on 20-Feb-2015 (Fri)

In general, a "spread" of any kind is a strategy where a trader simultaneously buys something and sells another similar thing.

For example, a bond spread is a strategy where a trader buys one bond and simultaneously sells another bond,

a FRA spread —in this case called a "calendar spread" —is a strategy where a trader buys one FRA and sells another FRA

A dealer expecting the yield curve to twist anti-clockwise sells a shorter-dated FRA and buys a longer-dated FRA.

A dealer expecting the yield curve to twist clockwise buys a shorter-dated FRA and sells a longer-dated FRA.

If the trader expects interest rates to rise, he buys a FRA;

if the trader expects rates to fall, he sells a FRA

STIR (short-term interest rate)

a trader buying or selling a futures contract is therefore taking a view on what 3-month LIBOR will be fixed at on a certain date in the future - again, the same as if he were trading a FRA with a 3-month forward period.

because a FRA is traded on an interest rate and a futures contract is traded on a price, FRAs and futures are in opposite directions

Therefore a buyer of a FRA will profit if the interest rate rises

a buyer of a futures contract will profit if the interest rate falls.

Most 3-month STIR contracts worldwide are based on the delivery month cycle of March, June, September and December each year. There is only one value date in the delivery month, which is the third Wednesday (or the next following business day) of that month.

1-month STIR contracts are based on a monthly delivery cycle (also the third Wednesday of each month)

Trading in a STIR contract generally finishes at the time when the reference rate against which it is settled at expiry - such as LIBOR - is fixed. For contracts settled against a reference rate with spot value (such as EURIBOR or CHF LIBOR), this is two working days before the third Wednesday.

In the case of sterling futures, both the last trading day and the LIBOR fixing used for settlement are the third Wednesday of the delivery month.

the size of a EURIBOR STIR futures contract is €1 million. Therefore the profit or loss on one contract arising from a move ment of only one basis point in interest rates (which is equivalent to a 0.01 change in the futures price) would be: €1,000,000 x 0.0001 x 1/4 = €25

the calculation of profit or loss on a STIR futures on the basis of exactly one quarter of a year does not depend on the currency. The calcu lation is the same even for a sterling contract (despite the fact that other sterling money market instruments are calculated on a 365-day year).

The exchange determines the minimum price change allowed in trading. This is known as a "tick".

The "tick value" of a contract is the profit or loss made due to a one tick change in price. Tick values therefore vary in line with the tick size for a par ticular contract, as well as with the notional amount of the contract itself.

As it is not permitted for an interest rate future contract to be delivered; if a trader buys such a contract, he cannot insist that, on the future delivery date, his counterparty makes arrangements for him to have a deposit for 90 days from then onwards at the interest rate agreed. Rather, the trader must reverse his futures contract by delivery, thereby taking a profit or loss.

The futures exchange is responsible for administering the market, but all transactions are cleared through a clearing house, which may be separately owned.

In order to protect the clearing house, clearing members are required to place collateral with it for each deal transacted in a "margin" account.

The users of a (intetest rate futures) exchange are its members and their customers. An exchange also has "locals" —private traders dealing for their own account only.

Following confirmation of a trans action, the clearing house substitutes itself as a counterparty to each user and becomes the seller to every buyer and the buyer to every seller

The initial margin is intended to protect the clearing house for the short period until a position can be revalued and variation margin called for if necessary.

Members are debited or credited each day with "variation margin" which reflects the day's loss or profit on contracts held.

Customers are required to pay initial margin and variation margin to the member through whom they have cleared their deal.

On some exchanges, variation margin is not called for if it can be deducted from the margin account without reducing the account below a certain minimum level known as the "maintenance margin", which is set by the clearing house at less than the initial margin.

In some futures markets the maintenance margin is effectively the same as initial margin and all losses, however small, must be covered by variation margin payments.

Some markets impose limits on trading movements on certain contracts, in an attempt to prevent wild price fluctuations and hence limit risk to some extent. If the price reaches this limit, trading stops for a specified time.

In practice therefore, the FRA rate for a period coinciding with a futures contract would be (100 - futures price).

A FRA settlement is paid at the beginning of the notional borrowing period, and is discounted.

If a trader sells a FRA to a counterparty, he must therefore alsosella futures contract to cover his position