750 840003 RM RJS V Interest Rate Forwards and Futures

Copyright Oxford University Press
Derivatives and Risk Management

By Rajiv Srivastava
Forward Rate Agreement (FRA)

Interest Rate Futures on T-Bills
Euro-Dollar Futures
Treasury Bonds Futures

By Rajiv Srivastava
Chapter 6
Interest Rate Forwards and Futures
Interest Rate Derivatives

Interest rate derivatives have some
benchmark interest rate as underlying asset.
Derivatives on interest rates are used for
covering the risk of changing interest rates.
Most business face risk of changing profit
due to changes in the interest rates.
For some organizations like banks,
construction companies are extremely prone
to changing interest rates.

By Rajiv Srivastava
Chapter 6
FRA The Product

Pricing FRA
Hedging With FRA
Speculation with FRA
Arbitrage with FRA

By Rajiv Srivastava
Chapter 6
Forward Rate Agreement

Forward rate agreement, commonly referred
as FRA is a contract to deposit or borrow a
notional sum in future for a specified maturity
at interest rate fixed now.
FRA as a product is specified as follows:
Quotation of FRA
INR
3/9 months
Currency
Commencement
of deposit/lending
By Rajiv Srivastava
Maturity of
deposit/lending
6.00
6.50%
Deposit
Rate
Lending
Rate
(Bid Rate)
(Ask Rate)
Chapter 6
Borrowers FRA
Firms need to borrow capital.
Such firms need protection against rising
interest rate.
By booking FRA at ask rate they can freeze
the interest rate and hence the cost of
borrowing.

By Rajiv Srivastava
Chapter 6
Investors FRA
Firms surplus with capital need to lend funds.
Such firms need protection against falling
interest rate.
By booking FRA at bid rate they can freeze
the interest rate and hence the revenue from
lending.

By Rajiv Srivastava
Chapter 6
Settlement of FRA
Settlement of FRA is done by exchanging the differential

cash flow of contracted interest rate and the actual
benchmark on the notional principal.
With r = settlement rate, f = FRA rate, d = Nos of days in FRA contract, and P =
notional principal amount, the settlement amount for investor and borrower FRA are
1
d
Cash flow (Investor' s FRA) =
x(f - r) x
xP
(1+ r x d/365)
365
Cash flow (Borrower's FRA) =
1
d
x(r - f) x
xP
(1+ r x d/365)
365
The amount to be received under the borrowers 3/9 FRA at 6.5%

with actual interest rate at 7% would be Rs 2,40,907:
Amount to be received

By Rajiv Srivastava
1
182
x(0.07 - 0.065) x
x 1,00,00,000
(1+ 0.07 x 182/365)
365
2,49,315
= Rs 2,40,907
=
1.0349
=
Chapter 6
Pricing FRA
Term structure of interest rate implies forward interest

rates and forms the basis of pricing of FRA. Assume
following term structure up to 12 months:
Investment Horizon (months)
Yields (% annualised)
3
5.00
6
5.30
9
5.60
12
6.00
3-m interest rate expected to prevail after 3 months used

as a guide to quote 3/6 FRA. Mathematically,
(1+ 0r3)(1+3r6) = (1+0r6) or
(1+3r6) = (1+0r6)/(1+ 0r3)
180
360 = 1.0265 = 1.01383;
(1+3 r6 ) =
90
1.0125
1+ 0.050 x
360
gives 3 r6 = 0.01383, or equivalent to annualised
1+ 0.053 x

By Rajiv Srivastava
3 r6
= 5.53%
Chapter 6
Hedging with FRA

FRA is an independent contract that delinks
the actual investing or borrowing and serves
as effective tool for hedging.
FRA provides hedging against
1. Rising Interest Rates for borrowers, and

2. Falling Interest Rates for investors
Borrowers FRA is a contract that covers risk

of rising interest rate while investors FRA
protects against the falling interest rates.

By Rajiv Srivastava
Chapter 6
10
Hedging Rising Interest Rates
EXCEL Industries Ltd (EIL) would have a shortfall of Rs

500 lacs after 6 months for next 6 months. EIL have
been availing loan at MIBOR currently at 9%. The
borrowing cost is 10%.
The interest rates are expected to go up in next 6
months.
To hedge against rising interest rates, EIL buys a
MIBOR based 6/12 FRA from another bank, Forward
Bank (FB) at 9.25% for notional principal of Rs 500 lacs.

