K.Cuthbertson, D.

Nitzsche 1
Version 1/9/2001
FINANCIAL ENGINEERING:
DERIVATIVES AND RISK MANAGEMENT
(J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche



LECTURE

Interest Rate Futures
K.Cuthbertson, D. Nitzsche 2
Topics
Cash Market for T-Bills

T-Bill Futures Contract

3m Sterling Futures Contract

Hedging

Arbitrage: Pricing a T-Bill Futures Contract
K.Cuthbertson, D. Nitzsche 3
Cash Market for T-Bills
K.Cuthbertson, D. Nitzsche 4
Spot Market: T- Bills,Market Price and Yield
Face or par value is FV= $100
n = days to maturity / days in year

Simple yield ( y ~ proportion , p.a.):
P = 100 / [ 1 + y (n) ]

Compound yield ( y ~ proportion , p.a.):
P = 100 / ( 1 + y )
n



Continuously compounded yield, y
P = 100 exp(- y . n )
K.Cuthbertson, D. Nitzsche 5
Price from discount Rate: T- Bills
The dollar (or sterling) discount is :
D = FV

The price is:
P = FV - D
Also:
P = FV

Price and discount rate are inversely related
d m
a 100
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K.Cuthbertson, D. Nitzsche 6
T-Bill Futures Contract
K.Cuthbertson, D. Nitzsche 7
What is a T-Bill Futures Contract ?
At expiry, (T), which may be in say 9m time

the (long) futures delivers a T-Bill which matures at

T+90, with face value M=$100.


This allows you to lock in at t=0, the forward rate, f
12

K.Cuthbertson, D. Nitzsche 8
Figure 5.2 : Interest rate (T-Bill) futures contract
t
0
t
*
T=t
1
t
2

r
1

r
2

t
12,
f
12

Futures protection period = t
12

Exposure period, t
0
to t
1

T= t
1
= Maturity of futures contract
K.Cuthbertson, D. Nitzsche 9
Buy one Sept, T-Bill
futures at F
0
= 98
(no cash is exchanged
T = t
1
0
T+90days = t
2

Exposure period
(2m)
Protection period=t
12

Receive a
90-day T-
Bill and
pay F
0

T-Bill
matures
at M =100
(M/F
0
)
365/90
= ( 1 + annual interest earned over t
12
)
(simple)annual interest earned is approx (2/98) x 4 = 8.16 %
T-Bill Futures Contracts
K.Cuthbertson, D. Nitzsche 10
What is the known yield locked in at t=0, which applies between T (t
1
)
and T+90 = t
2
)
F
0
= M / ( 1 + annual interest earned over t
12
)
90/365

F
0
= M / ( 1 + f
12
)
t
12



Since f
12
(compound) is observable at t=0, then this is how
we price the futures contract (riskless arbitrage is hidden
in above)
Also F
0
= M / ( 1 + f
12
t
12
) - f
12
is simple interest/yield
= M exp(- f
12
t
12
) - f
12
is contin compound
Note: For all interest rate contracts, if f falls then F rises
Futures Price and futures Yield
K.Cuthbertson, D. Nitzsche 11
3m Sterling Futures Contract

K.Cuthbertson, D. Nitzsche 12
STERLING 3-MONTH CONTRACT (LIFFE)
Contract Size
Delivery
Price Quotation
Tick Size (Value)
Settlement
Initial Margin

z = 500,000
Mar/June/Sept/Dec
F = (100 - futures rate)
AF = 0.01 (= 1-tick) (12.5)
Cash
500
Can lock in interest rate on 3-mth deposits
Tick value = 500,000 (0.01 / 100 ) (1/4) = 12.5
If F changes by 0.01 ie.1-tick (eg from 95.00 to
95.01) then value of one contract changes by
12.5
F = 100 - f where f in the futures /forward
rate(applicable from T to T+3m )
K.Cuthbertson, D. Nitzsche 13
Calculation of Tick Value
500,000 ( 0.01 / 100 ) (1/4) = 12.5
z ( ( F
1
- F
0
) / 100 ) (1/4)

The 1/4 appears because a change of 1% pa
in f is equal to a change of 1/4 of 1% over 3-mnths
(the life of the deposit underlying this futures
contract)

K.Cuthbertson, D. Nitzsche 14
Hedging
K.Cuthbertson, D. Nitzsche 15
Simple Hedge :Short Sterling, Nave Hedge Ratio
Will receive 1m in 2m time and then wishes to place funds
on deposit for 3m . Fears a fall in interest rates

15th April(today)
r
0
= 10% f
0
= 10.5% F
0
= 89.5

15th June(Hedge ends)
r
1
= 8% f
1
= 8.5% F
1
= 91.5

N
f
= TVS
0
/FVF
0
= 1m/ (0.5m x 0.895) = 2.33 (=2)
Lose 2% in cash market and gain 2% on futures
K.Cuthbertson, D. Nitzsche 16
Simple Hedge :Short Sterling
Loss of interest in cash market
= 0.02 x (1/4) x 1m = 5000

Profit on futures contract
= 2 x 200 ticks x 12.5 = $5000
Perfect hedge

Note:
Strictly the cash market loss is based on r
0
= 10% could not
have been achieved.
(Futures contract used matures in say, December)
K.Cuthbertson, D. Nitzsche 17
Risks in a Hedge: Short Sterling
Example: 1st Jan and will receive 1.2m on 1st Sept
On 1st Sept wish to put proceeds into Commercial Bill for 6-months

