Lecture Note Six:

Forward and Futures on Bonds

FINA3323 Fixed Income Securities

HKU Business School
University of Hong Kong
6-1

Dr. Huiyan Qiu

 Outline
Forward rate and forward curve
Forward rate agreement (FRA)
Forward contracts: pricing and market value
Interest rate swap
Futures on short-term rate: Eurodollar futures, fed fund
futures
Treasury bond futures and Treasury note futures

Reference: Fabozzi’s chapter 26, Tuckman’s chapter 13, 14,

15
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 Review on Forward Rate
A forward rate is an interest rate that is specified now
to be used for a future period.
Let denote the per-period forward interest rate observed
at time 0 that begins in i periods and ends in n periods
• It is interest rate that is implied by the rates prevailing in
the market today

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 Review on Forward Rate
𝑟0, 𝑖 𝑓 0 ,𝑖 ,𝑛
0 i n

𝑟0, 𝑛

Compounding at for the first i periods and then at from

period i to n results in the same as compounding at for
the n periods. Note: all rates here are effective periodic
rates.

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 Forward Rate: Example
You will receive $100 at month-3, and you decide to
save it for 9 months. What annual rate can bank commit
to offer today? Assume today
• 3-month rate = 3% ( annual effective)
• 1-year rate = 5% (annual effective)
By applying the formula, the effective annual forward
rate is

You will get $104.23 one year later.

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 The Forward Curve
Fixing the length of the investment period Δ, the
forward curve gives the relation between the forward
rate and the time of the investment T.
Recall that the spot rate curve gives the relation
between the spot rate and maturity T.
Under the no-arbitrage assumption, we can get forward
curve if given spot rate curve and vice versa.

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 The Forward Curve (cont’d)
Step Maturity Spot Rate Forward Rate
4.5
i T_i r0, T_i f0, T_{i-1}, T_i Spot Rate

1 0.5 2.7605 2.7605 Forward Rate

4.0
2 1 2.7141 2.6677
3 1.5 2.7471 2.8131
4 2 2.8125 3.0089 3.5

5 2.5 2.8884 3.1926

6 3 2.9680 3.3669 3.0
7 3.5 3.0512 3.5518
8 4 3.1338 3.7139 2.5
9 4.5 3.2127 3.8461
10 5 3.2884 3.9722
2.0
11 5.5 3.3613 4.0931 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6
12 6 3.4295 4.1827
*: all rates here are effective annual rate (%).

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 The Forward Curve (cont’d)
Suppose the given spot rates are effective annual rates,
the effective annual forward rates for each investment
period (6-month) can be calculated.
For example,

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 Forward Rate Agreement
A Forward Rate Agreement (FRA) is an over-the-
counter contract that guarantee a future borrowing or
lending rate on a given notional principal amount.
• One party agrees to pay the forward rate while the other
party agrees to pay according to future market floating
rate.
• The net payment between the two parties at the maturity
of the contract is the interest payment difference.

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 FRA: Example
FRA can be used as a bet on interest rate going up or
going down. FRA can also be used to manage interest
rate risk by locking in future borrowing or lending rate.
Example: A borrower will have to borrow $100 million
one year later for one year. Assume today
• 1-year effective rate = 3%
• 2-year effective rate = 4%
The forward rate .

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 FRA: Example (cont’d)
The borrower enters an FRA and commits to pay at the
fixed rate and to receive at the floating rate. One year
later, the borrower borrows at then-prevailing 1-year
interest rate .
In year 2, the borrower pays the interest based on the
actual borrowing.
Based on FRA contract, the borrower receives the
interest difference .
On net, the borrower pays interest at the forward rate of
5.0097%.
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 Forward Contracts
A forward contract is an agreement for the future
delivery of the underlying asset at a specified price at the
end of a designated period of time.
Forward contract has no clearing house (as futures
contract), usually has its terms negotiated individually
between two counterparties and typically has
nonexistent or extremely thin secondary markets.

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 Forward Contract: Pricing
Consider a forward contract in which one counterparty
agrees to purchase at a future date T a bond paying
coupon C and with maturity T * > T. Let T1, T2,..., Tn =
T* be the coupon dates after T, the maturity of the
forward contract. Then, the forward price is given by

