Interest Rate Futures

Chapter 6

Fundamentals of Futures and Options Markets

6.1

Day Count Conventions U.S.

The interest earned between any two dates =
[ # of days / # days reference ] x Total Interest in Reference Period
Treasury Bonds:

Actual/Actual (in period)

Corporate Bonds:

30/360

Money Market Instruments:

Actual/360

What is the interest earned between March 1 and July 3 on

$100 par Treasury bond, coupon rate 8%, coupon payment dates 3/1 and 9/1
Reference period is from March 1 to September 1
Which totals to 184 actual days
Coupon interest of $4 is earned during the period
There are 124 actual days between March 1 and July 3
Interest earned:
$4 x 124/184
= $2.6957
If this were a corporate bond:
$4 x 122 (=4x30 + 2)/180
= $2.7111
Fundamentals of Futures and Options Markets

6.2

What is being quoted is the discount yield.

Secondary-Market T Bill Quotes

Tuesday 9/24/2002 WSJ - Representative OTC quotations
based on transactions of $1 million or more
Mid-afternoon quotes colon indicates 32nds

Secondary T-bill Market:

Maturity
8
15
22
29
36
43
50
57
65

Bid Asked
Chg. Ask Yld.
1.62%
1.61%
0.02 1.63
1.62 1.61 0.0 1.63
1.64 1.63 0.01 1.65
1.64 1.63 0.02 1.65
1.60 1.59 0.01 1.61
1.61 1.60 0.01 1.63
1.61 1.60 0.0 1.63
1.61 1.60 0.0 1.63
1.61 1.60 0.0 1.63

Dealer buys at posted bid (1.62%), sells at posted ask (1.61%), spread=1 bp

Buying price = $10,000 [.0162*(8/360)*$10,000] = $9,996.40

Selling Price = $10,000 [.0161*(8/360)*$10,000] = $9,996.42
iT-bill (dy) = [(10,000-9,996.42)/10,000]*(360/8) = 1.61%

iT-bill (bey) = 1.61%*(10,000/9,996.42)*(365/360) = 1.63%

Fundamentals of Futures and Options Markets

Most transactions OTC

Market generally open
from 9:00 a.m. to 3:30
p.m. EST
Transactions between
primary government
securities dealers
conducted over Fedwire
Other banks/brokers
transact through the
primary government
securities dealers
Transactions recorded
via the Feds bookentry system

6.3

Discount Yields
Money
Money market
market instruments:
instruments: Treasury
Treasury bills
bills and
and
commercial
commercial paper
paper
Bought
Boughtand
andsold
soldon
onaadiscount
discountbasis:
basis:
PP0_______________________P
f
0_______________________Pf
00
Maturity
Maturity (days)
(days)
idy
idy == [(P
[(Pf f--PP00)/P
)/Pf](360/h)
f](360/h)
Where:
Where:
PPf == Face
Facevalue
value
f
PPo == Discount
Discountprice
priceof
ofsecurity
security
o
Problems:
Problems:
Yields
Yieldsuse
useface
facevalue,
value,PPf,f,in
inthe
thedenominator
denominator
Yields
Yieldsuse
useaa360-day
360-dayyear
yearrather
ratherthan
thanaa365-day
365-dayyear
year
No
Nocompounding
compoundingaccounted
accountedfor
for
Fundamentals of Futures and Options Markets

6.4

Bond Equivalent Yield

Bond Equivalent Yield:

Non-discount securities :like Treasury and other notes and bonds

Bonds pay periodic interest - sell at a discount, at par, or at a premium
For comparison with DY:
ibey = [ (Pf - P0)/ P0](365/h)

Compare:
Converting:
3% x 4 qtrs/yr = 12%
ibey = idy (Pf/Po)(365/360)
(1.03)4 - 1
= 12.55%

Note: DY and BEY are both linear projections:

