CHAPTER 11

CURRENCY AND INTEREST RATE FUTURES

Chapter Overview

This chapter describes the features and pricing of currency and interest rate futures as compared
with forward contracts. The chapter begins with a brief history of the financial futures markets.
The most basic reason why forward and futures contracts as derivatives or redundant securities
exist is reduced transaction costs.

The basic institutional features of currency and interest rate futures are reviewed and the
distinctions between futures and forward contracts are highlighted in this chapter. Like futures
on agricultural commodities and precious metals, currency and interest rate futures are
standardized contracts that permit trade among hedgers and speculators around the world in a
centralized marketplace. An important characteristic of futures is their symmetric payoff profile,
which comes from the obligation of a counterparty to pay off in both good and bad outcomes.
Trading among anonymous conterparties in futures is made possible by (1) the clearinghouse,
which provides a standardized, high-quality counterparty to each transaction; and (2) the
marking-to-market convention that minimizes the need for credit checks, relying instead on a
system of margin requirements. While futures and forward contracts are similar, institutional
differences make them different. As an empirical matter, there appears to be little difference in
the prices of futures and forwards. Futures markets may attract smaller investors who desire
liquidity, and forward markets may be preferred by larger agents who do not value liquidity.

The chapter then examines and compares the pricing of futures and forward contracts. Payoff
profile graphs show the value of a forward or futures contract at maturity. This value is well
defined because both forward and futures prices converge to the spot rate at maturity. Prior to
maturity pricing of a forward or futures reflects several factors including expectations and risk
premiums. The term structure of interest rates is an important tool for understanding the basic
structure of futures prices.

Futures contracts offers a means for risk management and a tool for speculation. In discussing
implications for private enterprises, the chapter considers two issues: the decision to use futures
versus forwards, and the decision to introduce a new futures contracts for trading. The
implication for public policy-makers includes market regulation regarding price volatility.

Chapter Outline

Distinctions between Futures and Forwards: Institutions and Terminology

Dispersed Versus Centralized Trading
Customized versus Standardized Transactions
Variable Counterparty Risks versus the Clearinghouse
Cash Settlement and Delivery versus the Marking-to-Market Convention
Description of Futures Contracts
Contract Specifications
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 Payoff Profiles for Future and Forward Contracts
Futures Pricing and Forward Pricing
Forward Pricing and the Cost-of-Carry Model
Futures Pricing and the Marking-to-Market Convention
The Term Structure of Forward Rates
A Risk Premium in Forwards?
Policy Matters - Private Enterprises
Deciding on Futures versus Forwards
New Futures Contracts and Trading Arrangements
Policy Matters - Public Policymakers
Futures Prices and Cash Market Volatility
Transaction Costs and Transaction Taxes
Summary
Appendix 11.1: Synthetic Interest Rate Futures

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Supplementary Notes

Basic differences between forward and futures contracts

1. Operation
Futures: Traded on an exchange; contracts and contract sizes are standardized.
Forward: Contracts and contract sizes are customized.

2. Delivery
Futures: Specified dates during the year.
Forward: On any date as set between the provider and the customer.

3. Settlement
Futures: Daily settlement via the Exchange’s clearing house – marking to market
Forward: Settlement on the date agreed upon between the bank and the customer.

4. Margins and credit risks

Futures: Initial margins and maintenance margins required; very little credit risk.
Forward: No margins required; credit risk borne by each party.

5. Regulation
Futures: Regulated by commission or agencies.
Forward: Self-regulating.

6. Transaction costs
Futures: Commissions paid to brokers.
Forward: Presented by bid-ask spread.

Specifics of foreign currency futures

• Standard method of stating exchange rate: American terms are used on the IMM: dollars per
unit of another currency.

• Commissions: Customers pay a commission to their broker to execute a round turn.

• Physical delivery of foreign exchange is allowed, although only a small portion of the
contracts are settled that way.

