Interest Rate Futures: Options, Futures, and Other Derivatives 6

Interest Rate Futures
Chapter 6
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 6.1
Day Count Conventions
in the U.S. (Page 129)
The interest earned between two dates is:
Number of days between dates x Interest earned in reference period

Number of dates in reference period
Example: Coupon dates are March 1 and September 1. We wish to

calculate the interest between March 1 and July 3, with coupon 8%
Treasury Bonds: Actual/Actual [(124/184)*4]
Corporate Bonds: 30/360 [(122/180)*4]
Money Market Instruments: Actual/360 [(124/180)*4]

Treasury Bond Price Quotes
in the U.S
Cash price = Quoted price +

Accrued Interest since last coupon date
Example
 Consider an 11% coupon bond maturing on
July 10, 2012 with a price today (March 5,
2007) $95.50.
 The most recent coupon date is January 10
 The number of days between January 10 and
March 5 is 54, while between January 10 and
July 10 is 181
 The accrued interest is (54/181)*$5.5=$1.64
 The cash price per $100 face value is $97.14
Treasury Bond Futures
Pages 133-137
The delivery is any government bond with more

than 15 years to maturity, which is not callable
within 15 years
Cash price received by party with short position

=
Most Recent Settlement Price × Conversion
factor + Accrued interest
Example
 Settlement price of bond delivered = 90.00
 Conversion factor = 1.3800
 Accrued interest on bond =3.00
 Price received for bond is (1.3800×90.00)+3.00 =

$127.20
per $100 of principal
The party with the short position in one contract
would deliver bonds with a face value of $100.000
and receive $127.20.
Conversion Factor
The conversion factor for a bond is

approximately equal to the value of the
bond on the assumption that the yield
curve is flat at 6% with semiannual
compounding
Example
 Consider an 10% coupon bond with 20 years
 Coupon payments are assumed to be made every 6
months
 The face value is $100
 When the discount rate is 6% per annum with
semiannual compounding:
i11.03i 1.0340
40
5  100 $146.23
 Dividing by the face value gives a conversion factor

of 1.4623
Cheapest-to-deliver bond
 Any of a range of eligible bonds can be delivered

 The party with the short position receives:
Settlement Price × Conversion factor + Accrued interest

 The cost of purchasing a bond is
Quoted bond price+Accrued Interest

 The cheapest-to-deliver bond is the one for which
Quoted bond price-(Settlement Price × Conversion

factor) is least.
Example
Quoted bond price Conversion factor
99.50 1.0382
143.50 1.5188
119.75 1.2615
The most recent settlement price is 93.25.
1. 99.50-(93.25*1.0382)=$2.69
2. 143.50-(93.25*1.5188)=$1.87
3. 119.75-(93.25*1.2615)=$2.212
Thus, the cheapest-to-deliver is bond 2
Determining The Futures Price
 We assume that both the cheapest-to-delivery

bond and the delivery date are known
 The Treasury bond futures contract is the
futures contract on a security providing the
holder with known income:
F0 = (S0 – I )erT
With I the present value of the coupons during
the life of the futures contract
Example
 The cheapest-to-deliver is a 12% coupon bond

with a conversion factor of 1.400
 The delivery will take place in 270 days.
 Last coupon date was 60 days ago
 Next coupon date is in 122 days, and the
coupon date thereafter is in 35 days
 The term structure is flat, the interest rate is 10%
 The current quoted bond price is $120
Example (continued)
 The cash price is 120+(60/(60+122))*6=121.978
 A coupon of 6% will be received after 122 days. The
present value is 6e-0.1*0.3342=5.803
 The futures contract lasts for 270 days. The cash
futures price is
(121.978-5.803) e0.1*0.7397=125.094
 The quoted futures price is calculated by first
subtracting the accrued interest
125.094-6*(148/(148+35))=120.242
The conversion factor is 1.400. Thus, the quoted
futures price should be 120.242/1.40=85.887
Eurodollar Futures (Page 137-142)
 A Eurodollar is a dollar deposited in a bank
outside the United States
 Eurodollar futures are futures on the 3-month
Eurodollar deposit rate (same as 3-month LIBOR
rate)
 One contract is on the rate earned on $1 million
 A change of 1 basis point or 0.01% in a Eurodollar
futures quote corresponds to a contract price
change of $25 :
1.000.000*0.0001*0.25=25
 When there is an increase in 1 bp, a trader who is
long 1 contract gains $25, while the short loses
$25 th
Options, Futures, and Other Derivatives 6 Edition, Copyright © John C. Hull 2005
6.14
Eurodollar Futures continued
 A Eurodollar futures contract is settled in

