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Yield Curve Modeling

Constructing the Curve with


Futures & Swaps

Copyright © 1996-2006 Investment Analytics


Ingredients for Building the Zero
Coupon Spot Curve
¾ Cash Rates
¾ FRA Rates (T-Bills)
¾ Futures Prices
¾ Swap Rates

Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 2
Lab: Constructing the Short End

Ask Bid Days


3 Month $ LIBOR 4.25% 4.23% 91
$ FRAs 3-6 4.40% 4.35% 91
6-9 4.55% 4.50% 92
9-12 4.70% 4.65% 91

Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 3
Lab: Constructing the Short End

¾ Excel Spreadsheet: Yield Curve


Modeling.xls
¾ Worksheet: Short End
¾ Use discount factor method
¾ See cell notes for hints

Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 4
Solution: Short End

Period DF Spot Rate


3 months 0.9894 4.2500%
6 months 0.9785 4.3486%
9 months 0.9672 4.4498%
12 months 0.9559 4.5519%
¾ Notes:
9 DF6-3 = (1 + Ask x Days / 360)
9 DF6 = DF6-3 x DF3
9 R6 = (-1 + 1/DF6) x 360 / (91 + 91)

Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 5
Futures Libor Rates

¾ Yield = 100 - Settlement Price


¾ Example:
9Futures price = 93.0
9Futures yield = 100 - 93.0 = 7.0%
¾ Note: this is not exactly the forward rate

Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 6
Futures & Forwards

¾ Assumption is often that 100-F = forward rate


¾ Not exact for several reasons:
9Interest differentials on margin surplus & funding
9Futures are marked to market
9“Convexity” - stochastic interest rates give rise to
differences (Cox, Ingersoll, Ross JFE)

Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 7
Convexity

Definition: Positive Convexity


Present value increases with rate decline
exceeds
Present value decline with rate increase
¾ What is the convexity of a Euro $ future and
an interest rate swap?
¾ Are convexity differences priced?

Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 8
Convexity: Future vs Swap

¾ Marking-to-market alters the convexity of a


future
9Gains/Losses are Settled Daily
9PV Gain/Loss = Gain/Loss
¾ Convexity Future: Approximately Zero
¾ Convexity of long swap (pay fix/rec
floating) is negative
9Fixed led +ve, Floating leg -ve

Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 9
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 © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 10
Lab: FRA-Futures 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: FRA-Futures
9 See cell notes for help

Copyright © 1996-2006 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 © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 12
Chart: FRA-Futures Convexity
1,200,000 Short FRA

1,000,000 Long Futures

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 © 1996-2006 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 © 1996-2006 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 © 1996-2006 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

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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:
∆S0-3 = [0.01 x 0.01 x (4.5 / 12) x 0.99] / 4 = 0.09375 bp
Average maturity of deposit period
¾ Second Contract:
∆S3-6 = [0.01 x 0.01 x (7.5 / 12) x 0.99] / 4 = 0.15625 bp
¾ Adjustment for 6 months = ∆S0-3 + ∆S3-6 = 0.25bp

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Adjustment Factors: Typical Values

9Six Months: 0.25bp


9One Year: 0.5bp
9Two Years: 1.0bp
9Three Years: 3.5 bp
9Five Years: 17bp
9Ten Years: 63bp

¾ Significant 3 years and beyond

Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 18
Building the Curve
Today F1 Start 90 days F2 Start
90 days
10-May 18-Jun 16-Sep 17-Sep
¾ CASH FUTURES
1w: 5.50 - 5.38 (17-May)
1m: 5.60 - 5.48 (10-Jun) Jun: 94.00 (18-Jun)
2m: 5.71 - 5.59 (10-Jul) Sep: 94.83 (16-Sep)

9 STEP 1: Interpolate spot rate to expiry of F1:


• R36 = 5.6% + (5.71% - 5.60%) x 8 / 31) = 5.628%
• D36 = 1 / (1 + R36 x 36 / 360) = 0.9944
9 STEP 2: Compute Forward Discount Factors:
• DF1 = 1 / (1 + 6% x 90/360) = 0.9852
• D126 = D36 x DF1 = 0.9797
• R126 = (-1 + 1 / 0.9797) x 360 / 126 = 5.92%

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Building the Curve Using Futures
¾ Find spot rate to expiry of first futures contract
9Interpolate from cash rates
¾ Calculate 90-day forward rate from expiry
9100-futures 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 © 1996-2006 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

¾ A swap is an exchange of an FRN for a bond


9The FRN trades at par on coupon payment dates
¾ FRN Price = 100 = D1C1 + D2C2 + D3C3 + 100D3

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
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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

¾ Excel Workbook: Yield Curve Modeling .xls


¾ Worksheet: Delmar Capital
¾ Build yield curve using:
9Cash & Futures
9Cash , Futures & Swaps
9Cash & Adjusted Futures
¾ See Notes & Solution

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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

Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 24