Financial Derivatives

Sessions 7&8

Agenda
1. Quick re-cap of CF and CTD
2. Cash and Carry
3. Worked Example
4. General Formula
5. Implied Repo Rate
6. Sellers Option- Bbg Exercise

Formula
INVAMT = FP x CF + ACC
INVAMT : Invoice amount
FP:

futures price

CF

Conversion factor

ACC

Accrued Interest

**CF for each bond is just the price per

$1such that every bond would provide an
investor the same YTM if purchased.

CTD Cheapest to
Deliver
Consider the following strategy:
1. Buy $100,000 face value of the deliverable

bond
2. Sell one futures contract
3. Immediately initiate the delivery process

CTD
Amount paid for the bond will simply be
BNDAMT = P+ ACC

(i)

So, profit = INVAMT BNDAMT

= ( FP x CF + ACC) (P+ ACC)
= ( FP x CF P)
The bond for which this expression is maximised
will be the CTD bond during the delivery
month.

Example
It is 1 December 2010 and the bonds available
for delivery into the Dec 2010 10yr-Tnote
contract were available at the prices shown.
On the same date , the Dec10 contract was
trading in the range 12327 to 124025 and
settled at 123275.
The Xcel sheet shows that for each deliverable
bond the profit that would be available from
buying the bond, selling the futures contract
at 123275 and immediately delivering the
bond against receipt of the invoice amount.

Results
Span the range from -0.38 down to -3.78
representing the $ losses per $100 of bonds
traded.
The best ( least bad) result arises from using the
4 % of Aug 2017 which is the CTD bond in this
example.
The figure of -0.38 therefore represents the LOSS
of $380 if this strategy were executed for
$100,000 face value of bonds.
NOTE: All bonds produce a small negative result!


Buy the future , sell the bond short ( reverse cash
and carry).
The seller of the future decides which bond to
deliver.
By shorting the 2.625% of Nov2020 to secure a
3.78% riskless profit should note that the seller is
unlikely to deliver that particular bond.
Features, called SELLERS OPTIONS have a positive
value to the holder of a short futures position ,
offsetting the small losses in the Xcel sheet.

Consider the strategy

A) Buy $100,000 face value of a deliverable
bond
B) Finance the bond through a repo( sale and
repurchase agreement a secured borrowing)
C) Sell one futures contract
D) Hold the bond till the last day of the delivery
month
E) deliver the bond against the short futures
position

Cash and Carry

Pictorial representation

Live Example
Suppose that on 30 September 2010 an
arbitrager decides to undertake a cash-andcarry using the 4 % of 15 August 2017, the
CTD against the December contract in the
delivery month.
The arbitrager therefore buys this bond and
sells the Dec 2010 contract, with the
intention to deliver the bond at the end of
December.
Data points are in the next slide

Data points
Trading date
Value Date

30 September 2010
1 October 2010

Bond
Bond Price
Conversion Factor

4 % maturing 15 August
2017
11824
0.9335

Repo Rate

0.52%

Future
Futures Price

Dec 2010 T-note Future

12603

Holding Period

91 days

Final Delivery Date

30 December 2010

Cash Flow of these

transactions
Go to the Board

Strategy
1. Quoted price of the bond = $118,750.00
ADD: Accrued interest for
47 days
=$
606.66
Total price
=$ 119,356.66
ACTION: Immediately repo out this bond to
finance its purchase in the first place!
The strategy terminates at the end of the delivery
month, when the bond is delivered against the
short futures position.

Lets Remember
A Futures contract is to fix the price at the OUTSET
at which a transaction will be executed in the
FUTURE.
The INVOICE AMOUNT should be the futures price
at the outset multiplied by the conversion factor of
the delivered bond, PLUS the accrued interest on
the delivery date.
INVAMT=126.09375x0.9335+1.78125 x $100,000
100
= $119,489.77(A)

We go on
The amount repaid under the repo
agreement is the principal of $119,356.66
PLUS interest at 0.52% for 91 days:
REPAMT=$119,356.66x((1+0.0052x(91/36
0))
= $119,513.55(B)
(A) And (B) are identical , within 0.02% of
each other!

Conclusion
With these rates , a arbitrager executing a
cash-and-carry operation would obtain
neither a profit or a loss. The same would be
true, if the opposite strategy a reverse-cashand-carry had been executed.
This implies that the futures price of 12603 is
FAIR.
If the price had been any different , the
arbitrager would have been able to exploit
the opportunity and profit as a result.

Is there a Flaw?
In the analysis , we used the INITIAL futures price of
12603 and arrived at FINAL cash flows.Huh? What
about the margins? Maintenance margin??
Final price 12108 for the Dec2010 contract ( given)
Extra $4,843.75 profit ( 12603 12108 = 427 )
But new INVAMT=121.25x0.9335+1.78125 x$100,000
100
= $114,968.13 ( $4,521.64 less than before, wiping all
but $322 of the profit.
( $4,521.64/0.9335=$4,843.75)

Lets use our learning to

derive the Formula
We use the cash-and-carry strategy to determine what
a fair futures price should be.
An important feature of the strategy is that all rates
are known in advance.
The purchase price , the conversion factor, repo rate ,
selling price of the future are all fixed at the
INCEPTION of the strategy.( incl Invoice price)
Nothing remains to be negotiated or determined later.
Profit or loss through a cash-and-carry strategy can be
determined in ADVANCE.

Summary-1
1. A cash-and-carry strategy comprises of borrowing
money, buying a deliverable bond and selling the future
2.The prices, rates and final outcome are all known at the
OUTSET when the cash-and-carry trade is executed
3.The cash-and-carry strategy is virtually riskless if the
bond is delivered against the short futures position.
THE FAIR PRICE OF A FUTURES CONTRACT CAN
THEREFORE BE DERIVED BY APPLYING THE ZERO
PROFIT CONDITION TO THE CASH-AND-CARRY
STRATEGY

Deriving a General
Formula
GTB

Carry: -ve
Running a cash-and-carry position involves
paying out interest at the repo rate and
earning interest at the coupon rate on the
cheapest-to-deliver bond.
When repo rates are higher than the
coupon rate , it will cost money to carry
the bond NEGATIVE carry and the bond
futures prices will be HIGHER the longer
the carry period.

Carry : +ve
If repo rates are lower than the coupon rate ,
someone running the cash and carry will
benefit.
In this POSITIVE carry environment , the futures
prices will be lower for later delivery months.
This compensates the party that is long futures
who must wait LONGER for delivery and who
therefore foregoes the opportunity to earn the
attractive coupon rates while they were
waiting.

CME live data analysis

http://www.cmegroup.com/trading/interest-ra
tes/us-treasury/10-year-us-treasury-note.ht
ml
Implied Repo rates( see working slide)
Exercise:From the Bbg terminal, find
the open interest and trading volume
figures for the Sep16 and Dec16 T-note
contracts on the CME. Do this for each
day of June and for July to date.
Also , how much of the Jun10 contract
got delivered?