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 Forward Contract: Pricing
What is the forward price of deliver a 4-year Treasury bond with
8% coupon in year 2?
Step Maturity Spot Rate Forward Rate Cash Dis. Fac. Val. of C Val. of Par
i T_i r0, T_i f0, T_{i-1}, T_i Flow in year 2 in year 2 in year 2
1 0.5 2.7605 2.7605
2 1 2.7141 2.6677 (1+𝑟 0,2)2
3.5
3 1.5 2.7471 2.8131 (1+𝑟 0 , 3.5)
4 2 2.8125 3.0089 1.0000
5 2.5 2.8884 3.1926 4 0.9844 3.9376
6 3 2.9680 3.3669 4 0.9682 3.8730
7 3.5 3.0512 3.5518 4 0.9515 3.8060
8 4 3.1338 3.7139 4 0.9343 3.7372
9 4.5 3.2127 3.8461 4 0.9168 3.6674
10 5 3.2884 3.9722 4 0.8992 3.5966
11 5.5 3.3613 4.0931 4 0.8813 3.5252
12 6 3.4295 4.1827 104 0.8634 3.4537 86.3426
Forward Price: 115.9393
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 Forward Contract: Market Value
The value of forward contract at inception is zero. After
inception, the market value of forward contract depends
on the forward rates and it may not be zero any longer.
The value of the forward contract for every is

where is the discount factor at time t for cash flows at

time T.

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 Interest Rate Swaps
A fixed-for-floating interest-rate swap is a mutually
advantageous agreement between two counterparties in
which one party agrees to pay a fixed rate while the
other pays a floating rate.
• The fixed-rate payer is often called the buyer of the swap
or is said to be long the swap
• The fixed-rate receiver is often said to be short the swap
• In general, a swap dealer will take positions on either side
of a swap, and will make a commission for carrying out
both ends of it

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 Interest Rate Swaps
The first interest rate swap was negotiated in 1982.
Since then, the use of interest rate swaps as a financing
device has soared.
The exceptional growth in the market for interest rate
swaps derives from
• the relative simplicity and flexibility of these transactions,
• the volatility in interest rate markets, and
• the financial benefits to each swap party.

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 Interest Rate Swaps

Source: BIS, https://stats.bis.org/statx/srs/table/d7

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 Interest Rate Swaps

Source: BIS Triennial Central Bank Survey 2019

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Use of Interest Rate Swaps: Example
Company A is an AA-rated firm desiring to issue 10-
year floating-rate bond. The company can borrow at the
following rates:
• Fixed-rate borrowing cost = 2.5%
• Floating-rate borrowing cost = LIBOR
Company B is a BBB-rated firm desiring to issue a 10-
year fixed-rate bond. The company can borrow at the
following rates:
• Fixed-rate borrowing cost = 5.0%
• Floating-rate borrowing cost = LIBOR + 1%
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 Interest-Rate Swaps: Example
Company A possess an absolute advantage in borrowing
terms for both fixed-rate and floating-rate debt and
comparative advantage at borrowing in the fixed rate
market.

Company A Company B Differential

Fixed-rate 2.5% 5.0% 2.50%

Floating-rate LIBOR LIBOR + 1% 1.00%
QSD = 1.50%

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 Interest-Rate Swaps: Example
Quality spread differential (QSD) is the difference
between the default-risk premium differential on the
fixed-rate debt and the default-risk premium differential
on the floating rate debt.
The key, or necessary condition, giving rise to the
possibility of a swap is that a quality spread differential
(QSD) exist.
QSD in the example is 1.50%.

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 Interest-Rate Swaps: Example

Issue Fixed- Issue Fixed-

Net result
rate Debt @ for B
rate Debt @
2.5% 4.4%
LIBOR LIBOR
– 0.10% + 0.10%
Swap
Company A Company B
3.0%
Bank 3.5%

Issue Floating- Issue Floating-

rate Debt @ Net result rate Debt @
LIBOR – 0.60% for A LIBOR + 1%
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 Interest-Rate Swaps: Example
Net Cash Out Flows
Company A Swap Bank Company B
Pays -2.5% -3.0% -3.5%
-(LIBOR–0.1%) -(LIBOR+0.1%) -(LIBOR+1.0%)
Receives 3.0% 3.5%
LIBOR–0.1% LIBOR+0.1%
Net -(LIBOR–0.6%) 0.30% - 4.4%
Savings 0.60% 0.30% 0.60%

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 The Swap Rate
The swap rate is the fixed interest rate in the swap
contract. Swap rate should be consistent with currently
available interest rate information.
For floating rate debt and fixed rate debt to be
swappable, the value of the two debts must be the same.
Thus, swap rate in principle equals to the par yield.
• In-class exercise 2: given the spot rate, find the swap rate.

