Fixed Income Derivatives

MONEY MARKET FUTURES & FORWARDS

 Forward-Forwards

A forward-forward is a loan or deposit which begins

on a forward date and matures on another forward
date
 All specifications are spelt out in advance
 Term
 Amount
 Interest rate
For a party seeking to borrow or lend on a future
date such contracts remove interest rate uncertainty
These entail principal exchange twice
 At the starting forward date and at maturity
 Forward-Forwards (Cont...)

These contracts lock in an interest rate and commit

both parties to the transaction
In practice parties will originally arrange
borrowing/lending and then hedge the rate
separately using a Forward Rate Agreement (FRA)
 FRA

These are OTC derivatives

They are based on a short-term interest rate (STIR)
They represent an agreement between
counterparties to fix a future interest rate
There is no physical delivery of cash
Profits and losses are settled by way of cash
settlement at the end of the contract period
 FRA (Cont...)

If on the settlement date the FRA contract rate

differs from a Reference rate then a settlement
payment is made from one party to another
There is no obligation on the part of either party to
borrow or lend cash
The implications of a loan with a FRA is essentially
the same as a forward-forward agreement
In that the party enters into a contract at the
prevailing market rate
 FRA (Cont...)

Subsequently a net cash payment is made by one of

the parties to make the net cash payment equivalent
to a fixed interest rate
The fixed interest rate is the FRA contract rate
Parties who seek to pay the contract rate will BUY
the FRA
 They will lock in a fixed rate for the payable
Parties who seek to receive the contract rate will
SELL the FRA
 They will lock in a fixed rate for the receivable
 Hedging with FRAs

Metro Rail has borrowed on a floating rate basis.

Interest is determined in advance and paid in arrears
every six months.
The rate for the forthcoming semi-annual period will
be fixed six months from today at the prevailing
LIBOR + 50 basis points.
The company is worried that LIBOR could be higher
than anticipated.
To lock in a rate the firm buys an FRA at 4.25%
 Hedging (Cont…)

Assume that the LIBOR after 6 months is 5%

On that day the firm will borrow at 5.5%
It will receive (5 – 4.25) = 0.75% from the counter-
party to the FRA
The net rate payable is 5.50% - 0.75% = 4.75%
This is nothing but the FRA rate plus the spread of
50 basis points.
 Speculating with FRAs

Traders who are bullish about interest rates will buy

FRAs.
 They will receive an inflow if rates were to increase
Traders who are bearish about interest rates will sell
FRAs
 They will receive an inflow if rates were to decline
 Terminology

FRAs are quoted with reference to two numbers

 The first is the settlement date
 The second is the final maturity date
Standard contracts have maturities of 3, 6 or 12
months
1 x 4; 3 x 6; 6 x 9;1 x 7; 3 x 9; 6 x 12
Consider a 3 x 9 FRA
 The settlement date is 3-months forward from the spot value
date (T+2)
 The maturity date is 6 months from that date
 Terminology (Cont...)

FRAs can have non-standard terms

They are money market securities so they are quoted based on
the same day-count convention as for the underlying cash
deposit rates
 ACTUAL/360 for USD and EUR
 ACTUAL/365 for GBP/AUS/CAN/JPN
Example
 Trade date 26 November 2014 (WED)
 Spot value date: 28 November 2014 (FRI)
 Start: 28 February 2015
 Maturity: 28 August 2015
If any of the days is a non-business day then usually the following
business day convention applies
 Terminology (Cont...)

FRA interest rate: This is the agreed upon rate as per

the contract
The FRA Reference Rate: is the fixing rate which is
cash settled against the contract rate –such as 6-M
LIBOR
FRA purchase: is done to hedge a forward short or
borrowed spot position
 It locks in a rate payable
 Protects the borrower against a rising interest rate
 Terminology (Cont...)

FRA Sales: it is a hedge for a forward long position

or a loan that is made
 It locks in a receivable rate
 Protects the lender against falling rates
Trade date – the date of the contract
Spot value date – 2 business days after the trade date
Reference rate fixing date – 2 business days before
the settlement date
 For a 3 x 9 FRA it will be 3 months after the trade date
 Terminology (Cont...)

