Session 4 Leverage and Derivatives

Content

The effects of leverage on returns and risk

Repos

Bond futures

Interest rate derivatives

Leverage
Borrowing to invest is nothing new – it is a way of synthetically changing the risk return
metrics of an investment view

With fixed income investments it will also help targeting a particular duration

Leverage comes in many different forms, its worth distinguishing the difference between
two very important types of leverage:
 Explicit leverage – where money is actually borrowed and invested in physical bonds
 Implicit leverage – using derivatives does not actually involve really borrowing money and paying
interest, but will have the same effect as doing so

Remember leverage will have the effect of increasing returns on both the positive and
negative side – and means you can lose more than you originally invested to begin with –
this is not for most retail investors!
Explicit leverage
If you borrow money to invest alongside your equity you will increase your
returns as long as the purchased asset performs better than the cost of the
borrowing

For example, calculate the return on a bond portfolio that is yielding 2.5% that
has $40m dollars of equity and has borrowed $60m at 1.5%

The entire $100m is invested in the bonds, calculate the return

Assuming the Macaulay duration of the bonds is 7.5, and the loan is a 3 month
bullet loan, what is the duration of the resulting portfolio’s equity?
Repos
A repurchase agreement is a collateralised loan in which the seller of a security
agrees to buy it back at a specified date and specified price
It effectively becomes a useful way to buy (or sell) bonds in a wholly financed way
The interest rates are very low due to the collateralised nature of the loan
Asset

Leg 1
A B
Cash

Asset

Leg 2
A B
Cash plus interest
Features of repos
Repos are most commonly overnight, but you can do longer term repos, and
open repos (cancellable on demand)

Interest on repos is under money market conventions, either 365 day count (GBP
and commonwealth currencies) or 360 (most others)

The seller remains the beneficial owner of the securities, so earns any coupon
that might be paid, and is still the winner or loser if they go up or down in value

A margin or haircut will be charged, (a minimum equity contribution) depending

on the quality of the collateral – can be as low as 2% for US Treasuries
Features of repos
The repo rate will depend on several factors, namely:

The term of the repo

Availability and quality of the collateral

Prevailing market interest rates

Seasonal borrowing/lending factors

Repo example
For example, counterparty A purchasing $100m worth of bonds with a 2%
margin, for 5 days at a repo rate of 0.3% - calculate the cash flows either way on
the two legs

$100m Bonds $100m Bonds

A B Leg 1

$100m ??

$100m Bonds

A B Leg 2

??
Appendix
You have other courses on derivatives and Interest Rate derivatives specifically, I am
including the following material but it is not the intention to cover it in class
Derivatives
There are various derivatives that bond traders/speculators/fund managers use
They use these to alter their portfolios duration, to hedge or speculate on
interest rate movements
It also provides leverage as in general only a small portion of the derivatives value
needs to be deposited as initial margin
The derivatives market can also provide much greater liquidity than the physical
cash markets at times
We will look at bond futures and some interest rate derivatives markets
Bond futures
A future is a contact to buy a specified amount of a underlying asset on some
future date, at a price agreed now
For bond futures they are based on hypothetical government bonds with a
$100,000 nominal value, for example a 30 year, with a coupon of 6%
The contracts do not specify a real actual bond, and yet are deliverable so people
who are open (short) at delivery will have to deliver an actual bond to people
who remain long – this comes from a basket of deliverable bonds
All the bonds will be given a conversion factor at the start of the contract trading,
the conversion factor allows for the fact that they bonds are different from the
hypothetical bond
Bond futures contracts
Contract Long Gilt Euro-Bund Euro-OAT Long-Term Euro-BTP Treasury Note JGB 10-Year

Exchange NYSE LIFFE EUREX EUREX EUREX CME Group Tokyo Stock Exchange

Underlying 10Y Gilt 10Y Bund 10Y OAT 10Y BTP 10Y Treasury 10Y JGB

Face Value £100,000 €100,000 €100,000 €100,000 $100,000 ¥100,000,000

Notional Coupon 4% 6% 6% 6% 6% 6%

Contract Months M, J, S, D M, J, S, D M, J, S, D M, J, S, D M, J, S, D M, J, S, D

Deliverable Maturities 8.75 to 13 years 8.5 to 10.5 years 8.5 to 10.5 years 8.5 to 11 years 6.5 to 10 years 7 to 11 years

Delivery dates Any business day in 10th calendar day of the 10th calendar day of the 10th calendar day of the Any business day in Any business day up to
delivery month (at delivery month delivery month delivery month delivery month (at 20th day of contract
seller’s choice) seller’s choice) month

Last trading day 2 business days prior to 2 exchange days prior to 2 exchange days prior to 2 exchange days prior to 7th business day before 7th business day prior to
last business day in Delivery Day Delivery Day Delivery Day last business day of each delivery date
delivery month delivery month

First notice day 2 business days prior to Last trading day Last trading day Last trading day 2 business days before First business day of
first day of delivery intended day of delivery delivery month
month

Last notice day 1st business day after Last trading day Last trading day Last trading day 2 business days before 20th day of delivery
Last Trading last business day of month
delivery month
Conversion factors
The conversion factor for US Treasuries is arrived at with the following details on
the CME:
Settlement: 1st day of delivery month
Maturity: Nearest earlier delivery month 1st day
Coupon: Bond's actual coupon
YTM: 6%
Redemption: 100
Frequency: Semi-annual
Basis: Actual/Actual