Equivalent annual return: apply formula to ibey

See comparison above

EAR = (1 + ibey/(365/h))365/h - 1

Fundamentals of Futures and Options Markets

6.5

Comparison of DY, BEY and EAR

Consider a $1 million Treasury bill,

selling on a discount basis,
for 97.5% percent of its face value,
and 140 days from maturity.

idy = (($1m. - $975,000)/$1m.)(360/140) = 6.43%

ibey = (($1m. - $975,000)/$975,000)(365/140) = 6.68%

EAR = (1 + .0668/(365/140)365/140 - 1 = 6.82%

Fundamentals of Futures and Options Markets

6.6

Treasury Bond Price Quotes - U.S.

T bonds

Quoted in dollars and thirty-seconds

Face value = $100
Quote of 90-05: $90,156.25 for $100,000 T bond

Clean price: without accrued interest versus dirty price

Cash price = quoted price + accrued interest
Say a quote of 95-16 or $95.50 per $100

Semiannual coupons, last 1-10-2003, next 7-10-2003, equaling 181 days

54 days between 1-10-2003 and 3-5-2003
Accrued interest = $5.5 coupon x 54/181 = $1.64
Cash price = $95.5 + $1.64 = $97.14 or $97,140 for the bond

Fundamentals of Futures and Options Markets

6.7

Treasury Bond Futures

Treasury bond futures on

Long-dated U.S. Treasuries

T notes

Bonds with maturities greater than (and not callable within) 15 years to
maturity
Maturities between 6.5 and 10 years deliverable

5-year T note

Fundamentals of Futures and Options Markets

6.8

Wall Street Journal Feb. 5, 2004

Treasury Bond Futures Quotes

Mar
113-29 14-005 113-15 113-22 -4.5
1,130,409
June 112-17 112-17 111-29 112-03 -4.5
147,892
Est vol 489,439, open int 1,278,301
Mar
12-215 112-24 12-125 112-17 -3.5
Est vol 219,841 , open int 948,759
Mar
07-132 07-142 07-102 07-127 -0.2
Est vol 15,846 , open int 166,044
Feb
99.000 99.000 98.995
Mar
99.00 99.00 98.99
Apr
99.00 99.00 98.99
May
98.96 98.96 98.95 98.96
Jun
98.94 98.95 98.94
Est vol 15,789 , open int 286,642

99.000
98.99
98.99

Which futures have the most contracts outstandin

Which futures have the most trading interest?

882,174

Are futures quoted in price or interest rate?

164,711

64,359
48,219
71,817

How is price and interest rate interchangeable?

37,989
98.95

27,460

10 Year Interest Rate Swaps

Mar
111-25 111-31 109-18 111-17 -3
467,134
June 110-09 110-12 109-16 110-03 -3
31,215
Est vol 183,502, open int 499,090

30 Day Fed Funds

Open Interest

2 Year T Notes

Settle Change

5 Year T Notes

Low

Treasury notes

High

Treasury bonds

Month Open

Mar
111-15 111-19 111-03 111-10 -6
Est vol 1,060 , open int 39,569

39,568

10 Year Muni Note Index

Mar
103-13 103-21 103-08 103-15 1
Est vol 269 , open int 2,249

Fundamentals of Futures and Options Markets

2,249

6.9

CBOT
T-Bonds & T-Notes
Factors that affect bond futures prices:

Delivery can be made any time during the delivery

month
Any of a range of eligible bonds can be delivered
The wild card play

Fundamentals of Futures and Options Markets

6.10

Conversion Factor
Treasury bond futures contract: allows delivery of any Treasury bond with
maturity > 15 years (not callable with 15 years). These bonds will have
different coupon rates and therefore different prices (which is cheapest to
delivery?).
Delivery price = the bonds price * conversion factor + accrued interest.
Assume a 10% 20-year T bond ($100 par):
i=140 $5/1.03i + $100/1.0340 = $146.23 / $100 = 1.4623=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.
Since the bonds current price changes continuously, the cheapest-to-deliver
bond is not determined until the settlement date. Trading in the bond on this
date may change its price and thus change the cheapest-to-deliver bond.
The purpose of the conversion factor is to extend the range of deliverable
bonds, and thus the liquidity of the contract.
Fundamentals of Futures and Options Markets

