Global Edition

Chapter 26
Interest-Rate
Futures Contracts
 Mechanics of Futures Trading

 A futures contract is a firm legal agreement between a

buyer (seller) and an established exchange or its
clearinghouse in which the buyer (seller) agrees to take
(make) delivery of something at a specified price at the end of
a designated period of time.
 The price at which the parties agree to transact in the future is
called the futures price.
 The designated date at which the parties must transact is
called the settlement date.
 The contract with the nearest settlement date is called the
nearby futures contract.
 The next futures contract is the one that settles just after the
nearby contract.
 The contract furthest away in time from settlement is called
the most distant futures contract.
 Mechanics of Futures Trading
(continued)

 Opening Position
 When an investor takes a position in the market by buying a
futures contract, the investor is said to be in a long position or
to be long futures.
 If, instead, the investor’s opening position is the sale of a
futures contract, the investor is said to be in a short position or
short futures.
 Liquidating a Position
 A party to a futures contract has two choices on liquidation of
the position.
i. First, the position can be liquidated prior to the settlement
date.
ii. The alternative is to wait until the settlement date.
 For some futures contracts, settlement is made in cash only.
Such contracts are referred to as cash-settlement contracts.
 Mechanics of Futures Trading
(continued)

 Role of the Clearinghouse

 Associated with every futures exchange is a clearinghouse.
 A futures contract is an agreement between a party and a
clearinghouse associated with an exchange.
 When an investor takes a position in the futures market, the
clearinghouse takes the opposite position and agrees to
satisfy the terms set forth in the contract.
 Because the clearinghouse exists, the investor need not
worry about the financial strength and integrity of the party
taking the opposite side of the contract.
 Besides its guarantee function, the clearinghouse makes it
simple for parties to a futures contract to unwind their
positions prior to the settlement date.
 Mechanics of Futures Trading
(continued)

 Margin Requirements
 When a position is first taken in a futures contract,
the investor must deposit a minimum dollar amount
per contract as specified by the exchange.
 This amount, called the initial margin, is required as
deposit for the contract.
 At the end of each trading day, the exchange
determines the settlement price for the futures
contract.
 This price is used to mark to market the investor’s
position, so that any gain or loss from the position is
reflected in the investor’s equity account.
 Mechanics of Futures Trading
(continued)

 Margin Requirements
 The maintenance margin is the minimum level (specified
by the exchange) by which an investor’s equity position
may fall as a result of an unfavorable price movement
before the investor is required to deposit additional margin.

 The additional margin deposited, called the variation

margin, is the amount necessary to bring the equity in the
account back to its initial margin level.
 Futures Versus Forward Contracts

 Just like a futures contract, a forward contract is an

agreement for the future delivery of the underlying at a
specified price at the end of a designated period of time.
 Futures contracts are traded on organized exchanges and are
standardized agreements as to the delivery date (or month)
and quality of the deliverable.
 A forward contract differs in that it has no clearinghouse,
usually has nonstandardized contracts (i.e., the terms of each
contract are negotiated individually between buyer and seller),
and typically has nonexistent or extremely thin secondary
markets.
 Because there is no clearinghouse that guarantees the
performance of a counterparty in a forward contract, the
parties to a forward contract are exposed to counterparty risk.
 Risk and Return Characteristics
of Futures Contracts
 The buyer of a futures contract will realize a profit if the futures
price increases; the seller of a futures contract will realize a
profit if the futures price decreases.

 If the futures price decreases, the buyer of a futures contract

realizes a loss while the seller of a futures contract realizes a
profit.

 When a position is taken in a futures contract, the party need not

put up the entire amount of the investment. Instead, only initial
margin must be put up.
 Leverage

 Futures markets can be used to reduce price risk.