By Rajiv Srivastava
Chapter 6
11

We present the position of EIL under two situations after 6 months of
MIBOR being more than and less than the FRA contracted rate:
When MIBOR goes beyond the FRA contracted rate of 9.25% up to 10%
FB would pay EIL the differential of current MIBOR and agreed rate of
9.25% on notional principal of Rs 500 lacs for 180 days, discounted at 10%.
The amount to be paid by FB is
Cash flow to firm
1.
2.
3.
4.
1
180
x (0.10 - 0.0925) x
x 5,00,00,000
(1+ 0.10 x 180/360)
360
1,87,500
=
= Rs 1,78, 571
1.05
Interest cost for loan from CB = 5,00,00,000 x 0.10/2

= Rs 25,00,000
Maturity amount of FRA at 10% = 1,78,571 x 1.05
= Rs 1,87,500
Effective interest amount paid
= Rs 23,12,500
Effective borrowing cost
= 23,12,500/5,00,00,000 = 0.04625
equivalent to 9.25% p.a

By Rajiv Srivastava
Chapter 6
12

When MIBOR falls below the FRA contracted rate to 8.60%
In case the benchmark rate falls to 8.60% EIL would have to pay FB the
differential of actual and contracted rate as follows:
Cash flow to firm
1.
2.
3.
4.
1
180
x (0.0860 - 0.0925) x
x 5,00,00,000
(1+ 0.086 x 180/360)
360
1,62,500
== - Rs 1,55,800
1.043
Interest cost for loan from CB = 5,00,00,000 x 0.086/2 = Rs 21,50,000

Maturity amount of FRA at 10% = 1,55,800 x 1.043
= Rs 1,62,500
Effective interest amount paid
= Rs 23,12,500
Effective borrowing cost
= 23,12,500/5,00,00,000 = 0.04625
equivalent to 9.25% p.a

By Rajiv Srivastava
Chapter 6
13
Hedging Falling Interest Rates

Investing companies earn revenue by
lending.
While rising interest rates are welcome by
them a fall in interest rate is detrimental.
They need to protect against the expected
fall in yields.
Investing companies can lock-in the yield
offered by FRA just in the same manner as
the borrowers lock-in the cost of borrowing.

By Rajiv Srivastava
Chapter 6
14
Speculation with FRA

If one is neither an investor nor a borrower,
then position in FRA is speculative.
The rates offered by FRA are reflecting the
future expected rates of interest.
If one has a different view of future interest
rate than the one reflected by FRA, then
If future interest rate expected to be > FRA rate:
Book Investors FRA

If future interest rate expected to be < FRA rate:
Book Borrowers FRA
By Rajiv Srivastava
Chapter 6
15
Futures Contract on T-Bills

Pricing T-Bills
Quoting T-Bills Futures
Hedging with Futures on T-Bills
Speculation with T-Bills Futures
Arbitrage with T-Bills Futures
Implied Repo Rate
Pricing T-Bills Futures

By Rajiv Srivastava
Chapter 6
16
Futures on T - Bills
A futures contract on T-bills on expiry calls for
delivery of T-bills maturing 91 days
thereafter.
The price of T-bill, a function of interest rate
determines the price of futures on it.
Futures Contract on T-Bills

t=0
t = T (Maturity)
t = T + 91 days
Futures position
Initiated
Futures contract matures

T-Bill delivered
T-Bill matures
T-Bill

By Rajiv Srivastava
Chapter 6
17
Why Futures on T-Bills

One determinant of interest rate is the default
risk. The yields on corporate debt (bonds)
also include the risk premium for default.
T-bills is sovereign debt and can be assumed
to have no risk of default.
Also the liquidity in the sovereign debt is high
as compared to corporate bonds.
T-bills serve as an ideal instrument as an
underlying asset for interest rate futures.

By Rajiv Srivastava
Chapter 6
18
Pricing T-Bills
T-Bills are issued at discount to face value and

redeemed at face value on maturity.
For discount yield of 6% the amount of discount,
D on the T-bill with 90 days to maturity would be:
0.06 x 90
dx T
D=Vx
= 100 x
= Rs 1.50
360
360
The purchase price of T-bill, P would be:

P = Face value, V Discount, D
The price of the T-bill with 6% yield would be
100 1.50 = Rs 98.50.