An example of daily settlement with a currency futures contract

Suppose on November 19, 1997, the futures price for the Deutschemark on CME for the
December contract is $.5784 /DM (That was the actual settle price on that day – source:

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 The Wall Street Journal). You buy one futures contract on the DM at the price of
$.5784/DM on that day morning.

At the day’s close, the price settles at $.5794/DM. Do you gain or lose in terms of
marking to market?

You gain, as the price goes up, long positions gain. How much?

Since the contract size for DM is 125,000 marks, you gain

($.5794 - $.5784) x 125,000 = $1,250.

On the last trading day in December, the price is $.5774/DM and you close your
position – take an opposite position. Do you gain or lose since November 19’s settlement?

You lose, as the price goes down, long positions lose. How much?

You lose

($.5774 - $.5794) x 125,000 = - $2,500.

Ignoring the opportunity cost of interest, do you gain or lose for the position? You lose.
How much?

($.5774 - $.5784) x 125,000 = - $1,250.

You decide to take delivery of DM at the price of $.5774, what is the net cost for you for
each mark (again, ignoring the opportunity cost of interest )?

$.5784 per mark. Why?

Special Features of interest rate contracts:

Notional values: The principal amount of an agreement or contract is used only for the
calculation of payment. The principal is not to be delivered.

Interest rate forward: Forward Rate Agreement (FRA)

An FRA is an agreement between the buyer and the seller to lock in a certain interest rate
for fixed period beginning at a fixed date in the future. Under this contract, the seller will
pay the buyer the increased interest cost on a nominal sum of money if interest rates rise
above the agreed rate, but the buyer will pay the seller the increased interst cost if the
interest rates fall below the agreed rate. A “three against six” FRA is for a three-month

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 period, beginning three months from now (the “three”) and ending six months from now
(the “six”).

An example in multiple choice:

A bank buys a "three against twelve" FRA for $1 million at a rate of 8%. In three months
the FRA settles at 7.5%. There are 273 days in the FRA period. How much cash does the
bank pay or receive?

a. The bank receives $3,587.54.

b. The bank pays $3,587.54.
c. The bank receives $1,003,587.54.
d. The bank receives $996,412.46.

Answer: b

Interest rate term structure theories

The pure expectations theory: (Sinkey, p 241)

1 + t y N = [ ( 1 + t y1 ) ( 1 + t+1 r 1 ) . . . ( 1 + t+ N -1 r 1 ) ]N
1
(1)

where y indicates an observed rate and r an expected rate (= implied forward rate in this
theory). The presubscript indicates time and the postsubscript maturity.

The entire term structure at a give time reflects the market's current expectations of the family
of future short-term rates. Under this view, a rising term structure must indicate that the
market expects short-term rates to rise throughout the relevant future.

Implications for bond portfolio management: (Fabozzi, p 206)

The expected total return for any investment horizon period will be the same regardless of the
maturity strategy selected.

The total return will be same over a short-term investment horizon starting today. For
example, if an investor has a 6-month investment horizon, buying a 5-year, a 10-year or a 20
year bond will produce the same 6-month total return.

The implied forward rates are an unbiased forecast of the market's expectation of future
interest rates.

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 The total return that an investor will realize by rolling over short-term bonds to some
investment horizon will be the same as holding a zero-coupon bond with a maturity that is the
same as that investment horizon.

The drawback of the pure expectations theory is that it does not consider the risks associated
with investing in bonds.

The liquidity premium theory

1 + t y N = [ ( 1 + t y1 ) ( 1 + t+1 r 1 + L 2 ) . . . ( 1 + t+ N -1 r 1 + L N ) ]N
1
(2)

where LN > LN-1 > 0, N ∃ 2 (i.e., the liquidity premiums are strictly positive and increase
monotonically).

To induce investors to hold longer-term maturities requires offering them a long-term rate
higher than the average of expected future rates by a risk premium that increases, the longer
the term to maturity. Put differently, the forward rates should reflect both interest rate
expectation and a "liquidity" premium (really a risk premium).

