HEDGING INTEREST RATE RISK

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Derivative Securities

 Stocks and Bonds represent claims to specific

future cash flows
 Derivative securities on the other hand represent
contracts that designate future transactions
 Currently, there are approximately 300 million
derivative contracts outstanding with a market
value of around $50 Trillion
 While equity trading is centered in New York
(NYSE, NASDAQ), derivative markets are
centered in Chicago (CME, CBOT, CBOE)

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 Futures Contracts
A futures contract describes a transaction (Commodity, Price,
and Quantity) that will be made in the future.

In “Trading Places” (1983), Eddie

Murphy and Dan Ackroyd were trading
Orange Juice Futures

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 Futures Contracts
Orange Juice futures (FCOJ) are traded
on the NYBOT (New York Board of
Trade)

Contract = 15,000 Lbs. ; Price = cents/lb

Exp Open High Low Settle Change Interest

MAR 85.75 86.00 84.20 85.20 -1.25 18,849

MAY 88.20 88.40 86.60 87.70 -1.20 14,354
JUL 88.50 88.50 87.60 88.45 -1.15 1,889
NOV 91.50 91.50 90.00 89.95 -1.65 905

Every contract must have two participants (Long = Buy, Short = Sell)

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Exp Open High Low Settle Change Interest
MAR 85.75 86.00 84.20 85.20 -1.25 18,849
MAY 88.20 88.40 86.60 87.70 -1.20 14,354
JUL 88.50 88.50 87.60 88.45 -1.15 1,889
NOV 91.50 91.50 90.00 89.95 -1.65 905

A long position in
MAR FCOJ would A short position in
require you to JUL FCOJ would
purchase FCOJ in require you to
March deliver FCOJ in
March

Now Mar Apr May June July Aug

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Dealers pass orders along to the pit
traders who create a contract.

Long Short

3 May Contracts (15k * 3 = 45k lbs.) @ 88 cents/lb.

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The contracts are then passed along to the
exchange who will become the middleman

Note: the exchange is holding two contracts with a

zero net position

Short (3 contracts) Long (3 contracts)

Long (3 Contracts) Short (3 Contracts)

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Contract Completion (FCOJ)

First Notice Date

Last Trading Day Last Delivery Date

First Delivery Date

Last Notice Date

May 1 May 8 May 10 May 23 May 31

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Contract Completion
Suppose that, on May 3, the short position decides that he wants out
of the contract. The current May futures price is .92 per Lb

He could take a long position on 3 May

3 Contracts contracts at a price of .92/LB
(Short) @ .88/LB

This would effectively “cancel out” the

previous position at a loss of 3 cents/LB
.03*45,000 = $1,350 Loss

May 1 May 8 May 10 May 23 May 31

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 Contract Completion
Suppose that, on May 12, the short position opts for delivery of the
commodity. The current spot price is .84 per Lb

3 Contracts The Exchange

3 Contracts (Long)
(Short) @ .88/LB Pairs up Longs
@ .88/LB
with Shorts

Profit = (.88-.84)*45,000
Loss = (.88-.84)*45,000
= $1,800 = $1,800

May 1 May 8 May 10 May 23 May 31

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Types of Futures
Currencies Agriculture Metals & Financial
Energy
British Pound Lumber Copper Treasuries
Euro Milk Gold LIBOR
Japanese Yen Cocoa Silver Municipal Index
Canadian Dollar Coffee Platinum S&P 500
Mexican Peso Sugar Oil DJIA
Cotton Natural Gas Nikkei
Wheat Eurodollar
Cattle
Soybeans

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 Stock Index Futures
 Stock Index Futures have no underlying
commodity
 S&P 500
 NYSE Composite
 Value Line Index

These contracts are settled on a cash basis:

Short Position Profits = (F – S)*500

Long Position Profits = (S – F)*500

F = Futures Price, S = Current Spot Price Hedging Interest Rate - skw 10/15/2018 12
 Regardless, futures positions are making “bets”
on the price of the underlying commodity.