 Hedging
 Interest-Rate Futures Contracts

 The two major exchanges where interest rate futures

are traded are those operated by the Chicago
Mercantile Exchange Group (CME Group) and
Euronext Liffe.
 The exchanges offer bond futures and short-term
interest rate futures.
 There are two major contracts used for risk control by
institutional investors:
1) Eurodollar futures and
2) U.S. Treasury futures.
 Interest-Rate Futures Contracts
(continued)

 Eurodollar Futures
 A Eurodollar futures contract is quoted on an index
price basis.
 From the futures index price, the annualized futures
three-month LIBOR is determined as follows: 100
minus the index price.
 A Eurodollar futures index price of 94.52 means the
parties to this contract agree to buy or sell the
three-month LIBOR for 100 – 94.52 = 5.48 where
5.48 refers to 5.48%.
 Since the underlying is an interest rate that obviously
cannot be delivered, this contract is a cash settlement
contract.
 Currently Traded Interest-Rate
Futures Contracts
 Eurodollar Futures
 The principal value for a Eurodollar Futures contract is $1 million.
 A one-tick change in the index price for this contract is 0.01;
e.g. an index price change of 94.52 to 94.53 is 0.01 or one tick.
 An index price change from 94.52 to 94.53 changes the
three-month LIBOR from 5.48% to 5.47%.
 In terms of basis points, a one-tick change in the index price
means a 1-basis-point change in the three-month LIBOR.
 The simple interest on $1 million for 90 days is equal to
$1,000,000 × (LIBOR × 90/360)
 If LIBOR changes by 1 basis point (where 0.01% = 0.0001), then
$1,000,000 × (0.0001 × 90/360) = $25
 Hence, a one-tick change in the index price or, equivalently, a 1-
basis-point change in the three-month LIBOR means a $25
change in the value of the contract.
 Currently Traded Interest-Rate
Futures Contracts (continued)
 Eurodollar Futures
 To see how a Eurodollar futures contract is used for hedging,
suppose that a market participant is concerned that its borrowing
costs six months from now are going to be higher.
 A higher borrowing cost means a lower index price. To protect
itself, it takes a short (selling) position in the Eurodollar futures
contract such that a rise in short-term interest rates will increase
the index price. To see this, consider our previous illustration in
the Eurodollar futures at 94.52 (5.48% rate).
 Suppose at the settlement date the three-month LIBOR increases
to 6.00% and, therefore, the settlement index price is 94.00. This
means that the seller sold the contract for 94.52 and purchased it
for 94.00, realizing a gain of 0.52 or 52 ticks. The buyer must
pay the seller 52 × $25 = $1,300.
 The gain from the short futures position is then used to offset the
higher borrowing cost resulting from a rise in short-term interest
rates.
 Interest-Rate Futures Contracts

 Treasury Futures
 The most active bond derivatives contracts are the
Treasury futures contracts.
 These contracts are classified by maturity.
 The underlying for the Treasury bond futures
contract are certain Treasury coupon securities that
were originally issued as Treasury bonds.
 Treasury note futures contracts include the two-
year, five-year, and 10-year Treasury futures.
 Interest-Rate Futures Contracts
(continued)

 Treasury Bond Futures

 The underlying instrument for a Treasury bond futures
contract is $100,000 par value of a hypothetical 20-year
6% coupon bond.
 The futures price is quoted in terms of par being 100.
 Quotes are in 32nds of 1%. Thus, a quote for a Treasury
bond futures contract of 97-16 means 97 and 16/32nds, or
97.50.
 So if a buyer and seller agree on a futures price of 97-16,
this means that the buyer agrees to accept delivery of the
hypothetical underlying Treasury bond and pay 97.50% of
par value, and the seller agrees to accept 97.50% of par
value.
 Because the par value is $100,000, the futures price that the
buyer and seller agree to transact for this hypothetical
Treasury bond is $97,500.
 Interest-Rate Futures Contracts
(continued)

 Treasury Bond Futures

 The minimum price fluctuation for the Treasury bond futures
contract is a 32nd of 1%. The dollar value of a 32nd for a
$100,000 par value (the par value for the underlying Treasury
bond) is $31.25.
 The seller of a Treasury bond futures who decides to make delivery
rather than liquidate his position by buying back the contract prior to
the settlement date must deliver some Treasury bond.
 The CME Group allows the seller to deliver one of several
Treasury bonds that the CME Group declares is acceptable for
delivery.
 The specific bonds that the seller may deliver are published by
the CME Group prior to the initial trading of a futures contract
with a specific settlement date.
 Exhibit 26-1 shows the Treasury issues that the seller can select
from to deliver to the buyer of four Treasury bond futures
contract by settlement month.
 Exhibit 26-1 Treasury Bonds Acceptable for
Delivery and Conversion Factors