The liquidity premium theory

According to this theory, the implied forward rates will not be an unbiased estimate of the
market's expectations of future interest rats because they embody a liquidity premium. An
upward-sloping yield curve may reflect expectations that future interest rates either (1) will
rise, or (2) will be flat or even fall, but with a liquidity premium increasing fast enough with
maturity so as to produce an upward-sloping yield curve.

The liquidity premium hypothesis asserts that forward rates always exceed the corresponding
expected future spot rates by a liquidity premium, which is required to compensate investors
for the greater capital risk inherent in the longer-term bonds.

The preferred habitat theory

1 + t y N = [ ( 1 + t y1 ) ( 1 + t+1 r 1 + a 2 ) . . . ( 1 + t+ N -1 r 1 + a N ) ]N
1
(3)

where aN can be either >, < or = 0.

It also adopts the view that the term structure reflects the expectation of the future path of
interst rates as well as a risk premium, but rejects the assertion that risk premium must risk
uniformly with maturity. Investors should not buy a short-term instrument but rather an
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 instrument with a maturity matching their investment objective. If investors buy a shorter
instrument, they will bear reinvestment risk, i.e., the risk of a fall in the interest rates available
for reinvesting proceeds of the shorter instrument. Investors can avoid that risk only by
"locking in" the current long rate, through a long-term bond.

According to this approach, either policy-determined or regulatory-imposed risk aversion

leads investors to hedge their balance sheets by staying in their preferred (maturity) habitat.

According to this theory, upward-sloping, downward-sloping, flat, or humped yield curves are
all possible.

The market-segmentation theory

It adopts an institutional approach focusing on the hedging behavior of market participants.

According to this explanation, the forces of supply and demand in segmented market
determine the yields in those markets. Since the markets are segmented on the basis of
maturity preferences tied to hedging behavior, there is no linkage by formula between short-
and long-term interest rates as in expectations-based theories.

The market segmentation theory also recognizes that investors have preferred habitats and that
the major reason for the shape of the yield curve lies in asset/liability management constraints
(either regulatory or self-imposed) and/or creditors (borrowers) restricting their lending
(financing) to specific maturity sectors.

A major limitation of both liquidity premium and market segmentation hypotheses is their
lack of specificity: since the relationship of liquidity premium to maturity is not specified,
there are as many undermined parameters in the model as there are bond maturities
considered.

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Answers to end-of-chapter questions

1. What does it mean to mark an investment to market?

The expression "mark-to-market" implies attaching a current market valuation to an

investment. In the context of an organized futures market, the "marking-to-market"
convention determines the required cash flows into and out of the customer's margin account
as the market price of the futures contract falls and rises.

2. A futures contract is a redundant instrument, i.e. it can be replicated using other, simpler,
financial instruments. What benefits come from the existence of futures contracts?

Even though the futures contract is a redundant instrument, customers benefit from the
greater liquidity and lower transaction costs that are associated with well-functioning futures
markets.

3. What are the four characteristics cited in the chapter that differentiate a futures contract from
a forward contract?

The four characteristics that differentiate a futures contract from a forward contract are: (1)
Dispersed trading in forwards versus centralized trading of futures contracts; (2) Customized
terms and conditions of forward contracts versus standardized futures contracts; (3) Variable
counterparty risks with forward contracts versus standardization of counterparty risk with
futures written against the Clearinghouse; (4) Absence of initial and intervening cash flows
with forward contracts versus initial and ongoing cash flows associated with marking-to-
market of futures contracts.

4. What services does the clearinghouse in the futures markets deliver to its clients?

The Clearinghouse serves as the counterparty to all futures contracts and guarantees the
performance of the terms of the contract.

5. What is the difference between a maintenance margin and a variation margin?

Maintenance margin is the lower bound for the acceptable level of margin. Touching the
maintenance margin level triggers a margin call. Variation margin is the amount needed to
restore the initial margin once a margin call has been issued. The variation margin may
change depending on how far the margin account has fallen below the maintenance margin
level.

6. What is a "notional bond?" What does it mean when a trader delivers the cheapest-to-deliver
bond at maturity? What determines the conversion factor?

