Derivatives markets allow traders to bet on the direction of many securities and even interest rates.
The most straight forward way to do this, is using the Short Term Interest Rate (or STIR) future. This is also known as the ‘short sterling’ future. In essence, this facilitates bets on where interest rates will be. One source of confusion is the price – the contract is priced at 100 minus the expected sterling interest rate. So if that rate is 1%, the future will be quoted at 99 (100-1).
A trader betting on a rise in rates would sell the contract at 99. If rates do rise (sterling money market rates, that is) to, say, 2%, the threemonth contract will be repriced at 98 (100-2). So by buying back the contract the trader makes a profit of 1 (99-98), or 100 basis points (1 basis point is 1/100th of 1%).
This is multiplied by a fixed charge of £12.50 per basis point to give a profit of £1,250. If the trader had sold ten contracts that profit would be £12,500. These contracts can also be used to hedge rate changes.