Profits from
Long Position
price increases

Short Position Profits from price

decreases

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 Treasury Futures
Treasury futures first began trading on the CME in 1976. The
underlying commodity is a Treasury Bill, Note, or Bond.
Remember, when interest rates rise, Treasury prices fall!

Profits from Profits from

Long Position price decreasing
increases interest rates

Profits from Profits from

Short Position price decreases increasing
interest rates

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 T-Bill Futures

With T-Bill Futures, the commodity is a $1M

Treasury Bill with 3 months left until maturity

Contracts exist for February, March, April, June,

September, and December delivery

Last Trading
First Trading Delivery Day
Day (T-Bill
Day
Auction)

Nov 16, 2004 Feb 14 Feb 18

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 T-Bill Yields
We have already calculated the Yield to Maturity for 90
Day Treasury Bills

Face Value - Price 365

YTM = *100
Price t Days left until
maturity

Annualized
Often, the yield referred to for Treasury Bills is the
discount yield
Annualized with a 360 day
year
Face Value - Price 360
DY = *100
Face t
Value

Interest As a percentage of Face

Value rather than Price
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 Pricing T-Bill Futures
T-Bill futures are listed using the IMM (International Monetary
Market) Index

IMM = 100 – Discount Yield

For example, if the Price of a $100, 90 Day Treasury were $98.

$100 - $98 360

DY = *100 = 8%
$100 90

IMM = 100 – 8 = 92

Every .005 increase in the IMM raises the value of a long T-Bill
position by $12.50 ($25 per basis point).
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Eurodollar

 The term Eurodollar refers to deposits

denominated in a currency other than the
bank’s home currency
 European banks offer Eurodollar time deposits
(terms can range from overnight to several years)
 European banks will lend dollar reserves to each
other at the LIBOR rate (London Inter-bank
Offering Rate)

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 Eurodollar Futures (1981)
 The underlying commodity is a $1M 3 month Eurodollar time
deposit. However, these deposits are not marketable.
Therefore, Eurodollar futures are settled on a cash basis
 Eurodollar futures can be treated like a T-Bill Future

IMM = 100 – LIBOR

Every .005 increase in the IMM raises the value of the long position
by $12.50. ($25 per basis point)

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Eurodollar Futures vs. T-Bill
Futures
T-Bill Futures Eurodollar
Futures
Volume (2001) 123 730,000
($123M) ($730B)

•As the Eurodollar market grew, it became more liquid

relative to the T-Bill market
•LIBOR is a “risky” rate. Therefore, it correlates better with
other risks

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Pricing T-Bill/Eurodollar
Futures
Suppose that a march Eurodollar future (expires in 47 days)
was currently selling for 94.555

We also have the current money rates

(LIBOR)

Term Yield
IMM = 100 - LIBOR
1 Month 5.18%
3 Months 5.3125
This contract is paying an
6 Months 5.6438 annualized (yield) of 100
– 94.555 = 5.445%
1 Year 5.8163
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 Term Yield The Eurodollar Future
currently has an annual
1 Month 5.18% yield of 5.445%

3 Months 5.3125 5.445

= 1.3613%
4
6 Months 5.6438
1 Year 5.8163 $1M (1.013613) = $1,013,613

Delivery of a
Purchase/Sale $1M 90Day Receipt of
of Eurodollar Eurodollar $1,013,613
Future account

Now Day 47 Day 137

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90 Days
 Use a linear interpolation to Term Yield
get the 47 day spot rate
1 Month 5.18%
47
5.2175% 360 = .6811%
3 Months 5.3125
47 Day Return
6 Months 5.6438
Yield
1 Year 5.8163