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 The Swap Rate
Over the years, the swap market grew so much that
market forces determine the swap rate for every possible
future maturity.
Given the swap curve we can determine the spot rate
through the bootstrap methodology and we call it swap
zero yield.
• In-class exercise 3: give the swap curve, find the spot rate
curve.
Spot rates, forward rates, and swap rates

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 Treasury Zero and Swap Zero
Using Treasury par yield curve, we learned how to use
bootstrap methodology to find the theoretical spot rate
curve.
Historically, the theoretical spot rate curves based on
Treasury par yield (called Treasury Zero yield) and that
based on swap rate curve (called Swap Zero yield)
differ.
The swap spread is defined as the difference between
the swap zero yield and the treasury zero yield.

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The 5-year Treasury and Swap Zero Yield

Data Source: Bloomberg and CRSP.

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 Swap Spread Trade
Based on the twenty-year data, the swap spread seems
unlikely to become negative and unlikely to move to
infinity.
When the swap spread is large, for instance, speculators
may bet on the fact that the spread will shrink in the
future by taking a short position on the Treasury bonds,
and enter in a fixed-for-floating swap, as a fixed rate
receiver.
This trading strategy is called swap spread trades and
is often taken by proprietary trading desks and hedge
funds. 6-29
 Futures Contracts
A futures contract is a firm legal agreement between a
buyer (seller) and an established exchange or its
clearinghouse in which the buyer (seller) agrees to take
(make) delivery of something at a specified price at the
end of a designated period of time.
The price at which the parties agree to transact in the
future is called the futures price.
The designated date at which the parties must transact is
called the settlement date.

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 Mechanics of Futures Trading
For some futures contracts, settlement is made in cash
only. Such contracts are referred to as cash-settlement
contracts.
The contract with the nearest settlement date is called
the nearby futures contract.
The next futures contract is the one that settles just after
the nearby contract.
The contract furthest away in time from settlement is
called the most distant futures contract.

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Mechanics of Futures Trading (cont’d)
When an investor takes a position in the futures market,
the clearinghouse takes the opposite position and agrees
to satisfy the terms set forth in the contract.
• Because the clearinghouse exists, the investor need not
worry about the financial strength and integrity of the
party taking the opposite side of the contract.
• Besides its guarantee function, the clearinghouse makes it
simple for parties to a futures contract to unwind their
positions prior to the settlement date.

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Mechanics of Futures Trading (cont’d)
Margin Requirement
• When a position is first taken in a futures contract, the
investor must deposit a minimum dollar amount per
contract as specified by the exchange. This amount is
called the initial margin.
• At the end of each trading day, the exchange determines
the settlement price for the futures contract. This price is
used to mark to market the investor’s position, so that
any gain or loss from the position is reflected in the
investor’s account.

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Mechanics of Futures Trading (cont’d)
Margin Requirement
• The maintenance margin is the minimum level
(specified by the exchange) by which an investor’s
position may fall as a result of an unfavorable price
movement before the investor is required to deposit
additional margin.
• The additional margin deposited, called the variation
margin, is the amount necessary to bring the amount of
the margin account back to its initial margin level.

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Mechanics of Futures Trading (cont’d)
The concept of margin differs for securities and futures.
• When securities are acquired on margin, the difference
between the price of the security and the initial margin is
borrowed from the broker with the security purchased
serving as collateral for the loan.
• For futures contracts, the initial margin, in effect, serves
as “good faith” money, an indication that the investor will
satisfy the obligation of the contract.

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 Futures on Short-Term Rates
Futures contracts on short-term rates are extremely
useful for hedging against risks arising from changes in
short-term rates and for speculating on the direction of
these rates.
Two main types of futures contracts for short-term debt
• Eurodollar futures
• LIBOR – London InterBank Offered Rate
• Fed funds futures
• Fed funds rate – overnight US federal funds rate

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 Eurodollar Futures
Trade unit: Eurodollar time deposit having a principal
value of $1,000,000 with a 3-month maturity
The futures contract price at the expiration date is (100 –
100*contract rate)
• A Eurodollar futures price of 94.52 means the parties to
this contract agree to buy or sell the three-month LIBOR
for 100 – 94.52 = 5.48 where 5.48 refers to 5.48%.
Actual/360 day count convention

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 Eurodollar Futures
A one-tick change in the futures price for this contract is
0.01. In terms of basis points, a one-tick change means a
1-basis-point change in the three-month LIBOR.
The simple interest on $1 million for 90 days is equal to
$1,000,000 × (LIBOR × 90/360)
• If LIBOR changes by 1 basis point, then $1,000,000 ×
(0.0001 × 90/360) = $25
Hence, a one-tick change in the index price means a $25
change in the value of the contract.

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Mark-to-Market from a Long Position

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 Eurodollar Futures: Trading Mechanics
At the close of 11/16/2001, the $237.5 is transferred
immediately from the longs to the shorts as a mark-to-
market payment.
The mark-to-market payments sets the value of the
futures contract to be zero every day.