A notional bond is a hypothetical bond; that is, a bond with a hypothetical maturity and
coupon rate. Since an actual bond with the maturity and coupon characteristics of the
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 notional bond need not exist in the market, customers are given the option to deliver one of
several alternative bonds. It will always be in the trader's self-interest to deliver the bond
with the cheapest market price when he is obliged to deliver a bond in settlement. This is the
cheapest-to-deliver bond. The conversion factor is the number of actual bonds that can be
delivered in place of the notional bond. Actual bonds with higher coupons and shorter
maturities than the notional bond are more valuable and have a conversion factor less than
one. Actual bonds with lower coupons and longer maturities than the notional bond are less
valuable and have a conversion factor greater than one.

7. State the arbitrage condition that links the interest rate futures contract and the current
borrowing / lending condition in the market.

An interest rate futures contract sets the price for an interest rate between two points in time
in the future, say between September 15 and December 15. If today's date in June 15, we
can estimate the futures price using the term structure of interest rates: (1+iJune, Dec)0.5 =
(1+iJune, Sept)0.25 x (1+iSept, Dec)0.25 and solving for the September to December rate.

8. Define what it means to be hedged against foreign exchange risk?

A position is hedged against foreign exchange risk if the value (V) of the position is
statistically independent of the exchange rate (S). For example, a position is hedged against
sterling exchange risk if ∂V/∂S = 0, where V is measured in US$ and S is measured as US$/£.

9. Suppose you believe that the DM will rise sharply against the dollar over the next three
months (i.e. the future spot rate will be higher than that predicted by the covered interest
parity). What position on the futures market would you take to benefit from your speculation?

To benefit from a sharp rise in the DM over the next three months, the speculator would buy
a short-term DM futures contract. Since currency futures contracts are issued only for March,
June, September, and December (plus the nearest two months), the speculator may have to
choose between a two- and five-month, or a one- a four-month contract if the three-month is
not available.

10. Suppose at the end of the year you have a capital gain on a T-Bond. You would like to lock
in your profits now but rather wait for the year to end to delay the capital gain tax until next
year. How would you use the futures markets to achieve your objective? What are the risks
of your strategy?

Suppose that in December you have a capital gain on a long-term US Treasury bond. You
are exposed to a rise in interest rates that would lower the value of the bond. By selling in
December a T-Bond futures for the month of March, the hedger locks in his capital gain. If
interest rates rise, the loss on his bond is offset by the gain on the futures contract. The bond
can be sold in January (for tax purposes); the futures hedge must be "lifted" at the same time
(buy back the March futures contract) to avoid additional risks. The risk in this strategy is

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 that the T-Bond price will not change on a one-for-one basis with the T-Bond futures, a
basis risk.

11. Suppose your firm will receive dividends in one month. You want to invest these funds in
short-term instruments at today’s interest rate, which you find particularly attractive. How
would you lock in your future interest income using interest rate futures?

In this case, you expect to receive dividends in one month, and you are concerned about a
fall in interest rates. By buying a Eurodollar futures contract with a maturity of one month,
the hedger locks in the interest rate given by the futures price. If interest rates fall in the next
month, the price of the futures contracts rises and offsets the lower rate of interest earned on
the short-term investment.

12. What are the factors that might imply a different valuation for futures and forward for the
same maturity?

Institutional differences may lead to a different valuation of futures and forward contracts.
Futures contracts entail intermediate cash flows because of the marking-to-market
convention. This gives futures contracts an additional cash flow risk. Futures contracts may
have an advantage to offset this because they offer greater liquidity than forward contracts.

13. How does the shape of the spot yield curve influence the theoretical price of interest rate
futures?

A rising spot yield curve, implies that future short-term interest rates are higher than present
short-term rates. Thus, interest rates on Eurodollar futures will tend to increase with maturity
(so their prices will tend to fall with maturity). An inverted, or falling, yield curve implies the
opposite -- that future short-term interest rates are lower than at present.

