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Chapter 6 - Interest Rate Futures

1. Treasury bond futures are financial derivatives used to hedge against the risk of rising interest rates. They work by taking an inverse position - if rates rise, the futures value falls, offsetting losses from higher rates. 2. Eurodollar futures are based on the 3-month LIBOR rate and settled in cash when the contract expires based on the actual rate. One basis point change in the quote equals a $25 change in the contract price. 3. Duration matching involves hedging interest rate risk by matching the durations of assets and liabilities. It provides protection against small parallel shifts in yields but assumes no non-parallel shifts or changes in deliverable bonds.

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147 views24 pages

Chapter 6 - Interest Rate Futures

1. Treasury bond futures are financial derivatives used to hedge against the risk of rising interest rates. They work by taking an inverse position - if rates rise, the futures value falls, offsetting losses from higher rates. 2. Eurodollar futures are based on the 3-month LIBOR rate and settled in cash when the contract expires based on the actual rate. One basis point change in the quote equals a $25 change in the contract price. 3. Duration matching involves hedging interest rate risk by matching the durations of assets and liabilities. It provides protection against small parallel shifts in yields but assumes no non-parallel shifts or changes in deliverable bonds.

Uploaded by

Taha Yaseen
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Interest Rate Futures

Chapter 6

Day Count Conventions


in the U.S.
Treasury Bonds: Actual/Actual (in
period)
Corporate Bonds: 30/360
Money Market Instruments: Actual/360

Treasury Bond Price Quotes


in the U.S
Cash price = Quoted price +
Accrued Interest

It is January 9, 2013. The price of a


Treasury bond with a 12% coupon
(issue date October 12, 2012) that
matures on October 12, 2020, is quoted
as 102-07. What is the cash price?
3

Treasury Bond Futures


An interest rate future is a financial
derivative (a futures contract) with an
interest-bearing instrument as the
underlying asset.
Examples include Treasury-bill
futures and Eurodollar futures.
4

Treasury Bond Futures


Interest rate futures are used to hedge against the
risk of that interest rates will move in an adverse
direction, causing a cost to the company.
For example, borrowers face the risk of interest
rates rising. Futures use the inverse relationship
between interest rates and bond prices to hedge
against the risk of rising interest rates. A borrower
will enter to sell a future today. Then if interest
rates rise in the future, the value of the future will
fall (as it is linked to the underlying asset, bond
prices), and hence a profit can be made when
closing out of the future (i.e. buying the future).
5

Treasury Bond Futures


It's Important to note that interest rate futures are not
directly correlated with the market interest rates. When
one enters into an interest rate futures contract (like a
bond future), the trader has ability to eventually take
delivery of the underlying asset. In the case of notes and
bonds this means the trader could potentially take delivery
of a bunch of bonds if the contract is not cash settled. The
bonds which the seller can deliver vary depending on the
futures contract. The seller can choose to deliver a variety
of bonds to the buyer that fit the definitions laid out in the
contract. The futures contract price takes this into
account, therefore prices have less to do with current
market interest rates, and more to do with what existing
bonds in the market are cheapest to deliver to the buyer.
6

Treasury Bond Futures


Cash price received by party with short
position =
Most recent settlement price Conversion
factor + Accrued interest

Example
Most

recent settlement price = 90.00


Conversion factor of bond delivered =
1.3800
Accrued interest on bond =3.00
Price received for bond is
1.380090.00+3.00 = $127.20
per $100 of principal

Conversion Factor
The conversion factor for a bond is
approximately equal to the value of the
bond on the assumption that the yield curve
is flat at 6% with semiannual compounding

Cheapest to deliver Bond


(Most recent settlement price * Conversion factor) +
Accrued interest
and the cost of purchasing a bond is
Quoted bond price + Accrued interest
the cheapest-to-deliver bond is the one for which
Quoted bond price - Most recent settlement price *
Conversion factor
10

Cheapest to deliver Bond


Suppose that the Treasury bond futures price
is 101-12. Which of the following four bonds is
cheapest to deliver?

11

CBOT
T-Bonds & T-Notes
Factors that affect the futures
price:
Delivery can be made any time
during the delivery month
Any of a range of eligible bonds
can be delivered
The wild card play
12

Determining the future price


In a Treasury bond futures contract, it is known that
the cheapest to-deliver bond will be a 12% coupon
bond with a conversion factor of 1.6000. Suppose that
it is known that delivery will take place in 270 days.
Coupons are payable semiannually on the bond. The
last coupon date was 60 days ago, the next coupon
date is in 122 days, and the coupon date thereafter is
in 305 days. The term structure is flat, and the rate of
interest (with continuous compounding) is 10% per
annum. Assume that the current quoted bond price is
$115. The cash price of the bond is obtained by adding
to this quoted price the proportion of the next coupon
payment that accrues to the holder. The cash price
is ??
13

Eurodollar Futures
A Eurodollar

is a dollar deposited in a bank


outside the United States
Eurodollar futures are futures on the 3month Eurodollar deposit rate (same as 3month LIBOR rate)
One contract is on the rate earned on $1
million
A change of one basis point or 0.01 in a
Eurodollar futures quote corresponds to a
contract price change of $25
14

Eurodollar Futures continued


A Eurodollar

futures contract is settled in

cash
When it expires (on the third Wednesday of
the delivery month) the final settlement
price is 100 minus the actual three month
deposit rate

15

Example
Suppose

you buy (take a long position in) a


contract on November 1
The contract expires on December 21
The prices are as shown
How much do you gain or lose a) on the
first day, b) on the second day, c) over the
whole time until expiration?

16

Example
Date
Nov 1

Quote
97.12

Nov 2

97.23

Nov 3

96.98

Dec 21

97.42

17

Example continued
If

on Nov. 1 you know that you will have $1


million to invest on for three months on Dec
21, the contract locks in a rate of
100 - 97.12 = 2.88%
In the example you earn 100 97.42 =
2.58% on $1 million for three months
(=$6,450) and make a gain day by day on
the futures contract of 30$25 =$750

18

Question
An

Investor wants to lock in the interest rate


for 3 months period beginning September
19, 2012, on a principal of $100 million. The
September 2012 Eurodollar futures quoted
is 96.50 per annum. Suppose that on
September 19, 2012 the 3 month Eurodollar
rate turns out to be 2.6%. Calculate the final
settlement amount gain/ loss.

19

Formula for Contract Value


If Q is the quoted price of a Eurodollar
futures contract, the value of one contract is
10,000[100-0.25(100-Q)]

20

Duration Matching
This

involves hedging against interest rate


risk by matching the durations of assets
and liabilities
It provides protection against small
parallel shifts in the zero curve

21

Duration-Based Hedge Ratio


PDP
FC DF

FC

Contract price for interest rate futures

DF Duration of asset underlying futures at


maturity
P

Value of portfolio being hedged

DP Duration of portfolio at hedge maturity

22

Example
It

is August. A fund manager has $10 million


invested in a portfolio of government bonds with a
duration of 6.80 years and wants to hedge against
interest rate moves between August and December
The manager decides to use December T-bond
futures. The futures price is 93-02 or 93.0625 and
the duration of the cheapest to deliver bond is 9.2
years
The number of contracts that should be shorted is
10,000,000 6.80

79
93,062.50 9.20
23

Limitations of Duration-Based
Hedging
Assumes

that only parallel shift in yield


curve take place
Assumes that yield curve changes are
small
When T-Bond futures is used assumes
there will be no change in the cheapest-todeliver bond

24

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