cash
 When it expires (on the third Wednesday
of the delivery month) the final settlement
price is 100 minus the actual three month
deposit rate:
100 - R
Example
 Suppose you buy (take a long position in)
a contract on November 1
 The contract expires on December 21
 The prices are as shown
 How much do you gain or lose a) on the
first day, b) on the second day, c) over the
whole time until expiration?
Example
Date Quote
Nov 1 97.12
Nov 2 97.23
Nov 3 96.98
……. ……
Dec 21 97.42
Example continued
 If on Nov. 1 you know that you will have $1
million to invest on for three months on Dec 21
the contract locks in a rate of
100 - 97.12 = 2.88%
 In the example you earn 100 – 97.42 =2.58%
on $1 million for three months (=$6,450) and
make a gain day by day on the futures contract
of 30×$25 =$750
 Total gain: $6.450+$750=$7.200 which is
equal to 1.000.000*0.25*0.0288
Formula for Contract Value (page 138)
 If Q is the quoted price of a Eurodollar futures
contract, the value of one contract is
10,000[100-0.25(100-Q)]
 In the above example, the settlement price of
97.12 corresponds to a contract price of
10.000[100-0.25*(100-97.12)]=$992.800
 The final contract price is
10.000[100-0.25*(100-97.42)]=$993.550
The difference is $750. This is the gain of an
investor with long position
Forward Rate Agreements vs
Futures Interest rates
 Futures is settled daily where forward is

settled once
 Futures is settled at the beginning of the
underlying three-month period; forward is
settled at the end of the underlying three-
month period
Forward Rates and Eurodollar
Futures continued
A " convexity adjustment " often made is

1 2
Forward rate = Futures rate   t1t 2
2
where t1 is the time to maturity of the
futures contract, t 2 is the maturity of
the rate underlying the futures contract
(90 days later than t1 ) and  is the
standard deviation of the short rate changes
per year (typically  is about 0.012)
Convexity Adjustment when
=0.012 (Table 6.3, page 141)
Maturity of Convexity
Futures Adjustment (bps)
2 3.2
4 12.2
6 27.0
8 47.5
10 73.8
Extending the LIBOR Zero Curve
 LIBOR deposit rates define the LIBOR
zero curve out to one year
 Eurodollar futures can be used to
determine forward rates (using the
convexity adjustment) and the forward
rates can then be used to bootstrap the
zero curve
Example
Ri 1Ti 1  RiTi
Fi 
Ti 1  Ti
so that
Fi (Ti 1  Ti )  RiTi
Ri 1 
Ti 1
If the 400 day LIBOR rate has been calculated

as 4.80% and the forward rate for the period
between 400 and 491 days is 5.30 the 491 days
rate is 4.893%
Duration Matching
 This involves hedging against interest

rate risk by matching the durations of
assets and liabilities
 It provides protection against small
parallel shifts in the zero curve
Use of Eurodollar Futures
 One contract locks in an interest rate on
$1 million for a future 3-month period
 How many contracts are necessary to lock
in an interest rate for a future six month
period?
Duration-Based Hedge Ratio
FC Contract price for interest rate futures
DF Duration of asset underlying futures at
maturity
P Value of portfolio being hedged
DP Duration of portfolio at hedge maturity
Since ΔP=-P DP Δy, and it is approximately true that

ΔFC=-FC DF Δy, the number of contracts required is:
N  PDP
FC DF
Example
 It is August. A fund manager has $10 million invested in
a portfolio of government bonds with a duration of 6.80
years and wants to hedge against interest rate moves
between August and December
 The manager decides to use December T-bond futures.
The futures price is 93-02 or 93.0625 and the duration of
the cheapest to deliver bond is 9.2 years
 The number of contracts that should be shorted is
10,000,000 6.80
  79
93,062.50 9.20
 If Interest rates go up, a gain will be made on the short
futures, but a loss will be made on the bond portfolio.
 If interest rates decrease, the opposite is true
Limitations of Duration-Based
Hedging
 Assumes that only parallel shift in yield
curve take place
 Assumes that yield curve changes are
small

Interest Rate Futures: Options, Futures, and Other Derivatives 6

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Interest Rate Futures

Number of days between dates x Interest earned in reference period

Example: Coupon dates are March 1 and September 1. We wish to

Corporate Bonds: 30/360 [(122/180)*4]

Money Market Instruments: Actual/360 [(124/180)*4]

Cash price = Quoted price +

The delivery is any government bond with more

Cash price received by party with short position

 Accrued interest on bond =3.00

 Price received for bond is (1.3800×90.00)+3.00 =

The conversion factor for a bond is

 Dividing by the face value gives a conversion factor

 Any of a range of eligible bonds can be delivered

Settlement Price × Conversion factor + Accrued interest

Quoted bond price+Accrued Interest

Quoted bond price-(Settlement Price × Conversion

 We assume that both the cheapest-to-delivery

 The cheapest-to-deliver is a 12% coupon bond

 A Eurodollar futures contract is settled in

 Futures is settled daily where forward is

A " convexity adjustment " often made is

If the 400 day LIBOR rate has been calculated

 This involves hedging against interest

Since ΔP=-P DP Δy, and it is approximately true that

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