6.11

CBOT U.S. TREASURY BOND FUTURES

CONTRACT

Fundamentals of Futures and Options Markets

6.12

Cheapest-to-Deliver Bond

Deliverable bonds vary wrt coupon and maturity

Short position receives

Cash price = (Quoted futures price Conversion factor) + Accrued interest

And pays

Quoted bond price + Accrued interest

The cheapest to delivery bond is the deliverable bond:

Say Quoted bond price

Cheapest (Quoted bond price - Quoted futures price Conversion factor)

1
2
3

99.50
143.50
119.75

Conversion factor
1.0382
1.5188
1.2615

Cost to deliver

1
99.50 (93.25 x 1.0382) = $2.69
2
143.50 (93.25 x 1.5188) = $1.87
3
119.75 (93.25 x 1.2615) = $2.12
Bond 2 is cheapest to deliver

Fundamentals of Futures and Options Markets

Note that you pay accrued interest

when buying the cheapest-to-deliver bond,
But receive it back when delivering the bond
under the futures contract. So accrued interest
is not part of the cost.

6.13

 Eurodollar

and Eurodollar Futures

Versus
Forward

Rate Agreement (OTC)

Fundamentals of Futures and Options Markets

6.14

Eurodollar

Time deposits denominated in U.S. dollars at banks outside the

United States - not under the jurisdiction of the Federal Reserve

There is no connection with the euro currency or the eurozone.

History:
Post WWII U.S. dollars increased outside the U.S. - the Marshall
Plan and imports into the U.S. - largest consumer market post WW
II
Also USD is an international currency

Fundamentals of Futures and Options Markets

6.15

Eurodollar Futures

Eurodollar = 1$ deposited in a U.S. or foreign bank outside the

U.S.

3-month Eurodollar futures contract

Locks in an interest rate on $1 million deposited for 3-months in
the future

March contract: 3-month deposit starts in March

Contract value = $10,000[100 0.25(100 Q)]
Q = quoted price
Mar 2004 close: 10,000[100 0.25(100 98.84)] = $997,100
1 basis point change: 10,000[100 0.25(100 98.85)] = $997,125 ($25 gain to short)
Shorts gain from an interest rate rise Longs gain from an interest rate decline
Contracts settle in cash on the 3rd Wednesday of the delivery month

Similar contracts

Euroyen contracts (CME)

Eurobor contracts euro 3-month LIBOR (LIFFE)
Euroswiss futures

Fundamentals of Futures and Options Markets

6.16

Contract Expirations

40 quarterly expirations
March June
Sept
Dec
2016
2016
2016
2016
2017
2017
2017
2017
2018
2018
2018
2018
2019
2019
2019
2019
2020
2020
2020
2020
2021
2021
2021
2021
2022
2022
2022
2022
2023
2023
2023
2023
2024
2024
2024
2024
2025
2025
2025
2025
Allows a detail yield curve to be developed

Also four serial (monthly) expirations (January, February, April, May)

Fundamentals of Futures and Options Markets

6.17

 Recall

forward rate agreement

Fundamentals of Futures and Options Markets

6.18

Forward vs. Futures Interest Rates

Eurodollar futures

Except for daily settlement

Maturities up to 1 year show virtually identical rates
For longer maturities:

vs. forward rate agreements

Forward rate = futures rate - 2T1T2

The futures contract matures at T1, and the rate underlying the futures contract
expires at T2. represents the

standard deviation of short-term

interest rates over one year.

Eurodollar futures contracts last as long as 10 years

Convexity Adjustment

Fundamentals of Futures and Options Markets

6.19

If you are short EuroDollar futures and rates go higher futures price drops
and you make money. Clearing house of exchange reimburses you excess
margin and you can reinvest them at higher rate. If rates go lower you have
to put extra cash into your margin account, you can borrow this money at
lower rate.