14. Describe the cost-of-carry model of pricing for a futures contract. What determines a
currency futures price? What would explain the difference in price between the theoretical
futures price and the actual futures price?

The cost-of-carry model asserts that the futures price of a commodity is equal to the spot
price adjusted by the cost of storage. In the case of financial instruments, there is no physical
storage cost, but the interest rate measures the foregone benefit (cost) of long (short)
positions. The theoretical value for a currency futures price is Ft,n = St (1 + i$,t)/(1 + iFC,t).
The actual price could differ from the theoretical price because of transaction costs and taxes.

15. Suppose that spot DM trades at $ 0.66/DM and three-month futures contracts on DM trade at
$ 0.69/DM. Is the DM 3-month interest rate higher or lower than the US$ equivalent?

If the three-month DM futures price is higher than the DM spot price, US$ three-month
interest rates must be higher than DM three-month interest rates.

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16. Describe how a forward interest rate can be derived. Look in today's newspaper for a
numerical example

To derive a forward interest rate, define i[0,1] as the one-period interest rate quoted today
for a given currency and define i[0,2] as the two-period interest rate for the same currency.
The implied value of the forward interest rate for one period and starting one period from
now is: i[1,1] = (1 + i[0,2])2 / (1 + i[0,1]) - 1.

17. What risks are associated with a futures position that are not present in a forward position?
What risks are associated with a forward position that are not present in a futures position?

A futures position carries a cash flow risk because of the marking-to-market convention. A
futures contract also involves basis risk, if the maturity and instrument in the futures contract
do not match precisely with our underlying maturity and interest rate. A forward position
carries a liquidity risk. A forward contract may also entail greater counterparty risks.

18. What are the main features a speculator would look for in deciding between a futures market
and a forward market? a hedger?

Both speculators and hedgers are looking for favorable pricing. Assuming that prices are
efficiently set in both markets, speculators should value liquidity (the ability to purchase and
sell quickly and at low cost). This point favors the futures market over forward contracts.
However, the futures market speculator has to be prepared to post margin and adhere to the
cash-flow requirements of the marking-to-market convention. A hedger may prefer the
customized approach allowed by forward markets. This minimizes basis risk. A hedger
would also prefer avoiding the intermediate cash flows of a future contract, especially if he
does not have access to the cash flows in the underlying asset until maturity. To use forward
contracts, however, the hedger must be dealing in sufficient size and have an adequate credit
rating to use the commercial bank forward market.

19. How could the existence of a futures market possibly increase the volatility of prices in the
underlying cash market? Could it have the opposite effect and decrease volatility in cash
market prices?

Futures markets generally reduce the cost of transacting and attract speculators and hedgers
to the market. For speculation to be profitable, most models suggest that speculators will
have a stabilizing affect on prices -- buying when prices are too low and selling when prices
are too high. More recent models theorize that futures markets may attract "noise traders."
Noise traders take small movements in prices as signifying the start of a trend. Noise trading
therefore exacerbates small upward and downward movements, turning them into larger
upward and downward movements that are not related to changes in economic fundamentals.
If futures markets attract a substantial number of noise traders, volatility may increase.

20. Describe the meaning of "noise trading." How could noise trading affect the volatility of
market prices?
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 Noise trading is the name given to a trading style where traders assume that small, short-term
price changes (which may simply represent "noise") are useful indicators of longer-term
price changes. Noise traders buy (sell) when there is a short-term price movement up (down).
Noise trading could exacerbate price volatility relative to an equilibrium level of volatility
consistent with the inherent uncertainty in economic fundamentals.

Answers to end-of-chapter exercises

ARBITRAGE IN THE CURRENCY FUTURES MARKET

1. Consider the following:

Spot Rate: $ 0.65/DM
German 1-yr interest rate: 9%
US 1-yr interest rate: 5%

a. Calculate the theoretical price of a one year futures contract.

b. What would you do if the futures price was quoted at $0.65/DM in the market place?
Where would you borrow? Lend? Calculate the gain on a $100 million arbitrage
transaction.

c. What would you do if the future price was quoted at $ 0.60/DM in the market place?
Where would you borrow? Lend? Calculate the gain on a $100 million arbitrage
transaction.

