STIR Future

A short term interest rate (STIR) future is a future which derives its value from the interest rate at maturation. Common short term interest rate futures are Eurodollar, Euribor, Euroyen, Short Sterling and Euroswiss, which are calculated on LIBOR at settlement, with the exception of Euribor which is based on Euribor. This value is calculated as 100 - interest rate.

All the above contracts are based on 3 months (although note that 3 months doesn't necessarily mean the same thing. It generally means 90 days (as LIBOR is mostly calculated on a 360 day year, and 360 divided by 4 is 90. For historical reasons, however, as Short Sterling uses 365 days, and so the contract specifies 91 days).

Strategies

A great deal of the trading on these contracts is strategies, essentially bets upon the future shape of the yield curve. Both Liffe and CME use implied pricing.

For example, an Z7H8 spread on Euroswiss can be calculated manually (this spread is going long on December and short in March, essentially betting that the yield curve between December and March will steepen) as being offered -.01, big -0.03 (from the prices currently 97.18-97.19 in Dec, 97.20-97.21 in Mar). In fact, the strategy currently has a big of -0.02, someone improving on the implied bid. Meanwhile, the offer of -.01 is part implied - currently 27 lots are offered, of which 3 lots are implied in from the 3 bid at 20 on March. On the other hand, the -0.02 spread is implied in the bids on Dec and the offers for March in the outright. This implied pricing is therefore very handy in improving liquidity, and because it is implemented by the exchange there is no risk in legging it, as the exchange guarantees the entire transaction.

Arbitrage

One can work out the theoretical value of a STIR future from Repo rates, and will often find them to be a few ticks out. Arbitrage is therefore possible, but realistically the opportunity cost is far too high (maybe a billion dollars could be tied up for a year to make a few hundred thousand), and although counterparty risk is very low it isn't non existent!

Nevertheless, STIR futures don't tend to get wildly out of line, as they can be offset against other instruments (swaps, government bonds, etc etc)

What's the point?

Although trillions of dollars worth (nominally) of STIRs are traded every day, primarily by speculators of one kind or another, they do actually have a use as well. The pricing system is odd because the Eurodollar, which I think was the first STIR, was designed to mimic US Treasuries fairly well. So to guarantee an interest rate at which one may borrow in the future, one goes short on, for example, March Euribor which, as I write this, the last trade was 95.705 (don't tell anyone I wrote that though as I'm giving you live market data) I.E. a rate of 100 - 95.705 = 4.295. If the rate is actually 4.8, then the future will settle at 95.20, so you will receive 50.5 * 25 Euros = 1262.5 which is the difference that you'll have to pay more on the loan. Each Euribor is for 1 000 000 Euros, which works out as 250 000 Euros when divided by 4 (remember it's for 3 months). So minimum movement is currently 12.5 Euros. (STIRs aren't for the likes of you if you're just trying to lock in a mortgage).

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