Cash settlement date

 Date on which the payment is made
 2 business days after the reference fixing date
 For a 3 x 9 FRA it will be 3 months from the spot value date
Maturity Date: for a 3 x 9 FRA this will be 6 months after
the settlement date
Settlement Amount – The only cash flow in a FRA
 It is due on the settlement date
 It depends on the difference between the contract rate and the
reference rate
 It depends on the notional principal and the day-count convention
 The payment is discounted to the settlement date
 Illustration

Consider a 3 x 9 FRA from the buyer’s angle

The notional amount is 18 MM USD
The contract rate is 6%
The LIBOR on the fixing date is 7.50%
Days of the FRA: The number of days in the period between the
settlement date and the maturity date
In this example: The undiscounted payment is
18,000,000 x (.06-.075) x 184/360 = -138,000
The settlement amount is -138,000/(1 + .075 x 184/360) =
-132,905.30
The buyer will receive this amount since the reference rate is
higher than the contract rate
 Determining The FRA Rate

The FRA rate is set by dealers

It reflects their expectations of future STIR
They can be derived from the prices of other market
securities
We can derive the rates from a combination of zero
coupon interest rates
 FRA Rates (Cont...)

Consider a 3 x 9 FRA
The three month LIBOR is 5% and the 9-M LIBOR is 6%
Investing for 9 months at the 9-M LIBOR is equivalent
to investing for 3-months at the 3-M LIBOR and then
rolling over for 6 months at the FRA rate
Let us denote the short-term rate by s1 and the long
term rate by s2
Assume the 3-month period consists of 90 days while
the 9-month period consists of 270 days
The market uses a 360-day year convention
 FRA Rates (Cont...)

(1 + .05 x 90/360)x(1+FRAx180/360) =

(1+.06x270/360)
Thus FRA = 6.4197%
If we have money market borrowing and lending
rates we can calculate the highest possible and
lowest possible FRA rates – by invoking no-arbitrage
 FRA Rates (Cont...)

Assume the 3-M rates are 0.0500 – 0.05125

9-M rates are 0.0600 – 0.0625
A dealer borrows at 0.05% for three months and rolls over
using the FRA for 6-months
 The amount borrowed is lent for 9 months at 0.0625
To be profitable the FRA rate should be less than 6.7901
By similar logic the FRA rate should be greater than
6.3561%
Thus the dealer’s bid should be greater than or equal to
6.3561% while the ask should be less than or equal to
6.7901%
 Differences

The differences between FRAs and Short-Term

Interest Rate (STIR) futures are:
 FRAs can be tailormade to suit the requirements of the trader
 Futures have fixed parameters
 Start Date
 Maturity Date
 Contract Size
Thus futures markets are more liquid and
transparent while FRAs offer a greater degree of
flexibility.
 Differences (Cont…)

The terms buy and sell have opposite meanings in

FRAs and STIR futures
 A party who buys a FRA will benefit if rates increase
 A party who sells futures will benefit if rates rise
Thus short futures and long FRA positions benefit
from increasing interest rate
While long futures and short FRA positions benefit
from declining interest rates
 Eurodollar Futures

These contracts are traded in Chicago

The underlying interest rate is LIBOR
Each contract is for a Time Deposit with
 A principal of 1,000,000 USD
 And 3M to maturity
 ED Futures (Cont…)

The quarterly cycle is March, June, September, and

December
On the CME a total of 40 quarterly futures contracts
spanning 10 years are listed at any point in time
In addition the four nearest serial months are also
listed
 Illustration

Assume that we are on 25 June 2015

 The four serial months will be July, August, October and
November 2015
 The other available months will be SEP 2012, DEC 2012,,
March, June, September, and December of 2016-24, March
2025, and June 2025
 ED Futures (Cont…)

Contracts expire at 11:00 a.m. London Time

 On the second London bank business day before the third
Wednesday of the contract month
 The contracts are cash settled to the BBA 3-M LIBOR
Prices are quoted in terms of an IMM index for
Eurodollars and implies an interest rate
 ED Futures (Cont…)

Quoted ED Futures Price = 100.00 – Implicit

Interest Rate
The implicit rate is an actual or add-on interest rate
and not a discount rate like in the case of T-bills
 Illustration