By Rajiv Srivastava
Chapter 6
19
Futures on T-bills are priced on index basis

because of
Inverse relationship of price with interest rate, and
Convention of long position gaining with price rise
in other futures markets.
Futures Price, F is stated as 100 I

The quoted price of futures on Tbill of Rs 92
implies a yield of 8%.

By Rajiv Srivastava
Chapter 6
20

With 8% yield on T-bills the futures price
would be Rs 92.
If hypothetically we assume one futures
contract for Rs 10 lacs of face value of T-bills
the discount would be 2% (8 x 90/360).
(100 - Futures Price, F) x Nos of days to maturity, T

100 x 360
T
or
D = T - bill Yield x
360
D=
For a long position on futures the buyer has

to pay 10 x (1 - 0.02) = Rs 9.80 lacs.

By Rajiv Srivastava
Chapter 6
21
Hedging with T-Bills Futures

T-bill futures are used to hedge the short
term interest rate risk.
Depending upon the position of funds one
may need protection against rising or falling
interest rates.

By Rajiv Srivastava
Chapter 6
22
Hedge Against Falling Yields

As prospective investor one faces the risk of
falling interest rates.
Rather than investing funds today (invest in
T-bills) one can buy futures on T-bills.
One is short on funds and to hedge investor
takes opposite position in futures i.e. go long
on T-bill futures.

By Rajiv Srivastava
Chapter 6
23
Hedge Falling Yield - Example
You have to invest Rs 10 crore after 3 months from now

fro next 3 months. The current yield on T-bills is
attractive 7.80% and is likely to fall. Futures on T-bill is at
92.20. Size of the contract is Rs 10 lacs.
To hedge you can buy a futures contract on T-bills and
lock-in the yield of 7.80%.
Nos of contracts bought = 1000 lacs/10 lacs = 100
Amount committed to pay = 100 x 9,80,500 = Rs 9,80,50,000
By buying 100 futures contract on T-bills you have

undertaken to pay Rs 9,80,50,000 and receive T-bills
with face value of Rs 10 crore (100 contracts x Rs 10
lacs per contracts)

By Rajiv Srivastava
Chapter 6
24
Hedge Falling Yield - Example

HEDGING INVESTMENT RETURN WITH INTEREST RATE FUTURES
Scenario
T-bill futures price
Futures contract sold at
Implied yield
Price of contract
Value to be received on the futures
contracts sold
Amount to be received (+) /paid () on futures contracts
Amount of interest earned on
actual deployment of Rs 10 crore in
T-bills
Actual earnings after adjusting for
profit/loss on T-bill futures (ignoring
time value of the gain/loss on
futures)
Effective yield
By Rajiv Srivastava
Yield falls to 7.00%

93.00
93.00
7.00%
Yield rises to 8.50%

91.50
91.50
8.50%
Rs 9,82,50,000
Rs 2,00,000
Rs 9,78,75,000
- Rs 1,75,000
0.07 x 90/360 x
10,00,00,000 =
Rs 17,50,000
0.085 x 90/360 x
10,00,00,000 =
Rs 21,25,000
Rs 19,50,000
Rs 19,50,000
7.80%
7.80%
Chapter 6
25
Hedging Rising Interest Cost

Protection against falling interest rate is
covered by buying interest rate futures,
while rising interest rate scenario is hedged
by selling them.
It is called short hedge.
By going short on T-bill futures the yield in
the futures price can be locked as the cost of
borrowing irrespective of the interest rate
scenario at the time of actual borrowing.