Maturity Mar. Jun. Sep. Dec. Mar. Jun. Sep. Dec. Mar.
Coupon Date 2011 2011 2011 2011 2012 2012 2012 2012 2013
6 3/4 08/15/26 1.0741 1.0735 ----- ----- ----- ----- ----- ----- -----

6 1/2 11/15/26 1.0500 1.0494 1.0490 ----- ----- ----- ----- ----- -----

6 5/8 02/15/27 1.0630 1.0625 1.0618 1.0613 ----- ----- ----- ----- -----

6 3/8 08/15/27 1.0385 1.0382 1.0377 1.0375 1.0370 1.0368 ----- ----- -----

6 1/8 11/15/27 1.0130 1.0127 1.0127 1.0125 1.0125 1.0123 1.0123 ----- -----

5 1/2 08/15/28 0.9466 0.9472 0.9475 0.9481 0.9485 0.9490 0.9494 0.9500 0.9504

5 1/4 11/15/28 0.9194 0.9200 0.9208 0.9213 0.9221 0.9227 0.9235 0.9242 0.9250

5 1/4 02/15/29 0.9187 0.9194 0.9200 0.9208 0.9213 0.9221 0.9227 0.9235 0.9242

6 1/8 08/15/29 1.0136 1.0136 1.0134 1.0134 1.0132 1.0132 1.0130 1.0130 1.0127

6 1/4 05/15/30 1.0281 1.0278 1.0277 1.0274 1.0273 1.0270 1.0269 1.0265 1.0264

5 3/8 02/15/31 0.9281 0.9287 0.9291 0.9297 0.9301 0.9307 0.9311 0.9318 0.9322

4 1/2 02/15/36 0.8078 0.8087 0.8095 0.8105 0.8113 0.8123 0.8132 0.8142 0.8151

4 3/4 02/15/37 ----- ----- ----- ----- 0.8398 0.8406 0.8413 0.8421 0.8427

5 02/15/37 ----- ----- ----- ----- ----- 0.8718 0.8725 0.8730 0.8737

4 3/8 02/15/38 ----- ----- ----- ----- ----- ----- ----- ----- 0.7918
 Interest-Rate Futures Contracts
(continued)

 Treasury Bond Futures

 To make delivery equitable to both parties, the
CME Group has introduced conversion factors for
determining the invoice price of each acceptable
deliverable Treasury issue against the Treasury
bond futures contract.
 The conversion factor is determined by the CME
Group before a contract with a specific settlement
date begins trading.
 The short must notify the long of the actual bond
that will be delivered one day before the delivery
date.
 Currently Traded Interest-Rate
Futures Contracts
 Treasury Bond Futures
 The price that the buyer must pay the seller when a Treasury
bond is delivered is called the invoice price, which is given
as:
invoice price = (contract size × futures contract settlement
price × conversion factor) + accrued interest

 In selecting the issue to be delivered, the short will select from

all the deliverable issues the one that costs less, i.e. the
cheapest-to-deliver (CTD) issue.
 Knowing the price of the Treasury issue, the seller can
calculate the return, which is called the implied repo rate.
 The cheapest-to-deliver issue is then the one issue among all
acceptable Treasury issues with the highest implied repo rate
because it is the issue that would give the seller of the futures
contract the highest return by buying and then delivering the
issue.
 Exhibit 26-2 Determination of Cheapest-to-Deliver
Issue Based on the Implied Repo Rate
Implied repo rate: Rate of return by buying an acceptable Treasury issue, shorting
the Treasury bond futures, and delivering the issue at the settlement date.
Deliver this issue Calculate return
Buy this issue at futures price (implied repo rate)

Acceptable
Deliver issue #1 Implied repo rate #1
Treasury issue #1

Acceptable Implied repo rate #2

Deliver issue #2
Treasury issue #2

Acceptable
Deliver issue #3 Implied repo rate #3
Treasury issue #3
…. …. ….

