Interest Rate Futures Versus Interest Rate Swap
I see a question posted in a newsgroup as followings:
In Reading 64 (page 300) of CFA institute book (Interest Rate Derivative Instruments) under topic ” C. Interpreting a Swap position – 1. Package of Forward (Future) Contracts” , I could not understand line 3 which says
*” The long futures position gains if interest rate declines and loses if interest rate rises – this is similar to risk / return profile for a floating-rate payer”.*
I think the first part of the above statement should be that “The long futures position gains if interest rate* rise *and *not* The long futures position gains if interest rate* decline”.*
** Even the example on Page 301 (Starting line 7) says that* when interest rate rise to 7%, the long forward position (the fixed-rate payer) gains, and the short forward position (floating-rate payer) loses.* **
This is an interesting question. To understand this, we need to clarify the definition of Interest Rate Futures first:
“Interest rate futures are based off an underlying security which is a debt obligation and moves in value as interest rates change.”
Therefore, interest rate futures, although is related to the interest rate, is not valued simply using the difference between the current interest rate and future interest rate. It is valued based on the value of the underlying security, for example treasury notes.
When I buy a treasury bond futures (which is an interest rate futures because treasury bond is an interest paying security), I am longing the futures. The seller promises to deliver a treasure bond to me at the current set price in the future. If in the future, the interest rate increases, the value of the bond of course will decrease. But I still have to buy at the current set price. Therefore, I lose. So you can see, in an interest rate futures, what we are longing is the underlying security, not the interest rate. So, longer wins when the interest rate drops.
For interest rate swap, all the transaction is about the interest rates. For example, in a plain vanilla interest rate swap, the fixed-rate payer pays fixed interest rate and floating-rate payer pays floating interest rate. The fixed-rate payer is longing the interest rate (Not any underlying securities). Therefore, when the interest rate increases, fixed-rate payer will receive higher floating rate paying and thus the swap value of his position increases. Therefore, when the interest rate increases, the one who longs the interest rate will win.
In summary, the first quote above is about interest rate futures and the second is about interest rate swap. Therefore, there is complete opposite result.