What it means
Short-term interest rates, such as the rate on three-month borrowing, are set by the central bank and by market expectations. A STIR futures contract is a standardised agreement whose value depends on where a short-term rate will be on a future date.
Because the contracts trade on exchanges, prices update all day as new economic data and central bank comments arrive. The price is quoted as 100 minus the rate.
If the market expects a rate of 4.25%, the contract trades at 95.75. If expectations fall to 4.00%, the price rises to 96.00, so a rise in price means the market expects lower rates.
Two groups use these contracts. Hedgers, such as corporate treasurers and banks, use them to lock in a borrowing or lending rate, for instance to protect a floating-rate loan from rises in rates.
Speculators and traders use them to profit from correct views about central bank moves, and they provide liquidity that makes hedging easier. The contracts are tied to a benchmark rate, which in many markets is now an overnight risk-free rate.
Each contract has a notional amount and a tick value, the dollar change for each small price move. Traders post a margin, a deposit to cover possible losses, and gains and losses are settled daily.
For non-specialists, STIR prices are a handy window into expectations. Financial news often quotes the market-implied path of central bank rates, which is derived from these contracts.
A finance team can compare that path with its own budget assumptions for interest costs. The contracts come in several maturities, so a series of them traces out the expected path of rates over the next few years.
Analysts read this series as a forward-looking guide, while recognising that it also contains a small premium for uncertainty. If the path moves sharply after a data release, it is a signal that the market has changed its mind.
In practice
Real-world examples.
Example
A treasurer at a manufacturer has a $20,000,000 floating-rate loan and expects interest rates to rise. She sells STIR futures so that a rise in rates produces a gain on the contracts. The gain offsets some of the extra interest she will pay on the loan.
Example
A bank trader believes the central bank will cut rates faster than the market expects. He buys 200 STIR futures contracts and benefits as the price rises when expectations shift. He closes the position after the central bank meeting.
Example
A fund manager looks at STIR prices to see what rate path the market has priced in. She compares it with her own forecast and finds the market expects fewer cuts than she does. She increases her holding of government bonds on the view that yields will fall.
Formula
Calculation
Contract price = 100 - implied interest rate
Gain or loss = change in price in basis points x tick value per basis point x number of contracts
Suppose a three-month STIR futures contract on a $1,000,000 notional amount trades at 95.75, implying a rate of 4.25%. Each basis point (0.01%) is worth 1,000,000 x 0.0001 x 3/12 = $25. If the market now expects a rate of 4.00%, the price rises to 96.00, a move of 25 basis points. A trader who bought 10 contracts gains 25 x 25 x 10 = $6,250, while a trader who sold 10 contracts loses the same amount.Case study
Seen in the real world.
Brightgate Logistics is an illustrative, fictional company with a $60,000,000 floating-rate loan resetting every three months. The treasurer worried that a spike in rates would cause the interest bill to rise by $600,000 a year for every percentage point.
She sold STIR futures covering the loan, so that if rates rose, the gains on the contracts would compensate for higher interest. Over the next six months rates rose by 0.75%, adding about $450,000 a year to the loan cost, since 60,000,000 x 0.75% = $450,000.
Gains on the futures offset a large part of the increase. The illustrative lesson is that hedging with STIR contracts does not remove all risk, since hedges can be imperfect, but it can sharply reduce the effect of a sudden move in rates.
Watch out
Common mistakes.
- Reading a rising STIR futures price as higher interest rates, when the price moves in the opposite direction to the implied rate.
- Ignoring margin requirements, when daily gains and losses must be funded in cash.
- Assuming a hedge matches a loan perfectly, when differences in dates, benchmarks and amounts leave some basis risk.
Questions
People also ask.
What does STIR stand for?
Short-term interest rate, and it is used for futures and options linked to short-dated interest rates.
Why is the price 100 minus the rate?
It is a market convention that makes the price rise when expected rates fall, which mirrors how bond prices behave.
Who uses STIR products?
Banks, corporate treasurers, asset managers and traders use them to hedge borrowing costs, manage portfolios or take views on central bank policy.
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