Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 2
Lab: Constructing the Short End
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 3
Lab: Constructing the Short End
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Solution: Short End
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Futures Libor Rates
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Futures & Forwards
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Convexity
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 8
Convexity: Future vs Swap
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Pricing Convexity Differences
¾ If not priced
9Short swap/short futures buys positive convexity
for free
• Significant for longer tenor securities 5+ years
• Arbitrage gains with rate increases/declines
¾ If priced
9Forward rates implied by FRA’s or swaps differ
from forward rates implied by futures
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 10
Lab: FRAFutures Convexity
¾ Sell $100 81 v 84M IMM dated FRA @ 5.00%
¾ Hedge by Selling Futures @ 95.00
¾ Yield curve is flat at 5%
¾ Work out:
9 Equivalent futures position
9 Gain or loss on FRA and equivalent Futures position for
parallel shifts +/ 4%
¾ Worksheet: FRAFutures
9 See cell notes for help
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 11
Solution: FRA  Futures
¾ D81 = 0.7150
¾ FRA Value for 1bp change in YC = $1,788
¾ Therefore equivalent position is:
9 $1,788/ $25 = Long 72 Futures
9(or if hedging, sell 72 futures contracts)
¾ Examine changes in position value due to
shifts in spot & forward rates
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 12
Chart: FRAFutures Convexity
1,200,000 Short FRA
Difference
800,000
600,000
400,000
200,000

1% 2% 3% 4% 5% 6% 7% 8% 9%
Spot & Forw ard Rates
200,000
400,000
600,000
800,000
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 13
Convexity
¾ Short FRA has positive convexity
¾ Futures have zero convexity
¾ Difference must be paid for:
9Forward rate is lower than implied by futures price
9(100  futures price) is greater than forward rate
9Need adjustment factor to take account of the
volatility of the two rates and their correlation
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 14
Convexity Adjustment Factor
¾ Depends on term structure dynamics
¾ Rule of thumb (Burghardt & Hoskins)
¾ Change in spread between forward rate and
futures:
∆S = σf x σzcb x σf,zcb
σf = standard deviation of change in forward rate
σzcb = standard deviation of zero coupon bond return
σf,zcb = correlation of forward rate change and zero
coupon bond returns
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 15
Convexity Adjustment Factor
¾ Futures and forwards are the same at expiry
¾ Rule gives change in difference over time
¾ Calculate the change for each three month period
¾ Standard deviation of returns on ZCB:
9 Duration (Maturity) * SD of Yield (Spot Rate) changes
• Standard deviations and correlations will be slightly different for each
period
• Derived from historical data or option prices
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 16
Adjustment Factor Example
¾ Assume:
• Annualized SD of changes in all futures prices = 1%
• Annualized SD of change in ZCB yields = 1%
• Correlation = 0.99
¾ First contract has 3 months to expiry:
∆S03 = [0.01 x 0.01 x (4.5 / 12) x 0.99] / 4 = 0.09375 bp
Average maturity of deposit period
¾ Second Contract:
∆S36 = [0.01 x 0.01 x (7.5 / 12) x 0.99] / 4 = 0.15625 bp
¾ Adjustment for 6 months = ∆S03 + ∆S36 = 0.25bp
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 17
Adjustment Factors: Typical Values
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Building the Curve
Today F1 Start 90 days F2 Start
90 days
10May 18Jun 16Sep 17Sep
¾ CASH FUTURES
1w: 5.50  5.38 (17May)
1m: 5.60  5.48 (10Jun) Jun: 94.00 (18Jun)
2m: 5.71  5.59 (10Jul) Sep: 94.83 (16Sep)
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 19
Building the Curve Using Futures
¾ Find spot rate to expiry of first futures contract
9Interpolate from cash rates
¾ Calculate 90day forward rate from expiry
9100futures price less adjustment factor
¾ Combine to give spot rate to 90 days from expiry
¾ Extrapolate to expiry of next futures contract
¾ Repeat steps above for successive futures
contracts
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 20
Extending the Curve Using Swaps
Today Year 1 Year 2 Year 3
C1 C2 C3
Bond Price
9Cash flows are known from the swap coupon
9The curve has already been built out to 2 years using
futures
9D1 and D2 are known, calculate D3 by bootstrapping
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 21
Bootstrap Method with Swaps
¾ Example:
9Three year swap rate = 5%
9D1 = 0.9655 D2 = 0.9259
9100 = 0.9655 x 5 + 0.9259 x 5 + 105 x D3
9D3 = (100  4.8275  4.6295) / 105 = 0.8623
¾ Repeat with 4, 5, . . . year swaps to
complete the curve
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Lab: Delmar Capital
Copyright © 19962006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 23
Delmar Capital: Yield Curves
5.4%
5.3%
5.2%
5.1%
5.0%
4.9%
4.8%
4.7%
4.6%
4.5%
0 500 1000 1500 2000
Futures Sw aps Adjusted Futures
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