A discount rate of 5% means that for a 90 day loan

with a maturity value of $1,000,000 the initial
investment is
1,000,000[1 – 0.05x90/360] = $987,500
The actual rate of return is
(1,000,000-987,500)/987,500 x 360/90 = 5.06%
 Illustration (Cont…)

An add-on interest rate of 5% per annum means that

if $1MM is invested for 90 days, the investor will get
1,000,000[1+0.05x90/360] = $1,012,500 after 90
days
 Profits on ED Futures

Assume that the futures price is 96

 The implicit interest rate is 4% per annum
 Or 1% per quarter
The implied quarterly interest payment on a time
deposit of $1MM is
 .01x1,000,000 = $10,000
If the price were to fall to $95 at the end of the day
then it would represent a quarterly interest payment
of $12,500 on a deposit of $1MM
 Profits (Cont…)

Take the case of an investor who goes long at $96

 He is obviously agreeing to lend at 1% per quarter
The logic is the same as for contracts on other debt
securities such as T-bills
 A long position means that you are willing to buy the debt
security
 In the case of ED futures, a long position means that you are
willing to make a time deposit of 3-M
 In either case you are a lender
 Profits (Cont…)

If interest rates were to rise to 5%, that is the futures

price falls to 95, the long will lose $2,500 while
marking to market
 Because when the contract is MTM it is as if he is offsetting by
going short
 In this case it would mean that he is agreeing to borrow at
1.25% per quarter
So when interest rates rise the longs will lose
When rates fall the shorts will lose
 Logic

Now we can appreciate the logic of quoting prices in

terms of an index and not in terms of an interest rate
What if prices were to be quoted in terms of rates?
 Longs would gain when prices fall
 Shorts would gain when prices rise
In all other futures markets however it is just the
opposite
 Logic (Cont…)

So to make money market futures consistent with

other futures markets
 We quote prices in terms of an index and not a rate
 When the index rises the longs will gain
 When it falls the shorts will gain
A second reason for quoting prices in terms of an
index is to ensure that the bid is lower than the ask
 Logic (Cont…)

The borrowing rate will always be higher than the

lending rate
 Thus if futures prices were to be quoted in terms of interest
rates the bid will be higher than the ask
 The bid is the rate for taking a short position
 The ask is the rate for taking a long position
 However if prices are quoted in terms of an index
 The bid will be lower than the ask
 Calculations

Assume that the futures price changes from F0 to F1

The profit for a long is as given below
Calculations (Cont…)
Minimum Price Move
Locking in a Rate
 Locking in a Borrowing Rate

Today is 15 July 2015

Ranbaxy is planning to borrow $1MM on 14
September for 90 days
The company can borrow at LIBOR
SEP 14 is the last day of trading for September
futures
The company is worried that rates may rise by then
 Locking…(Cont…)

The current futures price is 94

The current LIBOR for a 90-day loan is 5.85%
The company requires a short hedge since it is going
to borrow
Assume that the firm goes short in one futures
contract
 We will consider two different scenarios for September 14
 Case A
LIBOR = 4%

The interest payable on a loan of $1MM is:

0.04x1,000,000x90/360 = $10,000
Gain/Loss from the futures market is:
1,000,000x(F0-F1)/100x90/360
= 1,000,000x(94-96)/100x90/360 = (5,000)
Effective interest paid is: 10,000+5,000 = $15,000
 Case B
LIBOR = 7%

The interest payable is:

0.07x1,000,000x90/360 = $17,500
Profit/loss
1,000,000x(94-93)/100x90/360 = $2,500
The effective interest paid is
17,500 – 2,500 = $15,000
 Locking…(Cont…)

The company can lock in a payable of $15,000

irrespective of the prevailing LIBOR
This corresponds to a rate of:
15,000/1,000,000 x 360/90 = 6%
this is the rate implicit in the initial futures price of
94
 Locking in a Lending Rate

Today is 15 September 20XX

Microsoft is planning to lend $1MM on 14 December
for 90 days
It believes that it can lend at the prevailing LIBOR
plus 75 bp
 And wants to lock in a rate using ED futures
December 14 is the last day of trading for the
December contract
 The current futures price is 96
Since Microsoft wants to lend it should go long
 Case-1: LIBOR = 5.25%

