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Derivative Instruments

FI6051
Finbarr Murphy
Dept. Accounting & Finance
University of Limerick
Autumn 2009

Week 12 – US Treasury Futures


Treasury Futures
 US Treasury Futures are listed on CBOT
 Euro (Bund) Futures are quoted on Liffe
 This lecture will look primarily at US T-Futures

 Remember:
A future is an exchange-traded derivative. A future
represents an agreement to buy/sell some
underlying asset in the future for a specified
price. Both can be for physical settlement or
cash settlement.
Treasury Futures
 Futures on US Treasury notes are traded with
underlying maturities of 2, 5 and 10 years.

 This means that Futures are traded where the


deliverable is a US T-Note with an (exchange
specified) maturity range

 For this lecture, we’ll look at T-Note Futures


contracts with a 10-year bond
Treasury Futures
 The Futures contract typically has less than 6-
months to maturity

 For a 10-Year Futures note, at expiration of the


futures contract, the deliverable maturity “must
be no less than 6 years 6 months and no greater
than 10 years from the first day of the contract
expiration month” (source: CBOT)

 The long futures contract holder must pay an


invoice price equaling “the futures settlement
price times a conversion factor plus accrued
interest” (source: CBOT)
Treasury Futures
Treasury Futures
 Let’s look more closely at the quoted futures
price:

 The futures price at 10:00AM Nov 22nd , 2007


= 113’15
= 113 + (15/32)
= 113.4688
 This is a % expression of the future face value
Treasury Futures
 The face value of a Futures contract is $100,000.
This means a 1% change results in a $1,000
change in the futures contract
 At the futures expiration, rather than deliver
bonds, the vast majority of such contracts are
rolled
 I.e., the offsetting trades in the expiring contract
are combined with corresponding new positions
in the next contract month
 Less than one percent of all financial futures
traded at the Chicago Board of Trade result in
the actual delivery of financial instruments.
Treasury Futures
 On delivery, the short contract holder can deliver
any number of bonds specified by the exchange
in the futures contract

 Because the range of deliverable bonds is large,


each having different maturities and coupons, a
conversion factor is used to standardize the
futures price
Treasury Futures
 At expiration, the long futures contract holder
must pay
(Quoted Futures Price x Conversion Factor) + Accrued Interest
 For each $100 face value of bond delivered

 E.g. Assume the


 quoted futures price is 95’16
 The conversion factor is 1.25
 The accrued interest on the bond is 2.25
 The long contract holder must pay
 95.50x1.25+2.25 = $121,625
 for each $100,000 of face value delivered
Treasury Futures
 How do we calculate the conversion factor?

 For starters, CBOT provide a comprehensive


conversion factor list for each of the deliverable
bonds. This information is widely available and
we will calculate it ourselves
Treasury Futures

"@" indicates the most recently auctioned U.S. Treasury security eligible for delivery
This is also the 10year benchmark Note at time of writing
Treasury Futures
Treasury Futures
 The conversion factor is the face value of all of
deliverable bonds on the first day of the delivery
month assuming a 6% semi-annual coupon

 In our case, we can calculate the bond value at


20
2.125 100

i =1 1.03i
+
1.03 20

≈ $87.21
 Dividing by the face value give us the conversion
factor
= 0.8721
Treasury Futures
 The bonds that can be delivered cost:
 Quoted Price + Accrued Interest
 The short futures contract holder must pay
(Quoted Futures Price x Conversion Factor) + Accrued
Interest

 Therefore, the cheapest to deliver bond will be


the one where
Quoted Price –(Quoted Futures Price x Conversion Factor)

 is a minimum
Treasury Futures
 A number of factors decide on which bond is the
cheapest to deliver,
 E.g. when bond yields are less than 6%, high
coupon, short maturity bonds are more likely to
be cheapest
 And visa versa

 At any one time, the cheapest-to-deliver bond


(for specific contracts) is details by data
distributors (reuters, bloomberg, etc)
Treasury Futures
 Determining the quoted futures price

 From lecture 2.2, we know that the futures price


on an asset with a known income stream is
given by
F0 = ( S 0 − I )e rT

 Where T is the time to contract maturity†


 And r is the risk free rate for duration T

Because the contract specifies a delivery month, calculations are less concise

Treasury Futures
 Let’s use an example,
 Assume that the cheapest to deliver is
 4¼% T-Note
 Maturity = 15/11/2017
 Semi-annual coupon
 Last Coupon Date = 15/11/2007
 Next Coupon Date = 15/05/2008
 Futures contract expiry = 19/12/2007
 Conversion Factor = 0.8721
 Clean Bond Price = 101’31+ (see next Slide)
 Today’s Date = 22/11/2007
Treasury Futures
Treasury Futures
 First, calculate the bond cash (dirty) price
 Cash Price = Clean Price + Accrued Interest
= 101.9844 + (7/182.5)*(4¼/2)
= 101.9844 + 0.0815
= 102.0659

 Next, calculate the current value of the future


cash flows, I
 This involves calculating the present value of the
bond coupons during the life of the futures
contract
Treasury Futures
 But, before the future contract expires, there are
no bond coupons, so I = 0

 Now, let’s assume that the risk free rate


between today (22/11/07) and contract expiry
(19/12/07) is 3.15%

F0 = ( S 0 − I )e rT
F0 = (102.0659 − 0)e 0.0315( 27 / 365 )

F0 = 102.3040
 This is the dirty Futures Price
Treasury Futures
 On delivery of the bonds (15/12/05), the
receiver will owe the accrued coupons on the
bond, the clean futures price must be calculated

