Interest Rates Spread Betting
You can speculate on the direction of interest rates using spread betting. Yes, spread betting on interest rates might be one of the newer ideas, but it works on exactly the same principle of deciding whether a rate will go up or down, and placing the appropriate bet. What, with central banks such as European Central Bank (ECB), the Bank of England (BoE) and the Federal Reserve all attempting to balance the fine line between inflation and economic growth, interest rate speculation continues to be of growing interest for spread betters. But the bet may be in the opposite direction to the one you expect, as you will see.
Spread bets on interest rates are linked to the prices of interest-rate futures. In other words this is a bet on which way a particular interest rate will go in the future – up or down. There are several different rates you can bet on. I regard these as quite sophisticated bets, and not for the beginner. If you are just starting out, stick to the major indices (Dow and FTSE) or blue chip shares, then perhaps branch out into currency trading. Finally, get into interest rates and commodities.
Firstly, you usually get a choice of betting on short-term interest rates, which are basically different countries’ 3 month interest rates, or on long-term interest rates which relate to government bond issues. You can bet on a number of different interest rates, including US and euro rates.
There are two types of interest rate contract you can bet on:
- Short Term Contracts – (usually 3-month interest rates).
- Long Term Contracts – The market which best reflects long-term interest rate expectations is the market in government bonds, example USA T-Bills (Treasury Bills).
Private investors often hesitate to tread in these key financial markets because many small traders are unfamiliar with how to trade them. Traders can place a spread trade on the future course of interest rates in Britain, the US, the European single currency area and Switzerland.
The usual way of doing this is by betting on the level of market three-month interest rates. In this case, you are betting on whether the interest rate fixed by the government of a particular country will rise or fall, and by how many percentage points. You can bet on the interest rate in the UK, and in that of many other countries.
These track central bank target rates closely, but will rarely be identical to them. Interest rate trades are based on three month interest rate futures contracts traded on exchanges such as the London International Futures Exchange.
Betting on short-term interest rates can be somewhat confusing because they seem backwards! In other words these contracts do the opposite of what the relevant interest rate does. For example, if the London Interbank Offered Rate (LIBOR) goes up, the Short Sterling contract that tracks it would go down. Let’s see how this works in practice -:
The price of a 3-month interest rate contract is quoted as 100 minus the interest rate. For example, if the March interest rate is 8%, then the contract price will be 100 – 8 = 92 (quoted as 9200). If the March rate rises to 8.3%, then the contract price will fall to 100 – 8.3 = 91.7 (quoted as 9170).
So if the rate rises then the contract value falls. If the rate falls then the contract value rises.
For example: trades on British interest rates are on the short sterling contract, and those on US rates are on the short eurodollar contract. There is a trick to understanding how these futures contracts work:
- They each express the market’s view on the likely three-month interest rate at a particular month in the future, in terms of its distance from 100.
- So an interest rate future of 93.37 means that the market is implying three-month interest rates of 6.63% (100 minus 93.37 is 6.63).
The price of the contract is always expressed as 100 minus the interest rate. So if the interest rate is 3%, the price would be 97. This means that if you think the interest rate is going to fall, you will buy the contract. If interest rates are rising, you want to sell. This is the opposite to what you might have expected, as with other spread bets you buy when you think the price is going up.
In this case, each point is the second decimal place. So if you open a position at 96.35 and close it at 96.44, you have gained nine points. Usually the quotations are given by the spread betting broker without the decimal point, for example as 9644.
So (as you following this?) – if you expect the rate to RISE in the future, you SELL the future contract (because the contract will fall if you’re right). If you expect the rate to FALL in the future, then you BUY the future contract (because the value of the contract will RISE).
Traders can also make an up-bet on an interest rate future – which is tantamount to betting that central bank interest rates will not be as high as the market expects at the chosen date. Or they can make a down-bet on an interest rate future – which is effectively a gamble that central bank interest rates will be higher than the market is implying.
Currently with a period of stable economic growth in most developed countries interest rates do not offer good prospects for making a great deal of money as they are unlikely to fluctuate much. However, in less predictable times they can be a good hunting ground for the financial trader.
Clever Strategy: Interest rate changes tend to occur in fractions of a percentage point. For this reason, bet in basis points (known as ‘bp’). A basis point is one hundredth of a percentage point, eg. 10bp = 0.1%. Also bet on futures six or 12 months ahead to offer a wider spread and a great potential for gain (or loss).