Interest receivable on the loan is:

0.06 x 1,000,000 x (90/360) = $15,000
Futures profit/loss is:
1,000,000x(94.75 – 96)
__________ x (90/360) = (3,125)
100
Effective interest received = $11,875
 Case-2: LIBOR = 3.25%

The interest receivable is:

0.04 x 1,000,000 x (90/360) = $10,000
The futures profit/loss is:
1,000,000 x (96 .75 – 96)
__________ x (90/360) = 1,875
100
The effective interest received = $11,875
 Effective Interest Rate

$11,875 is equivalent to:

11,875
________ x (360/90) x 100 = 4.75%
1,000,000
This is equivalent to the rate implicit if the initial
futures price of 96 plus the assumed spread of 75 bp
Arbitrage
 Cash and Carry Arbitrage

We are on 15 August 20XX

Futures contracts expiring on 18 September are
priced at 94
The 90 day ED deposit made on 18 September will
mature on 17 December
The rate for an ED deposit between 15 August and 17
December is 6.75%
The rate for a loan between 15 August and 18
September is 4%
 Cash and Carry (Cont…)

Consider the following strategy

Borrow 1MM for 34 days
 34 is the number of days between 15 Aug and 18 SEP
Go short in a futures contract to borrow the maturity
amount for a further period of 90 days
Invest the borrowed money in a 124 day deposit
 124 is the number of days between 15 AUG and 17 DEC
 Cash and Carry (Cont…)

Amount due after 34 days is

1,000,000(1 + 0.04x34/360)
The futures contract will lock in a rate of 6% when
this amount is rolled over for 90 days
The amount payable after 124 days will be:
Cash and Carry (Cont…)
 Reverse Cash and Carry

Assume that all the other variables have the same

value except for the futures price which we will
assume is 92
Borrow 1MM for 124 days
Invest it for 34 days
Go long in a futures contract to rollover the maturity
amount for a further 90 days
 Reverse (Cont…)

The amount repayable after 124 days is:

1,000,000x(1+0.0675x124/360) = 1,023,250
The investment in a 34 day deposit will yield
1,000,000(1+.04x34/360)
The futures contract will lock in a rate of 8% for this
amount
The amount receivable after 124 days is:
Reverse (Cont…)
 No-Arbitrage Price

We will derive a futures price that rules out both

forms of arbitrage
We are standing on day t
The contract expires at T
The ED rate for a T-t day loan is s1
The borrowing/lending rate for a T+90-t day loan is
s2 .
No Arbitrage Price (Cont…)
 Hedging Rates for Periods Not Equal to 90 Days

ED futures can be used to lock in a borrowing or a

lending rate for a 90 day loan to be made on the
expiration date of the contract
ED futures can also be used to lock in the rate for an
N-day loan if N is close to 90
The necessary condition is that the rate for an N-day
loan should move closely with the rate for a 90-day
loan
The Hedge Ratio
The Hedge Ratio (Cont…)
 Illustration

Assume that we are on 15 July 2015

Ranbaxy will borrow 10MM on 14 September for 117
days
September futures price is 95.75
The firm can borrow at the prevailing LIBOR on 14
September
 Illustration

Obviously Ranbaxy requires a short position

The hedge ratio is:
Qf = 10x117/90 = 13
 LIBOR = 4%

Actual interest paid:

0.04x10,000,000x117/360 = $130,000
Futures profit/loss is:
13x1,000,000x(95.75 -96)/100x90/360 = -8125
So the effective interest paid is:
138,125
 LIBOR = 4.5%

Actual interest paid is:

0.045x10,000,000x117/360 = 146,250
Profit/loss from the futures position is:
13x1,000,000x(95.75-95.50)/100x90/360 = 8125
The effective interest paid is $138,125
 Illustration (Cont…)

Irrespective of the prevailing LIBOR on 14

September the company has locked in $138,125
This corresponds to a rate i such that:
10,000,000[1+ix117/360] = 10,138,125
i is equal to 4.25% which is the rate implicit in the
initial futures price
 Creating a Fixed Rate Loan

YES Bank is able to borrow at LIBOR for 3-M at a

time
Thus the interest payable is variable
It has a client who wishes to borrow at a fixed rate
for 1 year
So the interest receivable is fixed
The bank would like to use futures contracts to
mitigate the risk
 Creating…(Cont…)

