Interest rates are a market like any other. So if you want to trade on the movements of UK interest rates - perhaps to hedge your mortgage payments, for instance - you can bet on the 'Short Sterling' future. Traders can place a spread bet on the future course of interest rates in the US, UK (Britain), Japan, France, Germany and Switzerland.
The 'usual way' of doing this is by betting on the level of market three-month interest rates. These track central bank target rates closely, but will rarely be identical to them. Interest rate trades are based on three month interest rate futures contracts traded on exchanges such as the London International Future Exchange.
For instance: trades on British interest rates are on the short sterling contract, and those on US rates are on the short Eurodollar contract. The most popular bet on short-term interest rates is the three-month Sterling Deposits contract traded on LIFFE, better known as 'short sterling'. Short Sterling is a 3 month interest rate future which is highly correlated to base rates. If base rates were unexpectedly raised by 1% then the Short Sterling contract would also rise by 1%, or as is more commonly known 100 basis points. It is important to remember that the value of the short sterling contract doesn't just change when the Bank of England changes its rates. The price of the contract is always changing. It reflects the market's view of what is going to happen to interest rates at some time in the future. The short sterling contract usually reacts well to news that affect interest rates, with a higher price suggesting a softer monetary policy will be adopted and a lower price suggesting a more hawkish view. As news and economic numbers are released, the market will change its mind on what the interest rates will be.
If you've never traded short sterling before, the way it's quoted can seem a little awkward at first. Just remember that the trade works just the same as they have before - BUY (LONG) SELL (SHORT) etc. and your profit is the difference between you opening and close prices. The key difference you have to realize and take note of regarding Interest Rates is what the prices quoted to you actually mean. The value of a contract is 100 minus the implied interest rate. So if the June contract is trading at 94.50, the market expects that in June, three-month interest rates will be at 5.50 per cent.
If you plan to trade Interest Rates, it's obvious that you need to start trading your country's own interest rate; as news on your local interest rate is readily available with most daily newspapers, TV, periodicals and the internet...etc displaying the rates. Remember though to use this as a guide. As the trading we are involved with is linked to that of the Futures markets and therefore the interest rates are more volatile.
Interest rate futures can seem a bit strange at first because they seem backwards! However they are quite easy to understand. The transactions work in exactly the same as other bets. If you buy at one price and sell at another your profit or loss depends on the difference between the two prices. The only new thing that you need to know to be able to bet on interest rate contracts is what the prices actually mean. There are two different sorts of interest rate contracts you can bet on:
Short-term interest rate contracts allow you to bet on the direction of various countries' 3-month interest rates. The principle countries are the US, UK, Japan, France and Germany. Basically here you are betting on the interest rates announcements themselves.
The price of a 3-month interest rate contract is quoted as 100 minus the interest rate. For example if the March interest rate is 8%, then the contract price will be 100 - 8 = 92 (quoted as 9200). If the March rate rises to 8.3% then the contract price will fall to 100 - 8.3 = 91.7 (quoted as 9170).
So if the rate rises then the spread bet value falls.
If the rate falls then the spread bet value rises.
So if you expect the rate to RISE in the future, you SELL the future contract (because the spread bet will fall if you're right).
If you expect the rate to FALL in the future, then you BUY the future contract (because the value of the spread bet will RISE).
The contracts are structured that way so that dealing in them is like dealing in gilt-edged securities, where you buy if you think rates will fall and vice-versa.
You expect interest rates to fall, short term in the UK. This means that the price of 3-month Sterling deposits will rise. So you BUY 3-month short Sterling. You telephone for a quote for March Sterling deposits and get 9287/9293. You buy at £10 a point at the price of 9293. The deposit factor is 40, and so you would need to provide £400 deposit to cover this bet.
The middle price of 9290 means that the interest rates are expected to be 100 - 92.90 = 7.1% in March. You are betting that interest rates will be lower than this.
You are correct. Interest rates fall steadily on news of lower inflation. After a few weeks you telephone for a quotation and are given 9340/9346. You SELL 3-month Sterling deposits at 9340, £10 per point.
Your profits are:Opening position 9293
Difference: 47 x £10/point = £470 profit.
You believe that short-term UK interest rates will rise so that the price of 3 month Sterling Deposits (usually called 'Short Sterling' or 'Shorts') will fall. You decide to sell March Sterling Deposits. The market price is 92.80, implying an expectation that, in March 3 month interest rates will be 7.20% (100 minus 92.80). The Spread betting company's quotation, which does not contain the decimal point, is:
Sell 8,278 Buy 9,282.