(
F0 = 102.3040 − ( 4 1 4 / 2 ) . 34
182.5
)
 Where the last part of the equation details the
accrued interest on the bond at 19/12/2007

F0 = 101.9092
Treasury Futures
 The final step is to standardize the futures price
by dividing by the conversion factor

F0 = 101.9092 / 0.8721
F0 = 116.855

 The actual futures price was 113’15


 Notwithstanding some potential errors such as
daycount counventions and the risk free rate of
interest, it is clear that the underlying bond used
is not the Cheapest To Deliver
Treasury Futures
 We should therefore continue to price the
Futures for the 13 other deliverable bonds until

Quoted Price –(Quoted Futures Price x Conversion Factor)

 is a minimum

 See Hull, Page 136, example 6.2 for another


pricing example.
Further reading
 Hull, J.C, “Options, Futures & Other Derivatives”,
2009, 7th Ed.
 Chapter 6
Derivative Instruments
FI6051
Finbarr Murphy
Dept. Accounting & Finance
University of Limerick
Autumn 2008

Week 12 – Duration & Convexity


Duration
 We’ve seen how to construct a yield curve from
zero and coupon bearing bonds

 We need to understand how this curve moves


over time before we can mathematically model
its behavior

 Similarly, if we can better describe interest rate


curve movements both mathematically and
fundamentally, we are in a better position to
make value judgments on future behavior, and
make profits from those judgments.
Duration
 The most typical movement is a parallel shift.
I.e. all points on the curve move up or down by
the same amount

Source:RiskGlossary.com
Duration
 Duration† can be defined as the change in the
value of a fixed income security that will result
from a 1% change in interest rates.

 Duration is a weighted average of the maturity


of all the income streams of a coupon bearing
bond

 So a 5-year zero coupon bond will have a


duration of 5 years


Also know as Macaulay Duration
Duration
 A 3-year duration means the bond will decrease
by 3% if interest rates (across the curve)
increase by 1%

 A Bond price is give by:


n
B = ∑ ci e − yti

i =1

 Where y is the continuously compounded yield


Duration
 The Duration of the bond is defined as

∑i =1 i i
n − yti
t c e
D=
B
 Which can be re-written as

n
 ci e − yti 
D = ∑ ti  
i =1  B 

 The square bracket term is the ratio of PV of the


cash flows to the bond price
Duration
 Remember:
n
B = ∑ ci e − yti

i =1

 So ∂B n
= −∑ ci ti e − yti

∂y i =1

 But
D × B = ∑i =1 ti ci e
n − yti

 Therefore ∂B
= −D × B
∂y
Duration
 Rewritten
∂B
− D∂y =
B

 Think about this! The duration gives us a good


indication how the bond will behave when a
small parallel shift in the yield curve occurs
Duration
 Consider the following bond:
 2.5 years to maturity
 6.5% coupon paid quarterly
 4.5% yield (continuously compounded)

n
 ci e − yti 
D = ∑ ti  
i =1  B 
Duration
 Example
Time Cash PV Cash Time x
Weight
(years) Flow Flow Weight
0.25 1.625 1.6068 0.0154 0.0038
0.5 1.625 1.5888 0.0152 0.0076
0.75 1.625 1.5711 0.0150 0.0113
1 1.625 1.5535 0.0148 0.0148
1.25 1.625 1.5361 0.0147 0.0183
1.5 1.625 1.5189 0.0145 0.0218
1.75 1.625 1.5019 0.0144 0.0251
2 1.625 1.4851 0.0142 0.0284
2.25 1.625 1.4685 0.0140 0.0316
2.5 101.625 90.8118 0.8678 2.1696
104.6427 1.0000 2.3323
Duration
 Modified Duration

 Market conventions usually express y as semi-


annual compounded yield rather than
continuously compounded yield

D
D =
*

1+ y m

 Where D* is the modified duration


 And m is the compounding frequency per year
Duration
 Portfolio Duration

 The duration of a bond portfolio, is defined as


the weighted average of the individual bonds in
the portfolio

 So, you have an estimate for the change in the


bond portfolio value given a change in yields for
all bonds in the portfolio

 We are making the assumption that yields on all


bonds in the portfolio change by the same
amount
Duration
 Duration applies to small changes in yield δy

 The usefulness of duration declines for larger


changes in yield
Convexity
 We need a calculation to tell us how the bond
will perform with a larger change in yields

 In other words, we want a measure of the bond


(or portfolio) convexity.
Convexity
 What factors influence duration & convexity?

 As yields decrease, duration increases


 Convexity is greatest when
 Longer maturities
 lower coupons
 Zero-coupon bonds have the highest convexity
Convexity
 Convexity is given by the following formula

∑i =1 i i e
n 2 − yti
1∂ B 2 c t
C= =
B ∂y 2
B
 Taking convexity into consideration,

∂B
= − D∂y + 2 C (∂y )
1 2

B
Portfolio Management
 Duration and convexity are useful indicators o
how bond prices change with changing yields

 By construction a portfolio of bonds, we can


“engineer” our portfolio to have particular
performance characteristics under certain
characteristics

 We can therefore reduce the impact of parallel


shifts in the yield curve
Non-parallel shifts
 Duration and Convexity are not useful when it
comes to non-parallel shifts

Source:RiskGlossary.com
Further reading
 Hull, J.C, “Options, Futures & Other Derivatives”,
2009, 7th Ed.
 Chapter 4

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