5.3125%

5.2175%

5.18%

Term
1 Month 3 Months

47 Days
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 Use a linear interpolation to get Term Yield
the 137 day spot rate
1 Month 5.18%
137
5.4855% 360 = 2.0875%
3 Months 5.3125
137 Day Return
6 Months 5.6438
Yield
1 Year 5.8163

5.6438%

5.4855%

5.3125%

Term
3 Months 6 Months

137 Days
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Term Yield The Eurodollar Future
currently has an annual
S(47) .6811% yield of 5.445%
S(137) 2.0875%
5.445
= 1.3613%
4

S(47) = .6811%

S(137) = 2.0875%

Now Day 47 Day 137

1.020875
1.006811 =1.01397 = 1.3970% = F(47,90)
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The Eurodollar Future The implied no-arbitrage interest
currently has an annual yield rate between 47 and 137 days is
of 5.445% (1.3613%) 5.588% (1.3970%)
IMM = 100 – 5.445 = 94.555 IMM = 100 – 5.588 = 94.412

The interest rate on the futures contract is to low!!

or, alternatively
The price of the futures contract is too high!!!

Borrow at Futures Rate (Sell a

Futures contract)

Now Day 47 Day 137

Profit = 1.013970 – 1.013613 $1M = $357 Lend at the implied forward rate

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 How do you lend at the implied
forward rate?

By lending for the entire 137 day period and

borrowing for the first 47 days, your net position is as
a lender for the last 90 day period!

Borrow

Lend

Now Day 47 Day 137

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Go Short on a the futures contract at a
price of 94.555
Lend $992,885 for 137 days at the spot
rate of 5.4855% (You will be paid
$1,013,613 in 137 days)
Borrow $992,885 for 47 days at the
spot rate of 5.2175%
Receive $1,013,613 from the original
137 day loan
Pay $1,013,613 on the 90 day loan

Borrow $1,000,000 at the rate

established by the futures contract
(5.445%)
Pay back the $992,885 Loan + interest
($999,643)

Now Day 47 Day 137

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 On the 47th day, you get a net
cash flow of $352. This is the
present value of $357 dollars to
be received in 90 Days (you get
the profits on day 47 rather
than day 137)

Date Cash In Cash Out

Now $992,855 $992,855
47 Days $1,000,000 $999,648
137 Days $1,013,613 $1,013,613
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 The no arbitrage price of a price of a futures
contract will reflect the forward rate implied by the
yield curve. But remember, the forward rate is the
expected future spot rate

Futures Rate = Expected Future Spot Rate

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Treasury Note/Bond Futures

Contract Underlying Asset

20 Year T-Bond 15-20 Year T-Bond with
(FV = $100,000) a 6% coupon
10 Year T-Note 6.5 – 10 Year T-Note
(FV = $100,000) with a 6% coupon
5 Year T-Note 4.25 – 5 Year T-Note
(FV = $100,000) with 6% coupon
2 Year T-Note 1.75 – 2 Year T-Note
(FV = $200,000) with 6% coupon
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The commodity for T-Note/Bond futures is a
Treasury with a 6% annual coupon. What if there
are no 6% bonds available?

Treasury Note/Bond futures are based on cheapest to

deliver (CTD) basis.

Requirements for Delivery

1. The Face value of the delivered
notes must sum to $100,000 (per
It’s the short position’s
contract) option to deliver whatever
has the lowest cost
2. All the notes must have the same
characteristics (term, coupon)

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 Conversion Factors

Suppose that you have a short position on a a Treasury bond future that expires
this month (any bond with an expiration date between 2020 and 2030 would be
acceptable for delivery:

Maturity Coupon Bid Price

May 2020 8.75% 149:16
August 2023 7.25% 134:21
August 2025 6.875% 132:21

The cheapest to deliver bond will always be the lowest coupon, longest
maturity bond

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Conversion Factors
Maturity Coupon Conversion
Factor
May 2020 8.75% 1.2695
August 2023 7.25% 1.1331
August 2025 6.875% 1.1017