By Rajiv Srivastava
Chapter 6
26
Speculation : T-Bill Futures

The strategies of speculators are summarised
as below:
SITUATION
STRATEGY
When interest rates are expected

to go up more than what futures
market suggests The price of
underlying asset as well as futures
on them would fall
Sell futures now and buy later
When interest rates are expected

to go down more than what the
futures market suggests The price
of underlying asset as well as
futures on them would go up
Buy futures now and sell later

By Rajiv Srivastava
Chapter 6
27
Arbitrage : T-Bill Futures
If futures are mispriced one can execute

cash and carry or reverse cash and carry
arbitrage as follows:
OVER PRICED FUTURES - CASH AND CARRY ARBITRAGE

Today
On Maturity
Deliver asset against the futures contract
Sell the future
Receive value equal to futures price
Buy the underlying asset
Repay borrowing along with cost of borrowing
Borrow equivalent sum
UNDER PRICED FUTURES - REVERSE CASH AND CARRY ARBITRAGE
Today
On Maturity
Acquire asset against the futures contract
Buy the future
Receive the funds lent with interest
Sell the underlying asset
Pay for the asset as agreed in futures contract
Lend equivalent sum
By Rajiv Srivastava
Chapter 6
28
Implied Repo Rate

Futures contracts on interest rate are like
repo transactions and therefore futures price
imply a repo rate.
The repo rate implied in futures price is
Implied Repo Rate

=
Futures Price - Spot Price

365
x
Spot Price
Nos of days remaining for futures
Arbitrage with interest rate futures is

determined by the implied repo rate and the
actual yield in the market.

By Rajiv Srivastava
Chapter 6
29
Computing Implied Repo Rate
Consider T-bill futures sells for Rs 90.00. Note that

Contract has exactly 90 days to mature.
It warrants delivery of T-bills that have 90 days to mature.
Hence 180-day T-bill is the deliverable
Yield of 180-day bill is relevant spot price.
180-day T-bill is quoting with yield of 8%. The prices of

180-day T-bill and the futures contracts would be:
Price of 180-day T-bill = 100 0.08 x 180/360 = Rs 96.00
Invoice price of futures contract = 100 - 0.10 x 90/360 = Rs 97.50
The implied repo rate is 6.25%

Implied Repo Rate =

By Rajiv Srivastava
97.50 - 96.00 360

x
= 0.0625 6.25%
96.00
90
Chapter 6
30
Arbitrage : T-Bills Futures
If implied repo rate is different than the actual repo rate it

presents an arbitrage opportunity either way.
No arbitrage condition forces the implied repo rate to
converge to actual repo.
ARBITRAGE WITH INTEREST RATE FUTURES
Cash And Carry Arbitrage
Reverse Cash And Carry Arbitrage
When Implied Repo Rate
When Implied Repo Rate
> Financing Cost, Say 4%
< Financing Cost, Say 8%
Action
Cash flow
Action
Cash flow
Today
Today
Sell the Interest rate futures
- Buy the Interest Rate Futures
Buy 180-day T-bill in cash
- 96.00 Sell 180-day T-bill in cash
+ 96.00
Borrow equivalent sum
+ 96.00 Lend equivalent sum
- 96.00
Cash flow today
0.00 Cash flow today
0.00
On maturity after 90 days
On maturity after 90 days
+97.50 Acquire T-bill and pay
- 97.50
Deliver T-bill and realise futures
contract value
- 96.96 futures contract value
+97.92
Repay borrowing with interest
Receive funds lent with interest
Cash flow on maturity
+ 0.54 Cash flow on maturity
+ 0.42

By Rajiv Srivastava
Chapter 6
31
Eurodollars
Futures Contract on Eurodollars
Pricing Eurodollar Futures
Hedging with Eurodollar Futures

By Rajiv Srivastava
Chapter 6
32
Eurodollars
Eurodollar deposit is the US dollar deposit held by banks

outside USA by non USA banks or foreign branches of
US banks.
Eurodollar deposits came into existence when during
1950s and 1960s the erstwhile USSR and East
European countries parked their US dollar deposits with
banks in London, Paris and other non US locations for
they could not be confiscated by USA.
Eurodollars are not subject to regulation and control by
US government.
These made Eurodollar deposits and lending rates
purely determined by market forces;

By Rajiv Srivastava
Chapter 6
33
Futures on Eurodollar
Like contract on futures on T-Bill requires
seller to deliver T-bills that matures 91 days
thereafter, a future contract on Eurodollar
should have required delivery of deposit that
matures 3 months thereafter.
Eurodollar deposits are not deliverable being
non-transferable.
However, we use Eurodollar futures for
hedging, speculation and arbitrage in the
same way as futures on T-bills.