Fundamentals of Futures and Options Markets

6.20

Convexity Adjustment

Adjustment

Forward rate = Futures rate - 2t1t2

T1 = time to maturity of the futures contract

t2 = time to maturity of the rate underlying the futures contract

2 = the standard deviation of the change in the short-term interest rate in one
year, typically 1.2%

Fundamentals of Futures and Options Markets

6.21

Duration and Interest-Rate Risk

Fundamentals of Futures and Options Markets

6.22

Duration

Duration is just the weighted average maturity of a bond

Weighted average

A 15-year maturity coupon bond has a shorter duration since

It makes 30 payments over the 15 years.
In contrast, a 15-year zero-coupon bond has a duration of 15 years
Duration = witi

What are the weights?

The weight is the PV of the payment at time, ti, divided by the value of
the bond
The weights add up to 1.0
Wi = e-ti ci / B (B=the value of the bond, the term, e-ti , discounts the
payment to PV, using continuous-time discounting.

Fundamentals of Futures and Options Markets

6.23

Duration

Duration of a bond that provides cash flow c i at time t i is

ci e yti
ti

B
i 1

where B is its price and y is its yield (continuously compounded)

This leads to
In other words, the impact of a change in yield, ,
causes a change in the % value of the bond of
-D. Interest rates rise, bond values goes down.

B
Dy
B
Fundamentals of Futures and Options Markets

6.24

Duration

When the yield y is expressed with compounding m times per

year

The expression

B = -BD/(1+/m)

D* = D / (1+/m) is referred to as the modified duration

Then

B = -BD*

Fundamentals of Futures and Options Markets

6.25

Duration Matching or Portfolio

Immunization

Duration matching

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

But

Short-term rates more volatile, not perfectly correlated with, long rates
Short rates can move opposite to long rates

Fundamentals of Futures and Options Markets

6.26

Duration-Based Hedge Ratio

FC $ Contract Size 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

}
}

Interest-rate futures

Portfolio to be hedged

Durations:
P = -PDP
FC = -FCDF
Set P = NFC
N* = PDP / FCDF
optimal number of hedge contracts

or duration-based hedge ratio

The futures contract used for hedging should be based on the cheapest-to-deliver bond
Fundamentals of Futures and Options Markets

6.27

Chapter 6 Questions

( 1) How do day count conventions differ between markets?

( 2) What is the purpose of the conversion factor?
( 3) What is the significance of the cheapest-to-deliver bond?
( 4) What is meant by a wild card play?
( 5) What is a Eurodollar interest rate? How is it linked to Eurodollar futures?
( 6) Why is duration a good measure of the riskiness of a bond?
( 7) How does modified duration differ?
( 8) How is the optimal number of hedge contracts or the duration-based hedge ratio determined?
( 9) Portfolio A consists of a 1-year zero-coupon bond with a face value of $2,000 and a 10-year zero-coupon
bond with a face value of $6,000. Portfolio B consists of a 5.95-year zero-coupon bond with a face value of
$5,000. The current yield on all bonds is 10% per annum.

(a) Show that both portfolios have the same duration.

(b) Show that the percentage changes in the values of the two portfolios for a 0.1% per annum increase in
yields are the same.

(c) What are the percentage changes in the values of the two portfolios from a 5% per annum increase in
yields.
(10) A portfolio manager plans to use a Treasury bond futures contract to hedge a bond portfolio over the next
three months. The portfolio is worth $100 million and will have a duration of 4.0 years in three months. The
futures price is 122, and each futures contract is on $100,000 of bonds. The bond that is expected to be cheapest
to deliver will have a duration of 9.0 years at the maturity of the futures contact. What position in futures contracts
is required?
Use the equation: N*

= PDP/VFDF .

Fundamentals of Futures and Options Markets

6.28