An otherwise identical forward contract will accumulate

profits/losses over time without daily mark-to-market
payments.

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 Eurodollar Futures: Hedging
Eurodollar futures can be used in the same way as
forward contracts to hedge the risk of lending or
borrowing on future dates.
For example, a market participant is concerned that its
borrowing costs six months from now are going to be
higher.
• A higher borrowing cost means a lower Eurodollar futures
price. To protect itself, it takes a short position in the
Eurodollar futures.
• Suppose the Eurodollar futures price is 94.52.

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 Eurodollar Futures: Hedging
(cont’d) Suppose at the settlement date the three-month
LIBOR increases to 6.00% and, therefore, the settlement
price of Eurodollar futures is 94.00.
• This means that the seller sold the contract for 94.52 and
purchased it for 94.00, realizing a gain of 0.52 or 52 ticks.
The buyer must pay the seller 52 × $25 = $1,300.
The gain from the short futures position is then used to
offset the higher borrowing cost resulting from a rise in
short-term interest rates.

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 Similar Futures Contracts
There are futures contracts based on reference rates for
floating rate loans in other currencies that have
specification similar to that of Eurodollar futures.
• Euribor Futures: the futures contracts on Euribor -- the
reference rate used for euro-denominated loans
• HIBOR Futures: the futures contracts on one-month or
three month Hibors.

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 Fed Funds Futures
Another widely used short-term rate benchmarks is US
Fed funds rate.
Banks are required to keep a minimum level of reserves
at the Fed to support their deposit liabilities.
• Individual bank may have excess cash that can be
invested or need to borrow to meet minimum reserve
requirements. The market in which banks trade funds
overnight is called the federal funds or fed funds market.
Fed funds futures are based on Fed funds rate.

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 Treasury Futures
The most active bond derivatives contracts are the
Treasury futures contracts, traded on the CME Group:
http://www.cmegroup.com/
Trade unit: U.S. Treasury bond/note having a face
value at maturity of $100,000
Contract listing: Mar, Jun, Sep, Dec
Quotes: Futures prices are quoted in 32nds in terms of
par (100)
Example: Quote 97-16 = 97 16/32 of 100 = 97.50% of
par value
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 Treasury Futures: Delivery
If choose to settle physically, the seller of a Treasury
bond/note futures must deliver some Treasury security
on the settlement date
Bonds/Notes deemed acceptable by the CBOT can be
delivered – these are announced ahead of delivery.
• To make delivery equitable to both parties, the CME
Group has introduced conversion factors. The conversion
factor is the price of the delivered note ($1 par value) to
yield 6 percent.

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 Treasury Futures: Delivery
The price that the buyer must pay the seller when a
Treasury bond is delivered is called the invoice price,
which is given as:

The short must notify the long of the actual bond that
will be delivered one day before the delivery date.

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 Cheapest-to-Deliver Bond
At any given time during the delivery month, there are
many bonds that can be delivered in the CBOT Treasury
bond futures contract.
The party with the short position can choose which of
the available bonds is “cheapest” to deliver – this is the
one which minimizes

Choosing the cheapest-to-deliver bond is important

only when contracts are held until maturity – often they
are liquidated before this
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Theoretical Pricing of Bond Futures
The bond futures price is the sum of the discounted cash
flows of the bond at the delivery date t

where is the one-period forward rate from time t to time

t+1

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 Pricing of Bond Futures
Example: A bond pays annual coupons of $10, has a par
value of $100 and a maturity of 3 years. The 1-year
forward rate 1 year from today is 9.04%, and 2 years
from today is 13.11%. What is the price of the bond
deliverable 1 year from today?
Answer: the price of the bond deliverable 1 year from
today is

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Theoretical Pricing of Bond Futures
The previous equation can be rewritten as

where
• = the spot price of a bond that matures at time n
• = the spot rate (per period) for n periods of time

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 Pricing of Bond Futures
Example: A bond pays annual coupons of $10, has a par
value of $100, and a maturity of 3 years. The 1-year spot
rate is 5%, the 2-year spot rate is 7%, and the 3-year spot
rate is 9%.
What is the price of a futures contract deliverable one
year from today?

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Theoretical Pricing of Bond Futures
The two methods shown are equivalent and the second
method is easier to use
The spot rates are usually observable, while forward
rates are not and would need to be calculated
The price of the bond in the spot market is also
observable
It is an easier calculation for a long-term bond

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 Pricing of Bond Futures: Example
A bond pays annual coupons of $8, has a par value of
$100, and a maturity of 30 years. The bond is selling for
$95 in the spot market. The 1-year spot rate is 4%. What
is the price of a futures contract deliverable one year
from today?

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End of the Notes!

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