By Rajiv Srivastava
Chapter 6
34
Eurodollar & T-Bill Futures
There are two key differences between the

futures contracts on T-bills and Eurodollar
deposits as below:
Eurodollar deposits are non-transferable and
hence cannot be delivered. Therefore futures on

Eurodollar deposits are necessarily cash settled.
Yield on Eurodollar deposit is on add-on basis.
Add-on yield is related to discount yield is

Discount Yield 360
Add - on Yield =
x
Price
T

By Rajiv Srivastava
Chapter 6
35
Actual and Discount Yield
With discount yield of 10% the current price

of the T-bill maturing after 90 days would be
Price of T - bill = 100 x 100 x
0.10 x 90
= Rs 97.50
360
The actual yield would be:

Actual Yield =
100 - 97.50 360

x
= 10.526%
97.50
90
If yield mentioned on add-on basis is 10% it

simply means that if the current price is Rs
100, after 90 days one would get Rs 102.50.

By Rajiv Srivastava
Chapter 6
36
Pricing of Eurodollar Futures
Like futures on T-bills the futures on

Eurodollar deposits too are quoted on index
basis. Price of Eurodollar futures is given by:
Eurodollar Futures Price, F =
100 3-m LIBOR rate
Because of free pricing futures contract on

Eurodollars are extremely popular in
international markets

By Rajiv Srivastava
Chapter 6
37
Settlement: Eurodollar
Futures
Eurodollar futures are necessarily cash
settled i.e. difference of initial price F0 and
final price F1 exchanged in cash.
The cash profit/loss for long and short
position is given by:
Profit/loss on Eurodollar Futures

F1 - F0
90
For initial long position = $ 1,000,000 x
x
100
360
F -F
90
For initial short position = $ 1,000,000 x 0 1 x
100
360
By Rajiv Srivastava
Chapter 6
38
Hedging : Eurodollar Futures
3 months from now DFL needs to raise US $ 2

million for 6 months. Current LIBOR is 6.50%
and the Eurodollar futures contract with 3
months to expire is quoted at 93.00. DFL
expects the interest rate to rise to 8%.
1. How can DFL hedge against rising interest
rates?
2. What would be the effective cost if the interest
rate actually rises to 8%.
3. Also analyse the interest cost if LIBOR actually
falls to 6%.
By Rajiv Srivastava
Chapter 6
39
Hedging Strategy
DFL faces risk of rising interest rate for its

contemplated borrowing 3 months.
Since futures contract provides cash flow based
on 3 months and loan required is for 6 months
the compensation would be equal if the
exposure in futures is for twice the actual
borrowing.
DFL can therefore sell 4 futures contracts on
Eurodollar futures equivalent to $ 4 million.

By Rajiv Srivastava
Chapter 6
40
Hedging Outcome
If LIBOR rises to 8%
Eurodollar price would fall to 92.00. The profit of each futures is

Profit/los s on Eurodollar Futures (For Short Position)
F0 - F1
90
= $ 1,000,000 x
x
100
360
93.00 - 92.00
90
= $ 1,000,000 x
x
= $2,500
100
360
The borrowing cost for 6-m loan on $ 2 million

= 2 m x 0.08 x 180/360
= $ 80,000
Less: Profit earned from 4 Eurodollar futures contracts
= 2,500 x 4
= $ 10,000
Effective interest paid
= $ 70,000
Effective Interest Rate =
70,000
360
= 7.00%
x
2,000,000 180
This is the rate implicit in the futures contract now that can be locked in.
By Rajiv Srivastava
Chapter 6
41
Hedging Outcome
If LIBOR falls to 6%
Eurodollar price would rise to 94.00. The loss of each futures is

Profit/loss on Eurodollar Futures (For Short Position)
F0 - F1
90
= $ 1,000,000 x
x
100
360
93.00 - 94.00
90
= $ 1,000,000 x
x
= -$2,500
100
360
The borrowing cost for 6-m loan on $ 2 million