ED futures can be used to hedge the funding risk

And to determine a suitable rate for the fixed rate
loan
Assume that the borrower wants a loan for 100MM
USD for a period of one year from 15 SEP 20XX at a
fixed rate
 Creating…(Cont…)

The 90 day LIBOR on 15 September is 3.80%

December contracts are available at 97.10
March contracts are available at 96.60
June contracts are available at 97
Assume that the rollover dates for the 3-M
borrowings are the same as the expiration dates of
the futures contracts for the respective months
 Creating…(Cont…)

Each contract is for $1MM

So the bank needs a short position in 100 each of
 December
 March
 And June contracts
 Creating (Cont…)

The interest expense for the first quarter is:

100,000,000x0.038x90/360 = $950,000
There is no uncertainty about this for it is based on
the current LIBOR
The short position in December futures will lock in a
rate of 2.90% for a period of 90 days – from
December to March
The corresponding interest expense is:
100,000,000x0.029x90/360 = $725,000
 Creating (Cont…)

The short position in March futures will lock in:

100,000,000x0.034x90/360 = $850,000
for a 90 day period from March
The June contracts will lock in:
100,000,000x0.03x90/360 = $750,000
 Creating…(Cont…)

The total interest payable for the 12-M period is:

950,000 + 725,000 + 850,000 + 750,000 = 3,275,000
This corresponds to an annualized rate of:
3,275,000/100,000,000 x 100 = 3.275%
The bank can now quote a fixed rate based on this
effective cost of funding after factoring in
 Hedging costs
 And a suitable profit margin
Stack & Strip Hedges
 Stack and Strip Hedges

We assumed that that the bank would hedge using

100 contracts for each of the expiration months
A hedge where the same number of contracts are
used for each expiration month right from the outset
is called a STRIP Hedge
However if the maturity of a contract is far away it
may not be liquid
 Stack…(Cont…)

Illiquidity could be a deterrent for a hedger

 He would seek to enter and exit at a price close to the true or
the fair value of the asset
It is conceivable that in September when the hedge is
initiated the June contract may not be liquid
So the bank may initiate the hedge with an unequal
number of December and March contracts without
taking a position in the June contract
 Stack…(Cont…)

When the December contracts expire it will take a

position in the June contract
A hedge where the number of contracts for each
maturity is not equal at the outset is called a STACK
Hedge
 Illustration

Assume that June contracts are illiquid in September

The bank therefore hedges using 100 December
contracts and 200 March contracts
The December contracts will lock in a rate for the
planned borrowing in December
100 of the March contracts will lock in a rate for
March
The remaining are for hedging the June exposure
 Illustration (Cont…)

On 15 December the bank will partially offset its

March position and go short in 100 June contracts
 The assumption is that June contracts would have begun to be
actively traded by December
Which is better – STRIP or STACK?
 It would depend on the movement of rates between September
and December
 LIBOR Futures

The underlying asset is a time deposit with a

principal of $3MM and one month to maturity
The contracts expire at 11:00 a.m. London time on
the second bank business day before the third
Wednesday of the contract month
At any point in time, contracts for the next 12
consecutive months are listed
So on 25 June 2012: July -12 to June -13 will be
available
All contracts are cash settled
 Euroyen Futures

The underlying asset is a time deposit with a

principal of $100MM JPY and three months to
maturity
The contract settles to TIBOR and is cash settled
At any point 20 contracts are listed from the March
quarterly cycle
So on 2 January 2012 the available months will be:
March, June, September and December of 2012-
2016
 Euroyen LIBOR Futures

The underlying asset is the same as that for Euroyen

futures and the available contract months are
identical
However the contract settles to LIBOR
 Fed Funds Futures

The underlying asset is Federal Funds with a value of

$5MM
Prices are quoted as 100 – overnight Fed Funds rate
At any time contracts are available for the next 24
consecutive months.
The contracts are cash settled
Bond Market Futures
 The Cash Market Price Quotes