Acceptable
Deliver issue #N Implied repo rate #N
Treasury issue #N

The cheapest-to-deliver issue is that which produces the maximum implied

repo rate.
 Currently Traded Interest-Rate
Futures Contracts (continued)
 Treasury Notes Futures
 There are three Treasury note futures contracts: 10-year, five-year,
and two-year.
 All three contracts are modeled after the Treasury bond futures
contract and are traded on the CME Group.
 The underlying instrument for the 10-year Treasury note futures
contract is $100,000 par value of a hypothetical 10-year 6%
Treasury note.
 There are several acceptable Treasury issues deliverable by the short.
• An issue is acceptable if the maturity is not less than 6.5 years
and not greater than 10 years from the first day of the delivery
month.
• For the five-year Treasury note futures contract, the underlying is
$100,000 par value of a U.S. Treasury note.
 The underlying for the two-year Treasury note futures contract is
$200,000 par value of a U.S. Treasury note with a remaining
maturity of not more than two years and not less than one year and
nine months.
 Pricing and Arbitrage in the
Interest-Rate Futures Market
 There are several different ways to price futures contracts
with each approach relying on the “law of one price.”
 The “law of one price” states that a given financial asset
(or liability) must have the same price regardless of the
means by which it is created.
 The law of one price implies that the synthetically created
cash securities must have the same price as the actual
cash securities.
 Similarly, cash instruments can be combined to create
cash flows that are identical to futures contracts.
 By the law of one price, the futures contract must have
the same price as the synthetic futures created from cash
instruments.
 Pricing and Arbitrage in the
Interest-Rate Futures Market
(continued)
 Pricing of Futures Contracts
→ Suppose that a 20-year 100-par-value bond with
a coupon rate of 12% is selling at par. Also
suppose that this bond is the deliverable for a
futures contract that settles in three months. If
the current three-month interest rate at which
funds can be loaned or borrowed is 8% per year,
what should be the price of this futures contract?

→ Suppose that the price of the futures contract is

107. Consider the following strategy:
 Sell the futures contract at 107.
 Purchase the bond for 100.
 Borrow 100 for three months at 8% per year.
 Pricing and Arbitrage in the
Interest-Rate Futures Market
(continued)
 Pricing of Futures Contracts
→ The borrowed funds are used to purchase the bond, resulting in no
initial cash outlay for this strategy. Three months from now, the bond
must be delivered to settle the futures contract, and the loan must be
repaid. These trades will produce the following cash flows:

From Settlement of the Futures Contract:

Flat price of bond 107

Accrued interest (12% for 3 months) 3

Total proceeds (107 + 3) 110

From the Loan:

Repayment of principal of loan 100

Interest on loan (8% for 3 months) 2

Total outlay (100 + 2) 102

 Pricing and Arbitrage in the
Interest-Rate Futures Market
(continued)
 Pricing of Futures Contracts

→ This strategy will guarantee a profit of 8. Moreover, the profit

is generated with no initial outlay because the funds used to
purchase the bond are borrowed.

→ The profit will be realized regardless of the futures price at

the settlement date.

→ Obviously, in a well-functioning market, arbitrageurs would

buy the bond and sell the futures, forcing the futures price
down and bidding up the bond price so as to eliminate this
profit. This strategy is called a cash-and-carry trade.
 Pricing and Arbitrage in the
Interest-Rate Futures Market
(continued)
 Pricing of Futures Contracts

→ If the future price was 92 instead of 107, we could reverse

the process to make an arbitrage profit. This strategy is
called a reverse cash-and-carry trade.