= 2,000,000 x 0.06 x 180/360
Loss from 4 Eurodollar futures contracts = 2,500 x 4
Effective interest paid
Effective Interest Rate =
= $ 60,000
= $ 10,000
= $ 70,000
70,000
360
x
= 7.00%
2,000,000 180
With fall in the interest rates the firm would not benefit. It still has to
pay the same cost of 7% the rate implicit in the futures contract now.
By Rajiv Srivastava
Chapter 6
42
Pricing T-Bonds
Futures Contract on T-Bonds
Pricing T-Bond Futures
Conversion Factor
Cheapest-To-Deliver Bonds
Hedging Principle
Duration and Modified Duration
Duration Based Hedging

By Rajiv Srivastava
Chapter 6
43
Treasury Bond Futures

Futures contracts on treasury bonds are used for
hedging long term interest rate risk, while futures on
T-bills cover interest rate risk over short term.
Like T-bills these bonds are also regarded as free of
default risk.
The futures contract on T-bonds would require
delivery of an equivalent government security,
during the delivery period specified.
However, settlement by delivery may not arise
because most contracts would be negated by the
offsetting contracts prior to the maturity.

By Rajiv Srivastava
Chapter 6
44
Pricing Treasury Bonds
Following is term structure
Investment Horizon(m)
Yields (%)
6
5.70
12
6.00
24
6.70
30
6.90
36
7.20
The value of the GoI security with 8% semiannual with 3 years to maturity is given by:
P0 =
Ct
(1+ r
t/2
t/2 )
18
6.40
R
(1+ r3 )3
The price of the security is Rs 102.63
P0 =
4.00
0.5
(1.057)
4.00
1.0
(1.060)

By Rajiv Srivastava
4.00
1.5
(1.064)
4.00
2.0
(1.067)
4.00
2.5
(1.069)
104.00
3.0
(1.072)
= Rs 102.63
Chapter 6
45
Futures on T-Bonds
Futures contract on treasury bonds requires
delivery of a long term bond with minimum
specifications decided by the exchange.
Different exchanges adopt different practices
for delivery of the underlying instrument on
which the prices are quoted.
Any instrument meeting minimum
specification can be delivered by the seller of
futures contracts on treasury bonds.

By Rajiv Srivastava
Chapter 6
46
Pricing T-Bond Futures

The price of a futures contract on T-Bond
uses the concept of cost of carry, as is the
case with pricing of other futures contracts.
However, in case of T-bonds we also earn
the dividend in the form of accrued interest.
Fair price of futures on T-Bonds must reflect
true cost of financing.
Fair Price of futures
= Spot price + Cost of financing Accrued interest

By Rajiv Srivastava
Chapter 6
47
Fair Price of T-Bond Futures
Futures contract price represents a repo transaction;

selling a security and buying it later at the price
determined today.
Assume 8% GoI security sells for 96.0291 at YTM of
8.60%. Financing cost is 10%. Futures with 45 days to
maturity sells for Rs 96.5000.Then we have:
Spot price of the bond (at YTM of 8.60%)

Accrued interest for 45 days
= 4 x 45/182
Cost of financing for 45 days
= 96.03 x 0.10 x 45/365
Net amount to be paid = 95.66 + 1.1794 0.4931
Amount receivable against the futures contract sold
Arbitrage profit
By Rajiv Srivastava
= Rs 96.0291
= Rs 0.9890
= Rs 1.1839
= Rs 96.2240
= Rs 96.5000
= Rs 0.2760
Chapter 6
48
Implied Repo Rate
For no arbitrage:
Futures fair price

= Spot price + Cost of financing Accrued interest.
The repo rate implied in the futures price is 12.33%
while the actual financing cost is 10%
Implied Repo Rate
Futures Price - Spot Price + AI

365
x
Spot Price
Nos of days remaining for futures
96.50 - 96.02 + 0.9890 365

x
= 0.1233 12.33%
95.66
45

By Rajiv Srivastava
Chapter 6
49
Underlying Asset
For financial futures market the requirement of the

delivery forces the convergence of futures price to spot
price.
The futures contract on any long term securities would
warrant a delivery of the underlying asset.
Government securities issued at various points of time
have different coupon rates and maturities.
Futures exchange would need to identify some
government security on which the futures contracts may
be traded.
This standardized futures contract on specific security
would be notional and not available for delivery.

