The financial world has moved on from LIBOR. In its place, a new set of benchmarks called Risk-Free Rates (RFRs) now anchor the global interest rate market. In the US, the key rate is the Secured Overnight Financing Rate (SOFR). In Europe, it's a combination of the Euro Short-Term Rate (€STR) and the established Euribor.

This shift wasn't just a name change. These new rates are calculated differently from LIBOR, which was based on bank estimates. RFRs are based on actual overnight borrowing transactions, making them more robust. This fundamental difference changes how interest rate futures contracts—the primary tools for hedging and speculating on future rate movements—are designed and priced.

Understanding these new futures contracts is key to navigating modern yield curves. Let's examine three major short-term interest rate (STIR) futures: Three-Month SOFR, Three-Month Euribor, and Australia's 90-Day Bank Bill (BBSW) futures.

At first glance, these contracts look similar. They are all priced using a simple convention:

This means a higher price implies a lower expected interest rate, and vice versa. While the pricing is standard, the underlying rates they track are fundamentally different. The key distinction lies in whether the rate is determined by looking backward or forward.

SOFR: Compounding In-Arrears SOFR is an overnight rate. A Three-Month SOFR futures contract doesn't settle to a single three-month rate that exists today. Instead, its final settlement price is determined by the daily SOFR rates compounded over the contract's reference quarter. This is known as compounding "in-arrears" because the final rate is only known at the end of the period.

Euribor & BBSW: Term Rates In contrast, Euribor and BBSW are term rates. They represent the rate for borrowing for a future three-month period. The rate is determined at the beginning of the period, making it forward-looking. This reflects the market's expectation of borrowing costs over the next 90 days.

This structural difference is not just academic. It introduces different types of risk and requires distinct analytical approaches. For instance, SOFR futures react to daily changes in the Federal Reserve's policy rate throughout the quarter, while Euribor reflects expectations of where the European Central Bank will set rates at the start of the period.

To map out the market's view of future interest rates, traders look at the "strip"—a sequence of consecutive quarterly futures contracts. These contracts are standardized around the International Monetary Market (IMM) dates: the third Wednesday of March, June, September, and December.

A contract's name tells you its reference period. The March contract (code H) covers the period from the March IMM date to the June IMM date. The June contract (code M) covers June to September, and so on.

By lining up the prices of these contracts, you can build a forward curve of expected interest rates. For example, if the September 2024 (U4), December 2024 (Z4), March 2025 (H5), and June 2025 (M5) contracts have implied yields of 5.10%, 4.95%, 4.70%, and 4.60% respectively, the market is pricing in a series of rate cuts over that year.

This strip is the backbone of yield curve analysis. Traders look for inconsistencies or patterns. Is the curve steepening (long-term rates rising faster than short-term) or flattening? Is there a "hump" where mid-term rates are higher than both short and long-term rates? These shapes inform complex strategies like curve trades and calendar spreads.

The transition to RFRs like SOFR solved one problem—the unreliability of LIBOR—but it introduced another consideration: basis risk.

LIBOR was a measure of unsecured interbank lending, so it naturally included a component of bank credit risk. SOFR, being based on trades collateralized by US Treasuries, is essentially a risk-free rate. This creates a gap. A corporate borrower's loan might still be priced off a credit-sensitive benchmark, while their hedge is executed using SOFR futures. If credit spreads widen (the difference between risky and risk-free rates increases), the hedge might not perform as expected. This mismatch is called basis risk.

Managing this risk is a new challenge. While RFRs provide a more stable foundation, market participants must now actively account for the separate component of credit risk in their hedging and funding activities. The seemingly simple futures strip now tells only part of the story.

Test your understanding of these new rate mechanics.

Understanding the mechanics of these futures contracts is the first step toward building sophisticated yield curve strategies.