You sell £50/point at 9,278. The deposit is £1,000; (£50, bet size x 20, deposit factor). You are wrong; interest rates fall, the price goes up and the quotation becomes.
Sell 9,309 Buy 9,313.
You decide to take your loss and close your bet at 9,313.Closing level 9,313
Betting on these instruments does not only make way for speculative gains but can also be used for hedging purposes. If rising interest rates concern you, you could sell short sterling futures (the short sterling futures is a market on the future path of three-month Libor, which in turn mirrors movements in the base rate) and use any profits to pay for those rising mortgage payments.
Trades on interest rate futures can also be made over longer periods. Long Term Interest rates are reflected in the price of government bonds. A government bond is a fixed interest security. Thus, if interest rates rise, you can do better with your money and so you would sell bonds. The price of bonds would go down to reflect this.
If interest rates fall, safe fixed interest bond look very attractive as a home for your money, and so you would buy bonds. Thereby, the price of bonds rises to reflect this.
Bond prices are therefore a good indicator of people's expectations regarding long-term interest rates. Such bonds are also known as 'guilt edged' securities, or 'gilts'. In the USA they are known as T-bills (Treasury Bills) or T-bonds. Gilts or T-bills pay an interest rate known as the coupon. The coupon will depend on the level of prevailing interest rates when the bond is issued. If the coupon is 8% then each £100 bond will pay £8 per year.
The prices for treasury bills are quoted as a number followed by a certain number of 1/32nds. Strange, but true. Therefore a typical price is 110 - 12. This translates as 110 and 12/32nds. One point = one 32nd = 1/32.
Note that one of the main differences between buying a foreign bond outright and making a spread bet on a foreign government bond future is the extent of currency risk. Buying a foreign bond in the conventional way exposes investors to changes in the exchange rate between their home currency and the foreign currency concerned on the full value of their exposure. Making a spread bet on a foreign bond howevere will involve no exchange risk at all, if the bet is denominated in the home currency. If it is denominated in US dollars or another overseas currency, then the eventual size of the US$ dollar profit or loss will be affected by movements in the exchange rate. But whether the bet makes a profit or a loss will not be.
You believe long-term interest rates in the US will fall and therefore the price of T-Bonds will rise, so you decide to buy the December T-Bond. This particular market is quoted in fractions of 32 rather than decimals.
The Spread betting company is quoting
Sell 98-17 Buy 98-23.
You decide to buy $15/point at 98-23. The deposit is $1,290; ($15, bet size, x 86, the deposit factor). The Bonds do rise, to 101-14. The revised quote is:
Sell 101-11 Buy 101-17.
and you close the bet at 101-11. Your profit is calculated as follows:Closing level 101-11
Profit on a $15/point buy: 84 x $15 = $1260.
NOTE: You can also use a decimalized contract to bet on the T-Bond. This option allows you to trade the T-Bond with prices quoted in decimals rather than the traditional fractions.
Example: a firm wishes to hedge against a rise in the interest rate at which it will borrow funds at a later date.
Hedge: sell short-term interest rate futures
If the interest rate increases, the futures price falls and a gain is made on the short futures position. The gain on the futures position offsets the increased cost of borrowing.
What happens if the interest rate falls?.
The loss on the futures position offsets the "gain" of borrowing at a lower interest rate.
Example: an investor plans to buy long-term bonds at a date in the future and will pay a price which is not known today.
Hedge: buy long-term interest rate futures
If bond prices rise, the futures price increases and a gain is made on the futures position. The gain on the futures position offsets the increased cost of buying the bonds.
If bond prices fall, the futures price falls and a loss is made on the futures position. The loss on the futures position is offset by the "gain" because the price of buying the bonds is lower.
The following list is a summary of the main Interest rate markets offered for trading by most Spread betting companies (which work in the same way as the short sterling contract, 100 - the trading price gives you the implied interest rate for that country):Eurodollar
The level of interest rates in a country can be influenced by a range of affairs including the state of the public finances, the strength of the economy and expectations about what's going to happen to inflation. If you have an opinion in one of these areas and you want to back it, then an interest rate bet offers the most direct way of doing so.
Lastly, although most traders use spread bets for short term trading, interest rates actually do not move much and a Short Sterling contract might only move on average 5-9 points per day so a move of over 100 points can often take months to trade and you need to take this into account as such positions will need to be held for a few weeks if not months. Another even less direct way to bet on interest rates is by betting on currency pairs where you take the view on the relative performance of a currency pair, such as the pound vs euro, rather than how the rate will move from its current level. For instance in the last year a lot of money has been made by traders shorting the pound against the euro as the Bank of England embarked on an increasingly more aggressive monetary role in reducing interest rates as opposed to the European Central Bank.
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