I want to know what is expected future rate (fixing, floating rate of fra) in the market. Should i look at the IR futures or FRA rate of the corresponding period? I know they both differ due to convexity in FRAs. But which of the two rates is the correct implied floating/fixing rate?
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2 Answers
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This is quite an interesting question IMO.
The underlying problem is that you have two different instruments which settle to the same index value and yet demonstrate different expectations for their ultimate values. This is due to the deviation in the risk neutral density versus the true density.
The true density is latent. It cannot be observed and we can only speculate as to its value. But we know the convexity of the FRA versus the Future. This is a mathematical quantity derived from some knowledge about the expected volatility of the market and the current market level (and in the market it is often distorted by supply/demand). In a volatile market it is more advantageous to sell futures hedged by selling FRAs in a dynamic delta neutral portfolio, than to buy futures hedged by buying FRAs.
The question then is if we can designate one of these products as the numeraire, i.e. which reflects the true density and the other has a risk neutral adjustment (i.e. a convexity adjustment).
There is another market which has similar concept. The clearing house basis market. To trade a 10Y IRS versus LCH or a 10Y IRS versus Eurex(or CME) is about 3 bps difference. This is big, for the same trade that has exactly the same economics (and this is due to capital and margin costs). But which reflects the true market expectation? Here you have to assert LCH because its volumes are about 100x larger. You have to assume that the dominant market is not dependent upon the much smaller market and reflects genuine expectation, whereas the smaller market can readily treat the dominant market as its numeraire.
For Euribor FRAs and Euribor Futures the difference in volume and which is dominant is not as clear cut. I lean towards swaps/FRAs being the numeraire because it is much more liquid beyond the fronts/reds/greens and tends to have a generally smooth transition from shorter dates to longer dates. But, without seeing any volume data, I would tend to go 75% swaps and dominant and 25% as Euribor, pegging the latent true density somewhere in within the range.
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For EUR Swaps for example, the correct "forward EURIBOR rate" to use, would be the convexity adjusted (EURIBOR) futures rate (i.e. the forward rate). Assuming the future has the same fixing/end date as the period you wanted your forward fixing estimation for..
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$\begingroup$ Thanks for the reply. Would you mind elaborating why that is the case? $\endgroup$ Commented Aug 27 at 11:19
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$\begingroup$ I'd use futures, at the short end purely because I'd say they're more liquid and therefore are probably a better estimate of the future fixing. Ofcourse you need to adjust the future for convexity to derive a fair forward. $\endgroup$ Commented Aug 27 at 12:45
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$\begingroup$ @Attack68 response is very insightful below. $\endgroup$ Commented Aug 27 at 14:33