CME Group Derivatives Marketplace
CME Group is the world’s leading derivatives marketplace. The group has four exchanges, CME (Chicago Mercantile Exchange, established in 1848), CBOT (Chicago Board of Trade), NYMEX (New York Mercantile Exchange) and COMEX (The Commodity Exchange). These four exchanges offer a wide range of trading benchmarks for all major asset classes. CME Group’s website (https://www.cmegroup.com/) provides comprehensive information on derivatives trading and can be used as the major information source of this assignment.
Student teams from this course are going to investigate derivative securities trading using the trading simulator provided by CME. The simulator can be accessed after registration (free) and login (see following link). Initially, each trading team will have $100,000 to trade but you do not need use all the amount. For Question 7, each trading team may assume certain amount of currency within the equivalent $100,000 limit. https://www.cmegroup.com/trading_tools/simulator.html
The investigation report should be in a Questions/Answers format (you don’t need a cover page, executive summary, introduction etc.), answering the questions listed below in sequence. The report does not need a separate cover page
1. We saw the Fed increase its policy rate to 4.25%-4.50% in 2022, hiking seven 2 times in eight meetings in an attempt to clamp down on inflation. Based on guidance, a peak federal funds rate between 4.75% and 5.50% seems likely to be achieved at the March 22 FOMC meeting, although a delay is possible. The resulting risk management needs were significant for participants to CME Group. Investigate and report the price quotation method of the 3-month SOFR contracts. How to use the 3- month SOFR contracts to hedge against an increasing interest rate if you are a borrower?
CME Group Derivatives Marketplace Questions
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CME Group Derivatives Marketplace Questions
Question 1
Secured Overnight Financing Rate (SOFR) in CME Group
The Secured Overnight Financing Rate (SOFR) is an interest rate benchmark. This benchmark is utilized in measuring the cost of borrowing cash overnight. SOFR is authorized by the Fed-sponsored Alternative Reference Rates Committee (ARRC) for use in the USD market (Kronstein, 2022). SOFR was published by the Federal Reserve Bank of New York and the U.S. Office of Financial Research on April 3, 2018 (CME Group). The U.S. Treasury securities play the role of collateralizing the SOFR benchmark. SOFR is set as a financially distinct benchmark. However, it is highly related to existing money markets rates such as ICE LIBOR and the Effective Federal Funds Rate (EFFR). The U.S. Treasury overnight repurchase (repo) market underpins the rate. As the summary by Kronstein (2022) indicates, this is achieved through a collection of eligible transactions of around $750 billion daily. SOFR is evaluated as a transaction-volume-weighted median repo rate.
Price Quotation Method of the 3-Month SOFR Contracts
The price quotation method for the CME 3-Month SOFR futures contracts is based on the Contract-grade IMM Index. This index is calculated as 100 minus R. In this case, R represents the underlying 3-Month SOFR interest rate. For instance, if the underlying SOFR rate is 2%, the corresponding IMM Index would be 98 (100 – 2 = 98). The contract size is $25 per basis point annualy. The contracts' minimum price fluctuation depends on the period until the final trading day.
Using the 3-Month SOFR Contracts to Hedge against an Increasing Interest Rate
As a borrower, an individual can use hedging to deal with increasing interest rates. The 3-Month SOFR futures contracts can be employed as a hedge against increasing interest rates. Implementing such as strategy requires the borrower to sell (short) the SOFR futures contracts to lock in the current interest rate. If the rates increase in the future, the value of a short position in the futures contracts also increases. These changes help in offsetting the additional cost a borrower might be forced to pay following increased interest rates.
Example
Consider a case where I am a borrower who wants to hedge against the risk of increasing interest rates over the next quarter. The current 3-Month SOFR rate is 4.25%. In this case, I can sell the 3-Month SOFR futures contracts to lock in this rate.
* The IMM Index is 100 - 4.25 = 95.75.
* Determining the number of contracts I need to sell. This is based on the size of my loan and the contract size ($25 per basis point annually). For example, if I want to hedge a loan of $1,000,000, I would need to sell 40 contracts (1,000,000 / (25 * 100)).
* Sell 40 SOFR futures contracts at the IMM Index of 95.75.
If intere...