far, we have only looked at futures contracts implies in interest rate terms.
purely in terms of the value of ‘minimum tick size
movements.’ This would enable you to calculate Firstly, it is important to realise that STIR futures
profit and loss. contracts trade on a price that is directly
‘inverse’ to interest rates. For example:
Figure 2: STIR Futures Diagram
Typical futures price

Bid Ask (Offer)

97.205 97.210

The interest rate implied from this indirect
method of pricing can simply be found by taking
the price away from 100. Hence:

Bid Ask (offer)

100.000–97.205 100.000–97.210

Implied
interest rate: 2.795% 2.790%


Therefore:

A price for the September sterling futures
contract, of say 97.00, implies that the market’s
perception is that the official three month
LIBOR fixing on the 3rd Wednesday of Hence,
September at 11 am will be 3%.
A trader buys STIR futures when he thinks
interest rates are going to FALL.
(ie said to be “bullish” for interest rates.)
The Buyer
A trader wishing to buy the STIR futures on
G

LIFFE CONNECT®, ie simply taking the view
Whereas, a trader sells STIR futures when
that the price will be higher (ie implied
he thinks interest rates are going to RISE (ie
interest rates lower) is termed a
said to be “bearish” for interest rates)13.
speculator.
Furthermore, rather than simply speculating
The trader could therefore either: on future price movements, a dealer could
a) specify a price at which they wish to buy be using STIR futures as either a hedge ie to
(perhaps join the bid at 97.000), or protect an underlying cash position. (We will
b) enter a “market” order to buy (ie take look at an example of a hedger shortly.)
the best available offer at say, 97.005).
The concept of “Long” and “Short”
Buying a STIR is like lending12 at the equivalent
G
in STIR futures
interest rate, (ie in this case 2.995%.) When a dealer first initiates a new STIR
position, either to buy or sell, he is said to:
The Seller
A trader wishing to sell the STIR future on
G

Go “long” if he buys the contract.
LIFFE CONNECT®, ie simply taking the view
Or
that the price will be lower (ie implied
interest rates higher) is also said to be a Go “short” if he sells the contract.
speculator.
The concept of “going short” can therefore
The trader could therefore either: seem strange, ie selling something that one
a) specify a price at which they wish to sell does not own, especially since there is no
(perhaps join the offer at 97.005) or tangible underlying product here. However,
b) simply enter an order to sell (ie “hit the the position can either be closed out, by
bid” at 97.000). buying back at a later date, or simply holding
until expiry and paying, or receiving, a cash
Selling a STIR is like borrowing at the differential based on the official fixing of the
equivalent interest rate, (ie in this case 3%.) LIBOR/EURIBOR/TIBOR rate, this final price
is known as the EDSP (Exchange Delivery
Settlement Price) of the relevant futures
contract.

12
Beware of the concept of lending at that rate, since STIRS are all based on a LIBOR rate, whereas in the underlying cash
market lending would have to be transacted at LIBID, or equivalent rate. For hedging purposes, this would always make a
synthetic (ie futures) transaction (where you have bought the future) appear more attractive than lending in the underlying cash
market where you would be dealing at the prevailing LIBID rate.
13
“Bullish” in most markets means up, but in interest rate markets, it means interest rates lower, similarly “bearish” in most
markets means down, but in interest rate markets it means interest rates higher.


Adding to a position, (ie buying more, if one is
long, or selling more, if one is short), simply
adds to this “long” or “short” position.