→ There would be no arbitrage if the future price is 99. Hence,

the futures price of 99 is the theoretical futures price
because any higher or lower futures price will permit
arbitrage profits.
 Pricing and Arbitrage in the
Interest-Rate Futures Market
(continued)
 Theoretical Futures Price Based on Arbitrage Model
→ Considering the arbitrage arguments just
presented, the theoretical futures price can be
determined on the basis of the following
information:
1) The price of the bond in the cash market.
2) The coupon rate on the bond. In our example,
the coupon rate is 12% per year.
3) The interest rate for borrowing and lending
until the settlement date.
→ The borrowing and lending rate is referred to as
the financing rate. In our example, the financing
rate is 8% per year.
 Pricing and Arbitrage in the
Interest-Rate Futures Market
(continued)
 Theoretical Futures Price Based on Arbitrage Model
→ We will let:
• r = financing rate;
• c = current yield or coupon rate divided by the cash
market price;
• P = cash market price;
• F = futures price;
• t = time, in years, to the futures delivery date.
→ Now consider the following cash-and-carry trade
strategy that is initiated on a coupon date:
• Sell the futures contract at F.
• Purchase the bond for P.
• Borrow P until the settlement date at r.
 Pricing and Arbitrage in the
Interest-Rate Futures Market
(continued)
 Theoretical Futures Price Based on Arbitrage Model
→ The outcome at the settlement date is
From Settlement of the Futures Contract:
Flat price of bond F
Accrued interest ctP
Total proceeds F+ctP
From the Loan:
Repayment of principal of loan P
Interest on loan (8% for 3 months) rtP
Total outlay P+rtP
Profit (total proceeds – total outlay) (F+ctP) – (P+rtP)

→ In equilibrium with zero profit from the trade, we have:

F = P[1+t(rL– c)]
→ We could consider a reverse cash-and-carry trade strategy paralleling
the above.
 Pricing and Arbitrage in the
Interest-Rate Futures Market
(continued)
 Theoretical Futures Price Based on Arbitrage Model

 The theoretical futures price may be at a premium to the

cash market price (higher than the cash market price) or
at a discount from the cash market price (lower than the
cash market price), depending on (r – c).

 The term r – c is called the net financing cost because

it adjusts the financing rate (r) for the coupon
interest rate earned (c).
 Pricing and Arbitrage in the
Interest-Rate Futures Market
(continued)
 Theoretical Futures Price Based on Arbitrage Model

 The net financing cost is more commonly called the cost

of carry, or simply carry.

 Positive carry means that the current yield earned is

greater than the financing cost.

 Negative carry means that the financing cost exceeds

the current yield.
 Bond Portfolio Management
Applications
 Controlling the Duration of a Portfolio
→ By buying the appropriate number and kind of interest-
rate futures contracts, a pension fund manager can
increase the portfolio’s duration to the target level.
→ To illustrate, suppose that a manager is managing a
portfolio whose benchmark is the Barclays Capital
Intermediate Aggregate Index and has a duration of
3.68.
• Suppose further that the market value of the portfolio
on March 31, 2011 was $48,109,810.
• The portfolio holdings are shown in Exhibit 26-3.
• The portfolio duration is 2.97 and is less than that of
the benchmark duration of 3.68.
• This means that the portfolio has less interest rate
exposure (for a parallel shift in the yield curve) than
the benchmark.
 Exhibit 26-3 Portfolio Used for Hedging
Illustration

Market Effective
CUSIP Security Value Duration
COMCAST CABLE COMMUNICATIONS
00209TAA3 HOLDINGS
$367,082 1.84
05947UES3 BACM_02-PB2 498,539 0.58
07383FX52 BSCMS_04-PWR6 481,631 3.10
07386HNQ0 BALTA_04-12 170,260 0.10
07386HPX3 BALTA_04-13 81,731 0.10
… … … …
GN053230P GNMA 30YR 2003 PRODUCTION 88,083 3.52
GN060030P GNMA 30YR 2003 PRODUCTION 131,655 3.07
GN063230L GNMA 30YR 2000 PRODUCTION 59,712 2.78
GN063230Q GNMA 30YR 2004 PRODUCTION 30,165 2.94