By Rajiv Srivastava
Chapter 6
50
Deliverable Bonds
While the futures is quoted on a notional
asset, the asset actually may not be existing
and hence is non-deliverable.
Instead there are many other securities that
may be deliverable.
Despite same face/nominal value the YTMs
of securities would not be same as these
securities issued at different points of times
have varying coupon rates and maturities.

By Rajiv Srivastava
Chapter 6
51
Conversion Factor
Price of the bonds is dependent upon, interalia, on the

coupon rate and the time remaining for maturity.
A bond with higher coupon is worth more than the bond
with lower coupon given all other features of the two
bonds same.
For example if the futures contract requires delivery of
bond with 6% coupon the seller who chooses to deliver
a bond with 8% coupon would need adjustment of price
for making the contract good.
The seller who delivers high coupon rate bond needs to
be compensated more than the one who chooses to
deliver the bond with lower coupon.

By Rajiv Srivastava
Chapter 6
52
Conversion Factor
The conversion factors for deliverable bonds are

determined against the standard bond with 6%
coupon rate. It is
greater than 1.00 when coupon is more than 6%
lesser than 1.00 when coupon is less than 6%.
Conversion factor of the deliverable bond is its

value relative to the notional bond underlying the
futures contract.
Conversion factor for each deliverable security is
computed by the exchange prior to maturity of
contracts.

By Rajiv Srivastava
Chapter 6
53
Cheapest-To-Deliver Bond
Of the many deliverables the seller has to
choose which bond must be delivered.
Not all deliverable bonds would have same
value.
The seller would like to deliver the one which
costs him the least i.e. identify the cheapestto-deliver (CTD) bond.
Profit/loss

By Rajiv Srivastava
= Invoice amount cost of acquisition

= Settlement price x conversion factor
Current market price
Chapter 6
54
Hedging with T-Bond Futures

Hedging principle with futures on T-bonds
remains same, i.e. taking opposite position in
the futures to that of in the spot market.
One who is long on portfolio would need to
go short on futures.
The value of portfolio falls with rise in yields.
Risk from rising yield causing portfolio value
to fall can be covered by going short on
interest rate futures.

By Rajiv Srivastava
Chapter 6
55
Hedge Ratio
To what extent the loss in the value of the portfolio would

be offset by the gains in the futures position depends
upon the positions in the futures and portfolio value.
Hedge ratio depends upon the sensitivities of the
portfolio and the futures with respect to changes in the
interest rates.
Where asset underlying the futures contract and cash
position is same the optimal hedge ratio is unity.
In case of portfolio of bonds, due to different
sensitivities of the values of the assets underlying the
futures contract and those in the cash position the
optimal hedge ratio is would not be equal to 1.

By Rajiv Srivastava
Chapter 6
56
Duration of Bond Portfolio
Duration of the bond is the measure of sensitivity of its

value with respect to changes in the interest rates.
Duration of the bond is computed by dividing the time
weighted cash flows of the bond by its current value.
Duration of the bond, D =
t x DCFt
P0
Modified duration is more accurate measure of

sensitivity of bond prices given by:
D
1+ r/m
For semi - annual payment m = 2 and
D
MD =
1+ r/2
Modified Duration, MD =

By Rajiv Srivastava
Chapter 6
57
Computing Duration
A bond with three years remaining for

maturity bearing a semi-annual coupon of
10% is trading at YTM of 12%. Find out the
value of the bond, its duration and modified
duration.
Period, t
Cash flow
Present Value at
12%, DCF
t/2 x DCF
Value of the Bond
Duration
Modified Duration
1
5.00
2
5.00
3
5.00
4
5.00
5
5.00
6
105.00
Total
4.7170
2.3585
4.4500
4.4500
4.1981
6.2971
3.9605
7.9209
3.7363
9.3407
74.0209
222.0626
95.0827
252.4299
95.0827
2.6548
2.5046

By Rajiv Srivastava
Chapter 6
58
Hedge Ratio
Optimal hedge ratio for position in long term
futures depends upon the duration of bonds
portfolio and the duration of perceived CTD
bond in the futures contract.
The optimal hedge ratio would be one that
offsets the changes in the value of the
portfolio of bonds. It may be expressed as:
Change in value of bond portfolio

= h x Change in value of T-bond futures
By Rajiv Srivastava
Chapter 6
59
Duration Based Hedging
Change in value of bond portfolio, B