It is not until a trader actually takes an equal
and opposite position in the contract, that By using a simple mathematical formula, known
he is said to be “square” or “flat” (ie has no as the ‘forward/forward formula’, they were able
position). to calculate the interest rate they would need to
obtain for the forward period, in order to ensure
It is important to realise too, that a trader that they did not lose money on the cash
does not have to hold a position until expiry transaction as a whole.
of the contract, but can trade out of a
position at any time up until expiry. He can Furthermore, since futures are concerned with
do this by buying (selling) an equal and the implied value of interest rates for a given
opposite transaction in the futures market period, this so called ‘forward/forward formula’
to the position already held. can also be applied to the pricing of STIR futures
and works in exactly the same way, as shown
G The pricing mechanism of STIR futures below:
So far we have only looked at the STIR futures
contracts with a given price to work from. But The forward/forward formula
how is the price actually derived?
b c?
As one would expect, STIR futures are priced
from the underlying cash inter-bank money
a

markets from which they derive. Where ‘a’ is the long date,‘b’ is the short date
and ‘c’ is the forward/forward period.
Prior to the introduction of STIRs (and FRAs –
Forward Rate Agreements that trade in the OTC The formula for calculating ‘c’ (the unknown)
market) a dealer in the cash markets could easily is therefore:
ﬁnd himself with so-called ‘mis-matched’ positions.

For example, suppose a dealer in the inter-bank
market had lent six month cash and then found
that he could only borrow for the first three
months at an acceptable rate. He thereby
created for himself an exposure,‘borrowing
NB. *If the contract to be priced is the
requirement’, relating to a three month period,
Short Sterling contract, you must remember
but starting in three months time ie
to replace 360* with 365 in the above formula.
‘forward/forward’.
(All other STIR contracts are calculated using
a 360-day basis.)
The term ‘forward/forward’, therefore literally
means an exposure starting on a forward date,
Since STIR Futures are based on either a
for a further period of time.
LIBOR/EURIBOR/TIBOR rate, you must now
determine which information would be needed
It was because of the headaches associated with
to create a LIBOR/EURIBOR/TIBOR rate for
running these ‘mis-matched’ positions that
the future period ‘c’.
dealers soon devised a market for dealing
‘forward/forward’.


The following diagram shows how this would
be created:

interest rate futures from the Cash rates,
is therefore Thursday, 24th).

NB: If this were a Short Sterling example, it
would trade ‘out of today’ (T + 0), not spot.
Explanation:
To calculate the implied, or fair value, price for
Assume a trader has borrowed cash for six the June ’05 EURIBOR futures contract using the
months (ie ‘the long date’,) and only lent cash for forward/forward formula:
say three months (ie ‘the short date’.) By using
the forward/forward formula, the trader is able Given:
to calculate the rate at which he has effectively 6 month cash rates: 2.2735 – 2.1485 (use offered
borrowed for the 3–6 period. side ie “Borrow” long date)
three-month cash rates: 2.1486 – 2.0236 (use bid
This so-called forward/forward formula can side ie “Lend” short date)
be used to calculate the ‘value’ of
LIBOR/EURIBOR/TIBOR from any given start Although there are various methods of creating
date and for any given LIBOR/EURIBOR/TIBOR this rate, including creating a trading channel, this
period, and since STIR futures are based on the is probably the simplest method to create the
value of LIBOR/EURIBOR/TIBOR, it can be used implied forward/forward borrowing
in this context. (ie EURIBOR) rate.

Example: Pricing STIR futures off the cash This is because, if you use the “borrowing rate”
money market rates for the long date (here 173 days) and then
All STIR futures are essentially priced off the use the “lending rate” for the short date
Cash Inter-bank Money Market rates (with slight (here 83 days), you thereby create a synthetic
‘sentiment’ adjustments, as you shall see).This is implied rate, at which one could “borrow”
because the forward/forward formula needs the forward/forward period.
Cash rates in the first instance to give a rough
approximation of what the implied forward Since STIRS are based on what the implied
interest rate should be. borrowing rate should be (either
LIBOR/EURIBOR or TIBOR depending on the
For example: contract concerned), it can then be used in this
context to create a “fair” futures price.

Diagrammatically it would look like this:

* = 3rd Wednesday of contract delivery month

Assume today is Tuesday 22nd March 2005 For “c” use 91 days for Short Sterling (ie 1/4 of
(Spot date, for calculating implied EURIBOR 365 days), but 90 days for all other STIR futures
contracts (ie 1/4 of 360 days).Thus 90 days from

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