Portfolio  $ 48,109,810 2.97

 Bond Portfolio Management
Applications (continued)
 Controlling the Duration of a Portfolio
→ Suppose that the manager wants to restructure the portfolio so
that its duration matches that of the benchmark. That is, the
portfolio manager seeks to follow a duration-matched strategy
and therefore the portfolio’s target duration is 3.68.
→ For a 100 basis change in interest rates, the portfolio’s target
dollar duration is then the product of 3.68% times the current
market value of the portfolio. Therefore, portfolio target dollar
duration = 3.68% × $48,109,810 = $1,770,110
→ The current portfolio duration is 2.97, so for a 100 basis point
change in interest rates,
portfolio current dollar duration = 2.97% × $48,109,810 =
$1,428,594
→ The difference between the target and the current dollar
duration for the portfolio is $341,516. This means that to get to
the target portfolio duration of 3.68, the portfolio manager must
increase the dollar duration of the current portfolio by $341,516.
 Bond Portfolio Management
Applications (continued)
 Controlling the Duration of a Portfolio
→ Suppose that the portfolio manager wants to use the
5-year T-note futures contract. The futures price on March 31,
2011 was 116.79.
→ Based on an analysis of this contract, the portfolio manager
determines that for a 100 basis point change in interest rates, the
futures contract will change by roughly $5,022.
→ If the portfolio manager buys C contracts, then the dollar
duration of the futures position for a 100 basis point change in
interest rates is the product of the number futures contract:
dollar duration of futures contract = $5,022 × C

• The portfolio manager wants the above equation to be equal

$341,516.
• Solving for $5,022 × C = $341,516, we get C = 68 contracts.
→ By buying 68 5-year Treasury note futures contracts, the portfolio
manager will increase the dollar duration of the portfolio by
$341,516 for a 100 basis point change in interest rates.
 Bond Portfolio Management
Applications (continued)
 Controlling the Duration of a Portfolio
 Since the notional amount of the futures contract is $100,000, this
means that the total notional amount of the futures position is
$6,800,000. The market value of the futures position given that the
future price is 116.79 is equal to
(116.79/100) × $100,000 × 68 = $7,941,720
 A formula to approximate the number of futures contracts
necessary to adjust the portfolio duration to a target level is
portfolio target dollar duration - portfolio current dollar duration
dollar duration of futures contract

 A negative value indicates the number of contracts that should be

sold; a positive value indicates the number of contracts that should
be purchased.
 In our example, it is
$1,770,110 - $1,428,594
approximate number of futures contract = = 68
$5,022
 Bond Portfolio Management
Applications (continued)
 Controlling the Duration of a Portfolio
 Suppose instead that the portfolio manager does not want
to duration match versus the benchmark but instead wants
the duration to be 90% of the benchmark. Since the
benchmark duration is 3.68, this means that the manager
wants the portfolio’s target duration to be 3.31. The
portfolio target dollar duration for a 100 basis point change
in interest rates is
 portfolio target dollar duration = 3.31% × $48,109,810 =
$1,592,435
 Then the approximate number of futures contract to
increase the duration is equal to $1,592,435 - $1,428,594
 33
$5,022
 Hence, 33 futures contracts should be purchased.
 Bond Portfolio Management
Applications (continued)
 Hedging
 Hedging is nothing more than a special case of interest rate
risk management where the target duration is zero.
 When the net profit or loss from the positions is exactly as
anticipated, the hedge is referred to as a perfect hedge.
 The difference between the cash price and the futures price
is the basis.
 The risk that the basis will change in an unpredictable way
is called basis risk.
 In bond portfolio management, typically, the bond to be
hedged is not identical to the bond underlying the futures
contract.
 This type of hedging is referred to as cross hedging.
 There may be substantial basis risk in cross hedging.
 Bond Portfolio Management
Applications (continued)
 Allocating Funds between Stocks and Bonds
 A pension sponsor may wish to alter the composition of its
assets by increasing bonds and decreasing stocks. A manager
could undertake costly process of buying bonds and selling
stocks. However, an alternative course of action is to use
interest-rate futures and stock index futures.
 Buying an appropriate number of interest-rate futures and
selling an appropriate number of stock index futures can
achieve the desired exposure to stocks and bonds. The
advantages of using financial futures contracts are:
1) transactions costs are lower,
2) market impact costs are avoided or reduced by allowing the
sponsor time to buy and sell securities in the cash market,
and
3) activities of the portfolio managers employed by the
pension sponsor are not disrupted.