Tuesday, May 19, 2015

ED futures to replicate IRS

I feel FRA is the correct thing to replicate IRS...

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The LTCM case P13 footnote very briefly described how to replicate IRS using ED futures.

Say we have a vanilla 10Y IRS based on 3M Libor. There are 40 payments, either incoming or outgoing. First payment is 3M after trade date (assuming Jan 1), when BBA announces the 3M Libor for Apr-Jun. Based on the differential against the pre-agreed fixed rate, one party will pay the other.

Here's how an ED trader replicates this IRS position -- On trade date she would simultaneously buy or sell 40 futures contracts each with a maturity matching those announcement dates.

In both cases, we are sensitive to all the 40 Libor rates to be announced. Each rate is a 3M spot deposit rate.

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