SOLUTIONS:

a. F = S*(1 + r$) / (1 + rFC) = .65*(1.05)/1.09 = $.626/DM

b. Borrow $ at 5%; Exchange into DM at spot rate; Invest in DM at 9%; Sell forward at
$.65/DM. Earn interest differential on nominal amount with no loss or gain on
currency. Gain = $100,000,000 * (.09 - .05) = $4,000,000.

c. Borrow DM at 9%; Exchange into $ at spot rate; Invest in the US at 5%; Buy
forward at $.60/DM. Gain on currency more than offsets negative interest rate
differential. Gain = 100,000,000 * (.05 - .09) + 100,000,000 * (1/0.60 - 1/0.65) =
$882,051

2. Consider the following prices:

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 Spot Rate: Yen 100/$
1-yr US interest rate 5%
Futures price Yen 97.62/$

a. What value of the one-year Japanese interest rate will remove arbitrage incentives
conditional on the spot rate, futures price, and US interest rate?

b. If the yen interest rate is higher than the one found above, what would you do to take
advantage of arbitrage opportunities?

c. If the yen interest rate is lower than the one found above, what would you do to take
advantage of arbitrage opportunities?

SOLUTIONS:

a. The exchange rate is expressed in FC/$. Adjust formula to calculate the futures price
to take this into consideration.

F = S * (1 + iyen) / (1 + i$)
iyen = (F / S) * (1 + i$) - 1
iyen = (97.62 / 100) * (1.05) -1
iyen = 2.5%

b. Borrow US$ at i$; Buy yen at spot rate; Invest in yen securities at iyen; Sell yen
forward for US$.

c. Borrow in yen at iyen; Sell yen at spot rate for US$; Invest in the US$ securities at i$;
Buy yen forward.

ARBITRAGE IN THE INTEREST RATE FUTURES MARKET

3. Suppose the interest rate futures contract for delivery in three months is currently selling at
110. The deliverable bond for that particular contract is a 25-year bond, currently traded at
100 with a coupon rate of 10%. The current 3-month rate is 7%.

a. Is there any arbitrage opportunity? If yes, what would you do and what would be
your potential gain from an arbitrage transaction?

b. What is the theoretical price of the futures contract?

c. Suppose the price was 95 instead of 110. What would you do to take advantage of
arbitrage opportunities?

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 SOLUTIONS:

a. Yes, there is an arbitrage opportunity. Here is how:

Sell Futures contracts at 110; Purchase the bond at 100 Borrow 100 at 7%.
Profit = Proceeds - Outlays
Profit = (Price of Bond + Accrued Interest) - (Principal Repayment + Interest
Payment);
Profit = 110 + (100 * 10% / 4) - (100 - 100 * 7% / 4)
= 110 +2.5 - 100 - 1.75;
Profit = 10.75

b. The correct price is determined so that there are no arbitrage opportunities.

0 = (F + 2.5) - (100 + 1.75); F = 101.75 - 2.5 = 99.25

c. Buy the futures at 95; Sell Bond at 100; Lend at 7% for 3 months.
Profit = (Principal + Interest Payment) - (Price of Bond + Accrued Interest); Profit =
100 + 1.75 - 95 - 2.5; Profit = 4.25

SPREAD RISK IN THE EUROCURRENCY MARKET

4. The Portfolio Manager of the WXYZ pension fund wants to protect herself against a
decline in future interest rates. The fund’s planned short-term investments are placed in
3-month Eurodollar deposits at the LIBID rate. The current LIBID-LIBOR spread in the
interbank market is 7.375-7.500%, and the current price of a CME futures contract
(which settles on the basis of three-month Eurodollar LIBOR) is 92.50 reflecting a
7.500% interest rate.
a. How could the WXYZ fund use the futures market to hedge itself? What is the
minimum interest that the firm locks in?

b. Suppose that at maturity, Eurodollar rates have fallen to 6.375-6.500% in the

interbank market. Evaluate the hedge. What deposit rate has the fund secured?

c. Suppose that at maturity, Eurodollar rates have increased to 8.375-8.625% in the

interbank market. Assume that the LIBID-LIBOR spread has widened because of
greater interest rate and macroeconomic uncertainty. Now, evaluate the hedge.
What deposit rate has the fund secured?