The conversion factors are meant to make all deliverable bonds “equally
attractive”

Invoice Contract Futures Conversion Accrued

=
Amount Size Price Factor Interest

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Requirements for Delivery
1. The Face value of the delivered
notes must sum to $100,000 (per
It’s the short position’s
contract) option to deliver whatever
has the lowest cost
2. All the notes must have the same
characteristics (term, coupon)

To Find the cheapest to deliver bond/note

Conversion Current Spot

Maximize Futures -
Factor Price
Price

Note: This will always be negative

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 Pricing T-Note/Bond Futures

20 Year 20 Year
Treasury Treasury
Delivered Expires

Now March March

2025

The Logic behind pricing treasury note/bond futures is the same as

with T-Bill futures. The price should reflect expectation of future spot
rates. However, note that expectations of future spot rates are
already incorporated in bond prices!

Expected
Futures Price = Future + (Carry Costs – Carry Return)
Treasury
Price
Arbitrage Costs
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 Hedging
Lets return to the 5 year Treasury Note example. Interest rates are currently
5% and are expected to stay at 5% (the yield curve is flat). A 5 year treasury
note with $500,000 of face value and a 5% annual coupon.

$25,000 $25,000 $25,000 $25,000 $525,000

P = + + + + = $500,000
(1.05) (1.05) 2 (1.05) 3 (1.05) 4 (1.05) 5

We already calculated the Modified Duration for this bond

MD = 4.3

That is, a 100 basis point increase in the interest rate lowers
this bond’s price by (.043)($500,000) = $21,500

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 Hedging with T-Bill Futures

Profits from Profits from

Short Position price decreases increasing
(Futures) interest rates

If you are long in bonds, you are worried about rising interest rates (rising
interest rates lower the value of your bond). Therefore, you could hedge
this risk by holding short positions in T-Bill futures (Short positions make
money when interest rates drop)

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 Hedging with T-Bill Futures

Profits from Profits from

Short Position price decreases increasing
(Futures) interest rates

A perfect hedge eliminates all your interest rate risk

Change in value of Change in Change in

# of Futures value of each = value of bond
Value of Futures =
Contracts contract position
position

$2,500 $21,500

$21,500/$2,500 = 8.6 Contracts

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 Hedging with T-Bill Futures
Change in value of Change in Change in
# of Futures value of each = value of bond
Value of Futures =
Contracts contract position
position

$2,500 $21,500

$21,500/$2,500 = 8.6 Contracts

Dollar Duration of
Bonds MD(B) FV(B) 4.3 $500K
Hedge Ratio = = =
Dollar Duration of MD(F) FV(F) .25 $1M
Futures

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 One Problem…..

160 156.71

140
123.41
120
100
86.38
80
60
45.35 X 100
39.18
40
20
0
1Yr 2Yr 3Yr 4Yr 5Yr

Here we have the 5 year Treasury key durations. Note that

this bond’s price is most sensitive to the 5 Year spot rate.
The future’s value is based on the 90 day treasury rate
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Change in value of Change in Change in
# of Futures value of each = value of bond
Value of Futures =
Contracts contract position
position

$2,500 $21,500

$21,500/$2,500 = 8.6 Contracts

We assumed that the 90 Day T-Bill rate and the 5 Year Rate were
perfectly correlated. Suppose, instead, that we have

Change in 90
Change in 5
= (.5) Day Treasury
Year Rate
Rate

The hedge ratio drops to 4.3!

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 Hedging with T-Note/Bond
Futures
 The strategy would be the same. If you are worried
about increasing interest rates, take a short position
in futures contracts. The hedge ratio for T-
Note/Bond futures depends on
 Size of bond position relative to the size of a futures
contract
 Duration of your bond position relative to the duration of
the underlying asset in the futures contract
 Correlation between the interest rate affecting your bond
portfolio and the interest rate influencing the futures price
 Impact of interest rate on CTD bond

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