T-bond and T-note prices are always quoted as a

percentage of par + 32nds
The quotes are for a par value of $100
What is the rationale?
 Consider two bonds with face values of $1,000 and $2,000
respectively
 If both are priced at $1,400 the implications would be very
different
 The first is trading at a significant premium
 The second is trading at a considerable discount
 Price Quotes (Cont…)

However if prices are quoted per $100 of face value

 A price in excess of 100 would signify a premium bond
 A price less than 100 would connote a discount bond
Consider a quote of 98-28
What will be the price for a bond with a face value of
$100,000?
The price per $100 of face value is:
98 + 28/32 = $98.875
Thus the price of the bond is 98.875 x 1,000 = $98,875
 Price Quotes (Cont…)

The quoted prices are always clean prices

To calculate the actual price payable the accrued
interest has to be calculated and added
 Conversion Factors

A wide variety of notes and bonds with different

coupons and maturity dates are eligible for delivery
The choice of the bond to be delivered will be made
by the short
The price to be received by him will depend on the
bond chosen
 He will receive more if he delivers a more valuable bond
 CF (Cont…)

To facilitate comparisons between bonds the

exchange specifies a Conversion Factor for each
bond that is eligible for delivery
This is nothing but a Multiplicative price adjustment
factor
The conversion factor is the value per $1 of face
value as calculated on the first day of the delivery
month using an annual YTM of 6% with semi-annual
compounding
 CF (Cont…)

For the purpose of calculation the life of the bond is

Rounded Down to the nearest three months
If after rounding off the life is an integer multiple of
semi-annual periods then the first coupon is
assumed to be paid after 6 months
However if the life is not an integer multiple of half-
yearly periods then the first coupon is assumed to be
paid after 3 months
 And the accrued interest is subtracted
 Invoice Price

Invoice Price = Invoice Principal Amount + Accrued

Interest
= CF × F × 100,000 + AI
 F is the quoted futures price per dollar of face value
 AI is the accrued interest
 Quoted futures prices are always clean prices
 Illustration-1

Assume that we are short in a SEP futures contract

Today is 1 SEP 2008
There is a 5% T-bond maturing on 15 May 2037
 It is obviously eligible for delivery
On 1 September the bond has 28 years and 8.5
months to maturity
 Rounding down we get a figure of 28 years and 6 months
 Illustration-1 (Cont…)

This is an integer multiple of six-monthly periods

Thus the first coupon will be assumed to be paid
after 6 months
The CF may be calculated as follows.
Illustration-1 (Cont…)
 Illustration-2

Now consider a bond maturing on 15 FEB 2037 with

a coupon of 4.75%
 This is also eligible for delivery
On 1 SEP 2008 the bond has 28 years and 5 ½
months to maturity
When we round down to the nearest three months
we get 28 years and 3 months
Thus the first coupon will be assumed to be paid
after 3 months
 The CF can be calculated in three steps
Illustration-2 (Cont…)
Illustration-2 (Cont…)
 Why Two Procedures?

The CF is used to multiply the quoted futures price

The quoted futures price is a Clean Price
 So the CF should not include any accrued interest
In the first case the life of the bond after rounding is
an integer multiple of six months
 So there is no need to factor in the Accrued Interest
 Why? (Cont…)

In the second case however accrued interest for a

quarter is present in the value that we get at the
second step
 Thus AI for 3 months has to be subtracted in order to arrive at
the Clean Price
 Hedging The CTD Bond

A naïve approach would suggest that for hedging Q bonds we

use Q futures contracts
 That is we use a Hedge Ratio of 1:1
Consider a cash and carry strategy initiated on August 7 , 2008
September futures contracts expire on September 30
The CTD bond has a coupon of 7.5% and expires on 15
November 2024
The quoted spot price was 134-10 and the corresponding futures
price was 117-04
The CF is 1.1529
Assume that on September 7 the settlement price is 68-12 and
the quoted spot price is 78-27
Hedging CTD (Cont…)
Hedging CTD (Cont…)
 The CF Approach

As per this approach the hedge ratio is CF or the

conversion factor of the bond
In our example:
The proceeds from the spot market when the CTD
bond is sold is $ 81,207.8804
Profit from futures = 1.1529 x 48750 = 56203.875
The total proceeds = 137,411.7554 which is close to
the value of 137,397.5429 that is implied by the
original futures price