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Introduction to financial markets

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Trading interest rates

4.5-minute read

An interest rate future is a futures contract where the buyer and seller agree to the delivery of an interest bearing asset on a future date.

The price of an interest rate future reflects the sentiment of what the market expects the interest to be on the expiry date of the contract.

Interest rate trading focusses on the short term lending markets and lets investors speculate on the future movement of interest rates. They can also be used to hedge against the risk of an interest rate moving in an adverse direction.

How should you trade Interest Rates?

Interest rate trading lets you focus on short term lending markets and speculate on the future movement of interest rates. For example, the base rates set by the UK’s Bank of England or the rates at which banks lend to each other.

How do Interest Rates work?

Interest rate prices displayed are the future rate deducted from 100. For example, a price of 95 would indicate that the market is expecting future interest rates to be 5% (100-5). Interest rates are typically traded as future contracts or over the counter (OTC) between two counterparties.

What are the most popular Interest Rate markets?

Short Sterling
The short sterling contract is a means of speculating on potential changes in the Bank of England’s base rate and is highly correlated to UK interest rates.

Euribor
The Euro Interbank Offered Rate is based on the unsecured lending rates between Eurozone banks. Euribor rates range from one month to a year.

Eurodollar
Rates paid on US dollars held by banks outside the United States. The price is based on the Eurodollar futures contract traded on the Chicago Mercantile Exchange (CME).

How are interbank rates set?

Unlike the rates set by central banks, interbank rates are based on information collected from a wide range of banks. For example, Euribor is based on rates submitted daily by banks around the Euro area.

Where are Interest Rates traded?

Interest rates are typically traded as futures contracts on futures exchanges. Interest rate futures constitute one of the largest financial markets in the world in terms of their daily volume. There are many companies and investors who want to be able to protect themselves from the risk of interest rates changes by hedging.

Interest rate futures can also be traded bi-laterally between direct counterparties over-the–counter (OTC).

Who trades Interest Rates?

Interest-rate derivatives are often used as hedges by institutional investors as well as banks, companies and individuals to protect themselves against changes in market interest rates. They can also be used to increase or refine the holder's risk profile.

What moves Interest Rate markets?

Rates set by central banks, including expectations of future rate changes
Health of a country’s economy
Inflation – higher inflation may cause central banks to raise rates
Lack of confidence on the part of banks in lending to each other
Lack of liquidity in the interbank market – this means that there are fewer banks willing / able to lend, allowing those that will lend to raise their rates, especially on short term money