Friday, December 7, 2012

Deliverable Interest Rate Swap Futures

By Tim Husson, PhD and Tim Dulaney, PhD

Interest rate swaps are important tools used by many financial and non-financial firms to manage their interest rate exposure. Earlier this week, the CME Group launched a new derivative product called Deliverable Interest Rate Swap Futures with the contention that the product offers "maximum efficiency for managing interest rate exposure." This move is close in spirit to the recent move by the Eris Exchange to offer interest rate swaps on an open exchange. Both of these products are designed to move the interest rate swap market from an over-the-counter format to transparent, cleared exchanges.

But the new deliverable interest rate swap futures are particularly interesting. They are in some ways very similar to US Treasury futures (PDF)--they are futures contracts that on a particular date promise delivery of a standardized financial product, just as a commodity futures contract promises delivery of a standardized commodity (oil, wheat, etc) on a given date.  These futures contracts are the standardization of forward swap contracts that firms use to manage their interest rate exposure at some point in the future.

Because the value of the futures contract will reflect the expected value of the product on that date, the value of an interest rate swap futures contract will fluctuate with the value of the underlying interest rate swap. From the CME Group:
This product has the same economic exposure as an interest rate swap, the margin and liquidity benefits of a futures contract, and at expiration all open positions will deliver into a CME Cleared Interest Rate Swap. The product will be a standardized future, trading both electronically on CME Globex and via open outcry, and will be eligible for privately negotiated transactions. 
Futures contracts will be listed for quarterly expiration on [International Monetary Market (IMM)] dates, for physical delivery of OTC US dollar interest rate swaps at key terms to maturity (2, 5, 10, 30 years). Contracts will be quoted on a price basis, with a fixed coupon for each contract that is set by the Exchange when the contract is listed for trading. At expiration the holder of a long futures position will become the fixed rate receiver and floating rate payer in an OTC interest rate swap cleared by CME Clearing.
According to the CME Group, "Credit Suisse, Citi, Goldman Sachs and Morgan Stanley" have already expressed interest in being market makers for these products.  The CME Group also offers some examples of how these new contracts can be used, for example, to make bets on the evolution of the swap term structure.

Clearly, interest rate swap futures are sophisticated tools.  What makes this new product so interesting, though, is that by structuring interest rate swap exposure as a futures contract, interest rate swaps may become more prevalent in other types of products.  Currently, many ETFs hold futures contracts, and are then sold to retail investors.  It may now be possible for deliverable interest rate futures to begin appearing in other retail products, despite being likely unsuitable for all but the most sophisticated traders.

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