Underlying in futures is a 3-month deposit
Futures matures at end of March, June, Sept, Dec


Potential Problems
Cash amount is not exact multiple of contract size
Margin calls may be required
Nearby contracts matures before Sept and would have to be
rolled over , otherwise use Sept contract
Underlying = Commercial bill, is not the same as the underlying
in the futures (ie. Eurosterling deposit) - Cross Hedge
K.Cuthbertson, D. Nitzsche 18
Fig 5.3 : Hedge using US T-Bill Futures
Purchase T-Bill
future with Sept.
delivery date
$1m cash
receipts
Maturity date Sept.
T-Bill futures contract
3 month
exposure period
Desired investment/protection
period = 6-months
May
Aug.
Sept.
Feb. Dec.
Maturity of Underlying
in Futures contract
K.Cuthbertson, D. Nitzsche 19
Duration based Hedge Ratio
F = futures price
z = size of one futures contract
FVF
0
= face value of one futures contract = z F
0
N
f
= number futures contracts held
y
s
= spot yield, y
F
= futures yield (usually = f
12
in text
book)
Using the min var hedge ratio but replacing o(AS, AF)
and

o
2
(AF) terms with duration and yields we
get:
c | o + A + = A
F y o s
y y
(

|
|
.
|

\
|
= ) (
0
0
y
F
s
f
D
D
FVF
TVS
N |
K.Cuthbertson, D. Nitzsche 20
Cross Hedge: US T-bill Futures

May (Today)
Funds of $1m accrue in August to be invested for 6m
months in bank or commercial bills
Use Sept 3m T-bill Futures contract
Assume parallel shift in the yield curve

Q
f
= 89.2 (per $100 nominal) hence:

F
0
= 100 - (1/4)(100 - Q
f
) = 97.30
FVF
0
= $1m (F
0
/100) = $973,000


N
f
= (TVS
0
/ FVF
0
) (D
s
/D
f
)
= ($1m / 973,000) ( 0.5/ 0.25) = 2.05 (=2)
K.Cuthbertson, D. Nitzsche 21
Cross Hedge: US T-bill Futures
Table 5.4 : Cross Hedge Using US T-Bill Futures
3 month US T-Bill Futures : Sept Maturity
Spot Market(May)
(T-Bill yields)
CME Index
Quote Q
f
Futures Price, F
(per $100)
Face Value of $1m
Contract, FVF
May
y
0
(6m) = 11% Q
f,0
= 89.2 97.30 $973,000
August y
1
(6m) = 9.6% Q
f,1
= 90.3 97.58 $975,750
Change -1.4% 1.10 (110 ticks) 0.28 $2,750
(per contract)
Durations are : D
s
= 0.5, D
f
= 0.25
Amount to be hedged = $1m. No. of contracts held = 2
K.Cuthbertson, D. Nitzsche 22
Cross Hedge: US T-bill Futures
Gain on the futures position
= $1m(0.9775 0.973)2 = $5,500

or (using tick value of $25 and AQ = 0.01 is 1 tick)

= 110 ticks x $25 x 2 contracts = $5,500

The gain on the futures position of $5,500 when invested
over 6-months at y
1
= 9.6% is $5,764 hence (using
simple interest):

K.Cuthbertson, D. Nitzsche 23
Cross Hedge: US T-bill Futures
Hedged Return
Effective (simple) interest
= y
1
+ = 0.096 + 0.0115 = 0.1075 (10.75%)


The 10.75% hedged return is substantially above the
unhedged rate (y
2
) of 9.6% and

is reasonably close to the implied (simple) yield on the
September futures contract of 11.1% (= (100/97.3 1) 4).
K.Cuthbertson, D. Nitzsche 24
Arbitrage: Pricing a T-Bill Futures
K.Cuthbertson, D. Nitzsche 25
Figure 5.5 : Pricing the futures contract
Receive $100
face value of
2-year T-bill
Buy 2-year
T-bill for $S with
face value $100
A.
0 1
2
r
2
r
2

Receive $100 face
value of T-bill
underlying the F.C.
Buy 1-year T-bill
for F/(1 + r
1
)
B.
0 1 2
r
1
f
12

Maturity of T-bill
receive $F
Portfolio A : 2-year T-bill
Portfolio B : 1-year T-bill plus interest rate futures contract
Go long a T-bill
futures (at zero cost today)
Pay $F for F.C.
on 1-year T-bill
K.Cuthbertson, D. Nitzsche 26
Figure 5.5 : Pricing the futures contract
The 1-year T-Bill with maturity value F must cost (at t=0) :

[5.30] Price 1-year T-Bill = F / (1+ r
1
)

The two portfolios payoff is the same at t=2 and hence
must cost the same today:
[5.32] F / (1+ r
1
) = S


Price at t=0 of a 2-year T-Bill is :
[5.33] S = 100 / (1+r
2
)
2
= 100 / (1+r
1
) (1 + f
12
)

Substituting equation [5.33] into equation [5.32] :

[5.34] F = 100 / (1+ f
12
)
K.Cuthbertson, D. Nitzsche 27


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