An interest rate swap can be seen as a series of futures contracts, and, in fact, many swap players use futures to hedge their swaps.
One popular contract among swap players is the Eurodollar futures contract, which is based on the rate paid on three-month Eurodollar deposits. Eurodollar futures contracts are traded on the Chicago Mercantile Exchange. Contracts mature every three months -- in March, June, September, and December -- for the next 10 years.
Each contract represents the rate on a $1 million loan. By buying or selling one contract, an investor can lock in a future three-month rate of interest on $1 million.
The future rate is equal to 100 minus the price of a contract. For example, the contract that matures in March 1997 traded recently at 92.66. With that contract, an investor could lock in a rate of 7.34%, or 100 minus 92.66, for the three months beginning in March 1997.
How does the contract allow the investor to lock in a rate?
Consider an investor who wants to lock in a three-month borrowing rate for $1 million beginning in March 1997.
The investor sells a single futures contract at a price of 92.66. The Mercantile Exchange matches buyers and sellers, greatly simplifying the investor's task. The exchange's clearinghouse also backs all trades, minimizing Credit risk.
The current rate on three-month Eurodollar deposits is about 5%. If the rate rises to 8% by March 1997, the futures contract will eventually settle at a price of 92, or 0.66 points below its current price.
At that time, the investor will be able to borrow $1 million for three months at 8%. But the contract is settled at 92. Since the investor sold the contract, taking a short position, when the price was 92.66, the investor is owed a payment.
The exchange subtracts the settlement price from the price of the original trade and multiplies the difference by $1 million. But the rate on the contract is an annualized rate for a three-month loan, so the settlement amount is divided by four representing three of the 12 months in a year.
The 0.66 gain for,the investor would be $6,600 on an annual basis, or $1,650 for three months.
The investor borrows $1 million at the current rate of 8%, or $20,000 for three months, but the interest cost is reduced by the $1,650 received on the futures contract.
So the investor's all-in cost for the loan is $18,350 for three months, equivalent to an annual rate of 7.34%.
The futures contract sold by the investor back in 1994 created a hedge. Borrowing rates rose, but the value of the contract fell. The falling value of the contract created a profit for the investor who had a short position.
The hedge would also work if rates moved in the opposite direction. The investor's borrowing cost would fall, but the value of the contract would rise, creating a loss for the investor.
In either situation, the investor would end up with a net borrowing cost of 7.34%.
An investor seeking to lock in an investment rate would do the opposite. Instead of selling a contract, the investor would buy a contract, locking in a rate of return on the future investment equal to the rate on the contract.
The buyer and seller of the contract can also be seen as swap counterparties.
The buyer will receive a fixed rate, while the seller will pay a fixed rate.
Just like on a swap, the buyer benefits from falling rates while the seller benefits from rising rates.