= Value x rB x Modified duration
= B x rB x MDB
= B x rB x DB/(1+rB/mB)
Change in the value of CTD bond (Govt

Security), G
= Value x rG x Modified duration
= G x rG x MDG
= G x rG x DG/(1+rG/mG)

By Rajiv Srivastava
Chapter 6
60
Hedge Ratio and Duration
Hedge ratio for portfolio of bonds

Hedge Ratio =
Change in the value of bond portfolio

B
=
Change in value of futures on T bonds F
B
x Conversion Factor
G
B x rB x DB (1+ rG /mG )
=
x
x Conversion Factor
G x rG x D G (1+ rB /mB )
=
Ignoring differences in the coupon payments
B x DB (1+ rG )
Hedge Ratio =
x
x Conversion Factor
G x D G (1+ rB )
By Rajiv Srivastava
Chapter 6
61
Bond Futures in India

Underlying
Tick size
Contract trading cycle
Last trading day
Settlement
Daily settlement price
Mode of settlement
Interest Rate Futures Contract Specifications

10 Year Notional Coupon bearing Government of India (GOI)
security.
(Notional Coupon 7% with semi annual compounding.)
Rs 0.0025
Four fixed quarterly contracts for entire year ending March, June,
September and December.
Seventh business day preceding the last business day of the
delivery month.
Daily settlement MTM: T + 1 in cash
Delivery settlement : In the delivery month i.e. the contract
expiry month.
Closing price or Theoretical price.
Daily Settlement in Cash
Deliverable Grade Securities GOI securities

Conversion Factor
Invoice Price

By Rajiv Srivastava
The conversion factor would be equal to the price of the

deliverable security (per rupee of principal) on the first calendar
day of the delivery month, to yield 7% with semi-annual
compounding
Daily Settlement price times a conversion factor + Accrued
Interest
Source: www.nseindia.com on August 28, 2009
Chapter 6
62

EXAMPLE
A mutual fund is holding bonds worth Rs 5.00 crore.

YTMs in next 3 months are expected to rise. The
portfolio of bonds has duration of 6.63 years. Futures
contract on notional 10-year, 7% semi-annual
Government of India (GoI) security is trading at Rs
104.3425. The cheapest-to-deliver GoI security is
expected to have duration of 7.72 years.
How many contracts should the mutual fund trade to
hedge against the risk of rising yields? Assume that the
YTMs of the CTD bond and the portfolio are same.

By Rajiv Srivastava
Chapter 6
63
Price in the futures market for bond

with face value of Rs 100
= 104.3425
Value of one futures contract
(Bonds with face value of Rs 2,00,000)
= 104.3425 x 2,000
= Rs 2,08,685
Therefore the number of interest rate futures contracts
that must be booked:
Hedge Ratio
B x DB (1+ rG )
x
F x DG (1+ rB )
5,00,00,000 x 6.63
2,08,685 x 7.72
= 205.766 say 206 contracts
=

By Rajiv Srivastava
Chapter 6
64

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Derivatives and Risk Management

Forward Rate Agreement (FRA)

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Interest Rate Derivatives

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FRA The Product

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Forward Rate Agreement

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Settlement of FRA is done by exchanging the differential

The amount to be received under the borrowers 3/9 FRA at 6.5%

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Term structure of interest rate implies forward interest

3-m interest rate expected to prevail after 3 months used

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Hedging with FRA

1. Rising Interest Rates for borrowers, and

Borrowers FRA is a contract that covers risk

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Hedging Rising Interest Rates

EXCEL Industries Ltd (EIL) would have a shortfall of Rs

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Hedging Rising Interest Rates

Cash flow to firm

Interest cost for loan from CB = 5,00,00,000 x 0.10/2

Derivatives and Risk Management

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Hedging Rising Interest Rates

Cash flow to firm

Interest cost for loan from CB = 5,00,00,000 x 0.086/2 = Rs 21,50,000

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Hedging Falling Interest Rates

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Speculation with FRA

If future interest rate expected to be > FRA rate:

Book Investors FRA

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Futures Contract on T-Bills

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Futures Contract on T-Bills

Futures contract matures

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Why Futures on T-Bills

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T-Bills are issued at discount to face value and

The purchase price of T-bill, P would be: