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FI6051
Finbarr Murphy
Dept. Accounting & Finance
University of Limerick
Autumn 2009
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.
"@" 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
≈ $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
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
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
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
is a minimum
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.
†
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%
i =1
∑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
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
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
D
D =
*
1+ y m
∑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
Source:RiskGlossary.com
Further reading
Hull, J.C, “Options, Futures & Other Derivatives”,
2009, 7th Ed.
Chapter 4