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Interest Rate Futures Refinements
Interest Rate Futures Refinements
Interest Rate Futures Refinements
Chapter 8 1
T-Bond Futures Contract
Chapter 8 2
Cheapest-to-Deliver with No Intervening
Coupons
Recall that the total price of a bond depends upon the quoted
price plus the accrued interest (AI).
Where:
CF = conversion factor
the conversion factor as provided by the CBOT
AI = accrued interest
the Interest that has accrued since the last coupon payment
on the bond
Chapter 8 4
Cheapest-to-Deliver with No Intervening
Coupons
Table 8.1
Days in HalfBYears
Days in HalfBYear
Interest Paid on Interest Paid on
Interest Period 1st or 15th Last Day
Regular Leap Regular Leap
Year Year Year Year
January to July 181 182 181 182
February to August 181 182 184 184
March to September 184 184 183 183
April to October 183 183 184 184
May to November 184 184 183 183
June to December 183 183 184 184
July to January 184 184 184 184
August to February 184 184 181 182
September to March 181 182 182 183
October to April 182 183 181 182
November to May 181 182 182 183
December to June 182 183 181 182
1 year 365 366 365 366
(any 2 consecutive
halfByears)
Source: Treasury Circular No. 300, 4th Rev.
Chapter 8 5
Cheapest-to-Deliver with No Intervening
Coupons
5.25% Bond
8.00% Bond
Chapter 8 6
Cheapest-to-Deliver with No Intervening
Coupons
And simplifying:
Chapter 8 7
Cheapest-to-Deliver with No Intervening
Coupons
5.25% Bond
8.00% Bond
Chapter 8 8
Cheapest-to-Deliver with No Intervening
Coupons
Chapter 8 9
Cheapest-to-Deliver with Intervening
Coupons
Chapter 8 10
Cheapest-to-Deliver with Intervening
Coupons
Chapter 8 11
Cheapest to Delivery and Bond Yield
Chapter 8 12
Cheapest-to-Deliver with Intervening
Coupons
Chapter 8 13
Cheapest-to-Deliver with Intervening
Coupons
Suppose that today is Sept 14, 2004, and you want to find
the cheapest-to-deliver bond for the DEC 04 futures
expiration. The bond has a $100,000 face value and a
target delivery date of Dec 31, 2004. The futures contract
is the DEC 04. The T-bond contract had a settlement price
of 106-23 today. The coupon invested repo rates is 7%.
Summary
Today = Sept 14
Bond face value = $100,000
Target delivery date = Dec 31
Futures contract = DEC 04 T-bond
Coupon invested repo rate = 7%
Settlement price Sept 14 = 106-23
You are considering two bonds for delivery. The bonds are
as follows:
Chapter 8 14
Cheapest-to-Deliver with Intervening
Coupons
8% Bond
8% Bond
Chapter 8 15
Cheapest-to-Deliver with Intervening
Coupons
8% Bond
Chapter 8 16
Cheapest-to-Deliver with Intervening
Coupons
Table 8.2
Data for CheapestBtoBDeliver Bonds
Bond P0 AI0 C0,2 C1,2 DFP0 CF (DEC 04) AI2
5.25% $93,468.75 $1,740.49 .0210 .008944 1.0671875 0.9056 $667.13
8.00% $127,093.75 $2,652.17 .0210 .008944 1.0671875 1.2094 $1,016.57
π = $2,751.48
8% Bond
π =$1,647.43
Chapter 8 17
Cheapest-to-Deliver Bond and The
Implied Repo Rate
Chapter 8 18
Cheapest-to-Deliver Bond and The
Implied Repo Rate
Chapter 8 19
Cheapest-to-Deliver Bond and The
Implied Repo Rate
Chapter 8 20
Cheapest-to-Deliver Bond and Implied
Repo Rate
Table 8.3
Transactions Showing Implied Repo Rates
September 14, 2004
Borrow $129,745.92 for 108 days at implied repo rate of 11.23 percent.
Buy $100,000 face value of 8.00 T-bonds maturing on Nov. 15, 2021, for a total
price of $129,745.92 including accrued interest.
Sell one DEC 04 T-bond futures contract at the current price of 106-23.
Chapter 8 21
T-Bond Risk Arbitrage
Chapter 8 22
T-Bond Risk Arbitrage
Table 8.3
Transactions Showing Implied Repo Rates
September 14, 2004
Borrow $129,745.92 for 108 days at implied repo rate of
11.23 percent.
Buy $100,000 face value of 8.00 T-bonds maturing on Nov.
15, 2021, for a total
price of $129,745.92 including accrued interest.
Sell one DEC 04 T-bond futures contract at the current price
of 106-23.
Chapter 8 23
T-Bond Risk Arbitrage
Cash-and-Carry Strategy
Changes in the futures price can affect the cash flow from the
cash-and-carry strategy, as Table 8.4 illustrates. In this case,
the futures price drops from 106-23 to 104-23 over the life of
the contract.
Table 8.4
Transactions Showing Implied Repo Rates
September 14, 2004
Borrow $129,745.92 for 108 days at implied repo rate of 11.23 percent.
Buy $100,000 face value of 8.00 T-bonds maturing on Nov. 15, 2021, for a total
price of $129,745.92 including accrued interest.
Sell one DEC 04 T-bond futures contract at the current price of 106-23.
Chapter 8 24
T-Bond Risk Arbitrage
Reserve Cash-and Carry
Chapter 8 25
T-Bond Risk Arbitrage
Reserve Cash-and Carry
Chapter 8 26
T-Bond Futures Seller’s Options
1. Timing option
The seller’s right to choose the time of delivery.
2. Quality option
The seller’s right to select which bond to deliver.
Chapter 8 27
Wildcard Option
Chapter 8 28
The End-of-the-Month Option
Recall that the last trading day for T-bond futures is the 8th
of the month.
Assuming that interest rates are stable, then the seller may
apply the following general rules:
1. If the coupon yield on the bond exceeds the financing
rate to hold the bond, the seller should deliver on the
last day.
Chapter 8 29
Value of The Seller’s Options
F = S (1 + C)
F + SO = S (1 + C)
where:
F = S ( 1 + C ) - SO
Chapter 8 30
Interest Rate Futures Market Efficiency
Pure Arbitrage
Quasi-Arbitrage
Chapter 8 31
Pure Arbitrage
Table 8.9
Pure Arbitrage Results for TBBill Futures
Immediate Execution Delayed Execution
Size of Number Expected Actual Standard Number Expected Actual Standard
Filter of Trades Profit Profit Error of Trades Profit Profit Error
$ 0 2,304 $ 894 $ 889 $15 1,725 $ 893 $ 880 $18
100 2,093 980 975 16 1,569 977 964 19
200 1,902 1,064 1,058 16 1,428 1,059 1,041 19
300 1,738 1,142 1,135 16 1,301 1,137 1,117 20
400 1,595 1,212 1,206 17 1,206 1,199 1,176 20
500 1,469 1,279 1,271 17 1,107 1,267 1,244 21
600 1,332 1,352 1,346 18 1,005 1,339 1,315 22
700 1,190 1,437 1,432 18 890 1,429 1,401 23
800 1,063 1,519 1,516 18 789 1,517 1,490 24
Source: E. Elton, M. Gruber, and J. Rentzler, AIntraBDay Tests of the Efficiency of
the Treasury Bill Futures Market,@ The Review of Economics and Statistics,
February 1984, 66, pp. 129B137.
Chapter 8 32
Pure Arbitrage in T-Bond Futures
Chapter 8 33
Alternative Risk Management Strategy
4. Tailing Hedge
Chapter 8 34
Changing The Maturity of an Investment
Shortening the Maturity
Chapter 8 35
Changing The Maturity of an Investment
Shortening the Maturity
Chapter 8 36
Changing The Maturity of an Investment
Lengthening the Maturity
Chapter 8 38
Converting a Floating Rate to a Fixed
Rate Loan
Rates
Chapter 8 39
Converting a Floating Rate to a Fixed
Rate Loan
LIBOR Loan
Sept 20 7% 9.0%
DEC Eurodollar futures 7.3%. 9.3%
Chapter 8 40
Converting a Floating Rate to a Fixed
Rate Loan
BANK
Chapter 8 42
Converting a Fixed Rate to a Floating
Rate Loan
Chapter 8 43
Strip and Stack Hedges
The bank sets the rates to be LIBOR plus 200 basis points.
The rate will be adjusted every 3 months to reflect any
LIBOR rate changes.
I Quarter 9.0%
II Quarte r 9.3
III Quarter 9.6
IV Quarter 9.9
Chapter 8 44
Stack Hedges
Chapter 8 46
Strip Hedge
A strip hedge uses an equal number of contracts for each
futures expiration over the hedging horizon. By doing so, the
futures market hedge is aligned with the actual risk
exposure. The transactions necessary to implement a strip
hedge are demonstrated in Table 8.15.
Table 8.15
Results of a Strip Hedge
Date Cash Market Futures Market
September 20 Borrow $100,000,000 at 9.00% Sell 100 Eurodollar futures for
for three months and commit each of: DEC at 92.70, MAR at
to roll over the loan for three 92.40, and JUN at 92.10.
quarters at 200 basis points
over the prevailing LIBOR
rate.
December 20 Pay interest of $2,250,000. Offset 100 DEC Eurodollar
LIBOR is now at 7.4%, so bor- futures at 92.60. Produces
row $100,000,000 for three profit of $25,000 = 10 basis
months at 9.4%. points $25 per point 100
contracts.
March 20 Pay interest of $2,350,000 and Offset 100 MAR Eurodollar
borrow $100,000,000 for three futures at 91.70. Produces
months at 10.30%. profit of $175,000 = 70 basis
points
$25 per point 100
contracts.
June 20 Pay interest of $2,575,000 and Offset 100 JUN Eurodollar
borrow $100,000,000 for three futures at 91.40. Produces
months at 10.60%. profit of $175,000 = 70 basis
points $25 per point 100
contracts.
September 20 Pay interest of $2,650,000 and
principal of $100,000,000.
Total Interest Expense: Futures Profit: $375,000
$9,825,000
Interest Expense Net of Hedging: $9,450,000
Chapter 8 47
Advantages of Stacked and Striped
Hedge
Chapter 8 48
Tailing The Hedge
Tail Factor
Chapter 8 49
Hedging with T-Bond Futures
Chapter 8 50
Hedging with T-Bond Futures
A manager learns on March 1 that he will receive $5 million
on June 1 to invest in AAA corporate bonds with a 5%
coupon rate and 10 years to maturity. The yield curve is flat
and will remain so. The current yield on AAA bonds as well
as forward rates are 7.5%. So the manager expects to
acquire the bonds at 7.5%. However, fearing a drop in
rates, he decides to hedge in the futures market to lock-in
the forward rate of 7.5%.
Chapter 8 51
Hedging with T-Bond Futures
Table 8.16
A CrossBHedge Between Corporate Bonds
and TBBill Futures
Date Cash Market Futures Market
March 1 A portfolio manager learns he The portfolio manager buys $5
will receive $5 million to invest million face value of T-bill futur-
in 5%, 10-year AAA bonds in 3 es (5 contracts) to mature on
months, with an expected yield June 1 with a futures yield of
of 7.5% and a price of $826.30. 6.0% and a futures price, per
The manager expects to buy contract, of
6,051 bonds. $985,000.
June 1 AAA yields have fallen to 7.08%, The T-bill futures yield has
causing the price of the bonds to fallen to 5.58%, so the futures
be $852.72. This represents a price = spot price = $986,050 per
loss, per bond, of $26.42. Since contract, for a profit of $1,050
the plan was to buy 6,051 bonds, per contract. Since 5 contracts
the total loss is (6,051 $26.42) were traded, the total profit is
= B$159,867. $5,250.
Loss = B$159,867 Gain = $5,250
Net wealth change = B$154,617
Notice that this loss occurs despite the fact that rates
changed by the same amount on both investments.
Chapter 8 52
Hedging with T-Bond Futures
Table 8.17
A Cross Hedge Between Corporate Bonds
and TBBond Futures
Date Cash Market Futures Market
March 1 A portfolio manager learns he The portfolio manager buys $5
will receive $5 million to invest million face value of T-bond
in 5%, 10-year AAA bonds in 3 futures (50 contracts) to mature
months, with an expected yield on June 1 with a futures yield of
of 7.5% and a price of $826.30. 6.5% and a futures price, per
The manager expects to buy contract, of $94,448.
6,051 bonds.
June 1 AAA yields have fallen to 7.08%, The T-bond futures yield has
causing the price of the bonds to fallen to 6.08%, so the futures
be $852.72. This represents a price = spot price = $99,081 per
loss, per bond, of $26.42. Since contract, for a profit of $4,633
the plan was to buy 6,051 bonds, per contract. Since 50 contracts
the total loss is (6,051 $26.42) were traded, the total profit is
= B$159,867. $231,650.
Loss = B$159,867 Gain = $231,650
Net wealth change = +$71,783
Chapter 8 53
Hedging with T-Bond Futures
Chapter 8 54
Face Value Naive (FVN) Model
Disadvantages
Chapter 8 55
Market Value Naïve (MVN) Model
Disadvantages
Advantages
Chapter 8 56
Conversion Factor (CF) Model
Chapter 8 57
Basic Point (BP) Model
BPC S
HR = -
BPC F
Where
BPCS = dollar price change for a 1 basis point change
in the spot instrument.
Chapter 8 58
Basic Point (BP) Model
Table 8.18
Hedging Results with the BP Model
for the Commercial Paper Issuance
April 2
Cash Market Futures Market
Firm anticipates issuing $50 million in Firm sells 100 T-bill June futures con-
180-day commercial paper in 45 days tracts yielding 10% with an index value
at a yield of 11%. of 90.00.
May 15
Spot market and futures market rates have both risen 45 basis points. The spot
rate is now 11.45% and the futures market yield is 10.45%.
Cash Market Effect Futures Market Effect
Each basis point move causes a price Each basis point increase gives a
change of $50 per million-dollar face futures market profit of $25 per
value. Firm will receive $112,500 less contract.
for the commercial paper, due to the
change in rates. (45 basis points Futures Profit = 45 basis points +$25
B$50 50 = B$112,500) 100 contracts = +$112,500
Net wealth change = 0
Chapter 8 59
Basic Point (BP) Model
BPC S
HR = - RV
BPC F
where:
RV = volatility of cash market yield relative to futures
yield. Normally found by regressing the yield of
the cash market instrument on the futures
market yield.
$50
HR = - 1.25 = - 2.5
$25
Chapter 8 60
Basic Point (BP) Model
Table 8.19
Hedging Results with the BP Model
Adjusted for Relative Yield Variances
for the Commercial Paper Issuance
April 2
Cash Market Futures Market
Firm anticipates issuing $50 million in Firm sells 125 T-bill June futures con-
180Bday commercial paper in 45 days tracts yielding 10% with an index value
at a yield of 11%. of 90.00.
May 15
Spot market rates have risen 56 basis points to 11.56% and futures rates have
risen 45 basis points to 10.45%
Cash Market Effect Futures Market Effect
Each basis point move causes a price Each basis point increase gives a
change of $50 per million-dollar face futures market profit of $25 per
value. Firm will receive $140,000 less contract.
for the commercial paper, due to the
change in rates. Futures Profit = 45 basis points +$25
56 basis points B$50 50 = 125 contracts = +$140,625
B$140,000
Net wealth change = $625
Chapter 8 61
Regression (RGR) Model
COV S , F
HR = - 2
F
where:
COVS,F = covariance between cash and futures
σF2 = variance of futures
S t = + Ft + t
Chapter 8 62
Price Sensitivity Model
Chapter 8 63
Price Sensitivity Model
N = - Pi MDi RYC
FP F MD F
where:
FPF = the futures contract price.
Pi = the price of asset I expected to prevail at the
hedging horizon.
MDi = the modified duration of asset I expected to
prevail at the hedging horizon.
DF = the modified duration of the asset underlying
futures contract F expected to prevail at the
hedging horizon.
RYC = for a given change in the risk-free rate, the
change in the cash market yield relative to
the change in the futures yield, often
assumed to be 1.0 in practice.
Chapter 8 64
Price Sensitivity Model
Table 8.20
Data for the Price Sensitivity Hedge
Cash Instrument TBBill Futures TBBond Futures
Pi $826.30 FPi $985,000 FPF $94,448
MDi 7.207358 MDF 0.235849 MDF 10.946953
N -0.025636 N -0.005760
($826.30) (7.207358)
N=- = - 0.025636
($985,000) (0.235849)
Chapter 8 65
Price Sensitivity Model
Table 8.21
Performance Analysis of Price Sensitivity Futures Hedge
Cash Market TBBill Hedge TBBond Hedge
Gain/Loss B$159,867 +$162,876 +$161,460
Hedging Error B $3,009 $1,593
Percentage Hedging Error 1.8822% 0.9965%
Chapter 8 66
Summary of Alternative Hedging
Strategies
Table 8.22
Summary of Alternative Hedging Strategies
Hedging Model Basic Intuition
Face Value Naive Hedge $1 of cash instrument face value with $1 of futures
(FVN) instrument face value.
Market Value Naive Hedge $1 of cash instrument market value with $1 of
(MVN) futures instrument market value.
Conversion Factor Find ratio of cash market principal to futures market
(CF) principal. Multiply this ratio by the conversion factor for
the cheapestBtodeliver instrument.
Basis Point (BP) For a 1 basis point yield change, find the ratio of the cash
market price change to the futures market price change.
(Sometimes weighted by the relative volatility of interest
rates on the cash market instrument compared to the
futures instrument interest rate.)
Regression (RGR) For a given cash market position, use regression analysis
to find the futures position that minimizes the variance of
the combined cash/futures position.
Price Sensitivity Using duration analysis, find the futures market position
(PS) designed to give a zero wealth change at the hedging hori-
zon. (Sometimes weighted by the relative volatility of
interest rates on the cash market instrument compared to
the futures instrument interest rate.)
Chapter 8 67
Immunization
Chapter 8 68
Immunization with Interest Rate Futures
Planning Period Case
A portfolio manager has collected the following
information:
Table 8.23
Instruments for the Immunization Analysis
Coupon Maturity Yield Price Duration
Bond A: 8% 4 yrs. 12% 875.80 3.4605
Bond B: 10% 10 yrs. 12% 885.30 6.3092
Bond C: 4% 15 yrs. 12% 449.41 9.2853
TBBond Futures* 6% 20 yrs. 12% 548.61 9.0401
TBBill Futures* B 3 yr. 12% 970.00 0.2500
*For comparability, face values of $1,000 are assumed for these instruments.
Chapter 8 69
Immunization with Interest Rate Futures
Planning Period Case
Alternative 1
W A D A + W C DC = 6 years
Subject to:
WA + WC = 1
Where:
WI = percent of portfolio funds committed to asset I.
Chapter 8 70
Immunization with Interest Rate Futures
Planning Period Case
Alternative 2
The manager could also adjust the portfolio's duration to
match the six-year planning period by trading interest rate
futures and keeping bond C.
If bond C and a T-bill futures comprise the portfolio, the T-
bill futures position must satisfy the condition:
PP = PC NC + FPT-bill NT-bill
where:
Pp = value of the portfolio
Pc = price of bond C
FPT-bill = t-bill futures price
Nc = number of C bonds
NT-bill = number of T-bills
Expressing the change in the price of a bond as a function
of duration and the yield on the asset:
dP = -D{d(1 + r)/(1 + r)}P
Chapter 8 71
Immunization with Interest Rate Futures
Planning Period Case
Chapter 8 72
Immunization with Interest Rate Futures
Planning Period Case
Pp = $100,000,000
Dp = 6
DC = 9.2853
PC = $449.41
NC= 222,514
DT-bill = 0.25
FPT-bill = $970.00
Solving by:
Table 8.24 shows the relevant data for each of the three
scenarios.
Chapter 8 73
Immunization with Interest Rate Futures
Planning Period Case
Table 8.24
Portfolio Characteristics for the Planning Period Case
Portfolio 1 Portfolio 2 Portfolio 3
(Bonds Only) (Short T-Bill Fut.) (Short T-Bond Fut.)
Portfolio WA 56.39% B B
Weights WC 43.61% 100% 100%
WCash ~0 ~0 ~0
Number NA 64,387 0 B
of NC 97,038 222,514 222,514
Instruments B B
NT-bill (1,354,764)
NT-bond B B (66,243)
Value NAPA 56,390,135 B B
of Each NCPC 43,609,848 100,000,017 100,000,017
Instrument B B
NT-billFPT-bill 1,314,121,080
NT-bondFPT-bond B B 36,341,572
Cash 17 (17) (17)
Portfolio NAPA +
Value NCPC + 100,000,000 100,000,000 100,000,000
Cash
Source: Adapted from R. Kolb and G. Gay, AImmunizing Bond Portfolios with Interest Rate Futures,@
Financial Management, Summer 1982, pp. 81-89.
Chapter 8 74
Immunization with Interest Rate Futures
Planning Period Case
PA = $904.98
PC = $491.32
FPT-bill = $972.50
FPT-bond = $598.85
Chapter 8 75
Immunization with Interest Rate Futures
Planning Period Case
Table 8.25
Effect of a 1% Drop in Yields
on Realized Portfolio Returns
Portfolio 1 Portfolio 2 Portfolio 3
Original Portfolio Value 100,000,000 100,000,000 100,000,000
New Portfolio Value 105,945,674 109,325,562 109,325,562
Gain/Loss on Futures B0B (3,386,910) (3,328,048)
Total Wealth Change 5,945,674 5,938,652 5,997,514
Terminal Value of all Funds $201,424,708 $201,411,358 $201,523,27
at t = 6
Annualized Holding Period 1.120180 1.120168 1.120266
Return over 6 Years
Source: Adapted from R. Kolb and G. Gay, AImmunizing Bond Portfolios with Interest Rate Futures,@
Financial Management, Summer 1982, pp. 81-89. Terminal values and holding period returns assume
semi-annual compounding at 11 percent.
Chapter 8 76
Transaction Costs for Planning Period
Case
Table 8.28
Transaction Costs for the Planning Period Case
Portfolio 1 Portfolio 2 Portfolio 3
Number of Instruments Traded
Bond A 64,387 B B
Bond C 125,476 B B
TBBill Futures Contracts B 1,355 B
TBBond Futures Contracts B B 662
One Way Transaction Cost
Bond A @ $5 321,935 B B
Bond C @ $5 627,380 B B
TBBill Futures $20 B 27,100 B
TBBond Futures @ $20 B B 13,240
Total Cost of Becoming Immunized $949,315 $27,100 $13,240
Source: Adapted from R. Kolb and G. Gay, AImmunizing Bond Portfolios with Interest Rate Futures,@ Finan-
cial Management, Summer 1982, pp. 81-89.
Chapter 8 77
Immunization with Interest Rate Futures
Bank Immunization Case
Chapter 8 78
Immunization with Interest Rate Futures
Bank Immunization Case
Table 8.26
Liability Portfolio and Five Alternative Immunizing Portfolios
Portfolio 2 Portfolio 3 Portfolio 4 Portfolio 5
(Short (Long (Long (Short
Liability Portfolio 1 TBBill TBBond TBBill TBBond
Portfolio (Bonds Futures) Futures) Futures) Futures)
Only)
Portfolio WA 0 51.0936% 0 100% 100% 0
Weights WB 100% 0 0 0 0 0
WC 0 48.9064% 100% 0 0 100%
WCash ~0 ~0 ~0 ~0 ~0 ~0
Number of NA 0 58,339 0 114,181 114,181 0
Instru- NB 112,956 0 0 0 0 0
ments
NC 0 108,824 222,514 0 0 222,514
NTBbill 0 0 (1,227,258) 0 1,174,724 0
NTBbond 0 0 0 57,440 0 (60,008)
NAPA 0 51,093,296 0 99,999,720 99,999,720 0
NBPB 99,999,947 0 0 0 0 0
NCPC 0 48,906,594 100,000,017 0 0 100,000,017
Cash 53 110 (17) 280 280 (17)
NTBbillPTBbill 0 0 (1,190,440,260) 0 1,139,482,280 0
NTBbond 0 0 0 31,512,158 0 (32,920,989)
PTBbond
Portfolio
Value 100,000,000 100,000,000 100,000,000 100,000,000 100,000,000 100,000,000
Source: Adapted from R. Kolb and G. Gay, AImmunizing Bond Portfolios with Interest Rate Futures,@
Financial Management, Summer 1982, pp. 81-89.
Chapter 8 79
Immunization with Interest Rate Futures
Bank Immunization Case
Chapter 8 80