Interest rate fluctuations depend on a variety of factors which makes them partly predictable and partly subject to an element of luck! These factors include government policy, economic conditions at home and abroad, demand and inflation rates.
Example 1: Interest Rate Spread Bet
- Percy Pessimist believes that the Bank of England is likely to raise interest rates far more between now and December than the market is currently implying.
- The bookmakers’ spread for December short sterling is 9355-9361 (bookmakers do not put the decimal point in between the middle two numbers).
- This implies a three-month interest rate at the mid-December expiry of between 6.39% and 6.45%. Percy reckons a figure closer to 7% is more likely.
- So Percy makes a £10-a-point down-bet from 9355 on December short sterling.
- One month later, interest rate sentiment has become even more optimistic and the spread on December short sterling has risen to 9372-9378.
- Percy is now facing paper losses of £230 (9378 minus 9355, times £10). However his stop loss has not been triggered so he holds his position.
- Another month further on and some bad figures on wage inflation knock interest rate sentiment severely.
- The Bank of England puts up interest rates by a quarter point, and the spread on December short sterling moves down to 9321-9327.
- Percy decides to take a profit of £280 (9355 minus 9327, times £10). He closes the bet and thanks his trading plan that he did not panic a month earlier when he was losing on it.
Example 2: Buying 3-month Sterling Deposits
- You expect interest rates will fall, short term in the UK. This means that the price of 3-month Sterling deposit (usually called ‘shorts’) will rise. So you BUY 3-month short Sterling. You telephone for a quote for March Sterling deposits and get 9287/9293. You buy at £10 a point at the price of 9293. The deposit factor is 40, and so you would need to provide £400 deposit to cover this bet.
- The middle price of 9290 means that interest rates are expected to be 100 – 92.90 = 7.1% in March. You are betting that interest rates will be lower than this.
You are correct. Interest rates fall steadily on news of lower inflation. After a few weeks you ask for a quotation are given 9340/9346. You SELL 3-month Sterling deposits at 9340, £ per point.
Your profits are -:
Opening position: 9293
Closing position: 9340
Difference: 47 x £10/point = £470 profit
You can also use interest rates for hedging purposes. Hedging interest rate risks might make practical sense if you’re a borrower who’s concerned about higher repayment costs or a saver who’s concerned that falling rates might reduce your interest income. To hedge against rising mortgage payments, you could take a short trade on short position on short-dated UK treasury bonds (short sterling); in such a scenarior if interest rates were to spike up, you would make money on the trade which you could then use to offset the higher mortgage repayments costs. Let’s now take the case of a mortgage on an overseas property, which interest payments are linked to Euribor. If you were afraid that rates were going up, you’d sell a Euribor contract in sufficient quantities to approximate the size of your interest payments.
Spread betting providers allow clients to bet on what is commonly referred to as ‘short sterling’ rate futures. As the name suggests these are contracts for borrowing money at some time in the future so are not an accurate forecast of the Bank’s base rate; and move up and down in response to market expectations.
Note that short sterling simply represents the market’s future expectations of the change in base rates in the United Kingdom but it does not reflect current rates; it represents where traders believe the interest rate will go next.
Short sterling is computed by deducting the cost of borrowing money in the future from 100. The lower the price, the more likely is the market expecting interest rates to rise in the near future. If spread traders are of the opinion that UK interest rates are going to remain unchanged, that price will remain static.
So for instance, in 3 months’ time there is a rate of 0.86% (this is what’s left when you deduct 99.14, the present figure for March, from 100). Thus, if the Bank were to hike the base rate, short sterling would move down.
Let’s take an example. You think that interest rates are going to move up by 2% from their current lows of 0.5% by the end of the year. IG Index is quoting the market for short sterling at 9862 to ‘sell’ (i.e. betting that it will be lower) and thus you decide to bet £30 per point.
You would need to make an initial deposit margin to be able to open this position and in this case IG Index requires you to deposit 45 times your stake (45 x £30). So you deposit £1350.
Scenario: Let’s suppose that by December, interest rates have gone up sharply and are now at 2.5% in which instance short sterling would be trading at around 100 minus 2.5. This means that the short sterling contract would be around 9750 and since you sold at 9862 this nets you a 112 point move gain and since you bet £30 per point – so you’ve made a gain of £3360 on this trade.
Of course this works the opposite way as well and you would have possibly lost money had the market gone the other way (for instance, if the market started to believe that the rates will be held unchanged).