SOLUTIONS:

a. The fund manager should use the money to buy the CME futures contract at 92.50
to lock in the 7.50% interest rate.

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 b. In this case, the hedge caused a net gain and the locked-in deposit rate of 7.5% is
higher than the Eurodollar deposit rate of 6.375% at maturity.

c. In this case, the hedge caused a net loss and the locked-in deposit rate of 7.5% is
lower than the Eurodollar deposit rate of 8.375% at maturity.

FORWARD INTEREST RATES

5. Check today’s newspaper and locate values for today’s three-month, six-month, one-year,
and two-year interest rate on government securities.

a. Calculate the market implied value of the three-month interest rate beginning three
months from now.

b. Calculate the market’s implied value of the one-year interest rate beginning one year
from now.

SOLUTIONS:

a. Suppose today's 3-month and 6-month rates were 5.25% and 5.50% respectively,
expressed as per annum rates. Then i(3,3), which is the implied 3-month rate starting
3-months from now, can be found by solving:

(1 + i(0,6)/2) = (1 + i(0,3)/4) × (1 + i(3,3)/4)

The solution is i(3,3) = 5.6755% . Note that it was necessary to divide the 6-month
rate by 2 and the 3-month rate by 4 to find the actual per period return. A more
accurate calculation would count the actual number of days in the 3-month and 6-
month period and take account of whether the interest rate convention for the
security chosen required a 360 day or 365 day year. We ignore these real world
considerations and take 3 months as 1/4 year and 6 months as 1/2 year.

b. Suppose today's 1-year and 2-year rates were 6.00% and 6.50% respectively,
expressed as per annum rates. Then i(1,1), which is the implied 1-year rate starting 1-
year from now, can be found by solving:

(1 + i(0,2))2 = (1 + i(0,1)) × (1 + i(1,1))

This formula is the same as equation 11.2 in the text on page 376. The solution is
i(1,1) = 7.0024% .

Note the intuition of this result. In order to equalize the return on a two year
investment that earns 6.5% per year, a one year investment at 6.0% would have to be

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 followed by a second investment at about 7.0%. The average of 6.0% and 7.0% is
about 6.5% .

Additional exercises with answers

INVOICE PRICE, CHEAPEST-TO-DELIVER, AND CONVERSION FACTOR

6. Consider the following short position held on the futures market at maturity:

¨ $1,000,000 worth of contract

¨ Settlement price for the futures contract was 95
¨ The conversion factor is 1.20

a. What is the total invoice price if the shorter chooses to deliver?

b. What in addition does the buyer have to pay upon purchase?

SOLUTIONS:

a. Invoice Price = Contract Size * Futures Price * Conversion Factor

= 1,000,000 * 95% * 1.20
= $1,140,000

b. The buyer has to pay accrued interest to the seller as well.

7. At maturity, a 3-month futures contract has a settlement price of 92. A shorter has the choice
among the following three bonds to deliver:

¨ Bond 1 has a coupon rate of 10%, a conversion factor of .85 and a current price of
105;
¨ Bond 2 has a coupon rate of 9%, a conversion factor of 1.00 and a current price of
100;
¨ Bond 3 has a coupon rate of 8%, a conversion factor of 1.20 and a current price of 95.

a. Calculate the invoice price for each bond. Which one would you deliver?

SOLUTIONS:

Bond 1 - $100,000 * .85 * 105% = $89,250 Cheapest-to-deliver

Bond 2 - $100,000 * 1.00 * 100% = $100,000
Bond 3 - $100,000 * 1.20 * 95% = $114,000

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