Obviously the lower the coupon the less valuable a bond is, so these days most
bonds are under 6% coupon and thus conversion factors are less than one
normally
Conversion factors example
Coupon Issue Maturity CUSIP Jun. 2017 Sep. 2017 Dec. 2017
2 1/4 01/03/17 12/31/23 912828V23 0.8006 ----- -----
2 1/4 01/31/17 01/31/24 912828V80 0.8006 ----- -----
2 3/4 02/18/14 02/15/24 912828B66 0.8272 ----- -----
2 1/8 02/28/17 02/29/24 912828W48 0.7939 ----- -----
2 1/8 03/31/17 03/31/24 912828W71 0.7875 0.7939 -----
2 05/01/17 04/30/24 912828X70 0.7806 0.7873 -----
2 1/2 05/15/14 05/15/24 912828WJ5 0.8080 0.8139 -----
2 3/8 08/15/14 08/15/24 912828D56 0.7953 0.8012 0.8072
2 1/4 11/17/14 11/15/24 912828G38 0.7821 0.7882 0.7943
2 02/17/15 02/15/25 912828J27 0.7612 0.7676 0.7741
2 1/8 05/15/15 05/15/25 912828XB1 0.7626 0.7687 0.7748
2 08/17/15 08/15/25 912828K74 0.7488 0.7549 0.7612
2 1/4 11/16/15 11/15/25 912828M56 0.7587 0.7645 0.7702
1 5/8 02/16/16 02/15/26 912828P46 0.7120 0.7185 0.7252
1 5/8 05/16/16 05/15/26 912828R36 0.7055 0.7120 0.7185
1 1/2 08/15/16 08/15/26 9128282A7 0.6905 0.6971 0.7038
Conversion factors example
1 5/8% due 15/5/26, June 2017 contract
Inputs Values
Settlement:1-Jun-17
Maturity:1-Mar-26
Coupon:1.625%
YTM:6%
Redemption:100
Frequency:2
Basis:1
Conversion Factor: 70.55 ÷ 100 = 0.7055
Delivery bond
From a basket of deliverable bonds, the short will deliver a bond of their choosing
to the long, and the long will pay for it
The invoice price will be:
The futures expiry price x conversion factor + accrued interest
But which bond will be delivered? If the conversion factors were perfect it
wouldn’t be an issue but they don’t start out perfect and they change in relative
value over the life of the contract
Cheapest to deliver
The cheapest to deliver (CTD) bond is based on a cash and carry ‘no arbitrage’
So buy the bond today (dirty price);
Borrow the money to buy the bond at the repo rate;
Simultaneously sell the future
Hold the bond to delivery and deliver it against the future
The CTD bond will be the one with the highest profit, or lowest loss, of doing this
trade
Cheapest to deliver Sep 2016 10yr T-Note
Forward rate agreements
A forward rate agreement (FRA) is a trade based on an unknown interest rate in
the future for a period of time
The FRA buyer agrees to pay fixed and receive floating interest, while the seller
agrees to do the opposite
This will expose (or hedge) people for a fixed period of interest rate movements
and are based on notional principals, so have a high degree of implicit leverage
The FRA will be based off some interest rate benchmark, like LIBOR
Short term interest rate futures
STIRs are short term interest rate futures and are the exchange traded equivalent
of the FRAs
What are the differences between OTC and exchange traded products??

The STIR is standardised to a 3 month forward rate, and is cash settled

STIRs are priced as 100 – interest rates, so trade inversely to FRAs
So if you think interest rates are going up you buy FRAs or sell STIRs
Eurodollar Futures
Contract Unit Eurodollar interbank deposit having approximately $1 million principal value, for three-month term to maturity, for spot
settlement on the 3rd Wednesday of the contract month.

Price Quotation IMM price points: 100 points minus the three-month London interbank offered rate for spot settlement on the 3rd
Wednesday of contract month. E.g., a price quote of 97.45 signifies a deposit rate of 2.55 percent per annum. One interest
rate basis point = 0.01 price points = $25 per contract.

Trading Hours SUN - FRI: 5:00 p.m. - 4:00 p.m. CT

Minimum Price Nearest expiring contract month:

Fluctuation One quarter of one interest rate basis point = 0.0025 price points = $6.25 per contract.

All other contract months:

One half of one interest rate basis point = 0.005 price points = $12.50 per contract.
The “new” nearest contract begins trading in 0.0025 increments on the same trade date as the last trading day in the
expiring “old” nearest contract.

Product Code CME Globex: GE

CME ClearPort: ED
Clearing: ED

Listed Contracts Nearest 40 months (i.e., 10 years) in the March Quarterly cycle (Mar, Jun, Sep, Dec) plus the nearest 4 “serial” months not in
the March Quarterly cycle. The new March Quarterly contract month for delivery 10 years hence is listed on the business
day following expiration of the nearest March Quarterly contract month.

Settlement Method Financially Settled

Termination Of Second London bank business day before 3rd Wednesday of the contract month. Trading in expiring contracts terminates at
Trading 11:00 a.m. London time on the last trading day.
Interest rate swaps
FRAs and STIRs only protect for defined interest rate periods, so only parts of the
yield curve and speculators normally want to trade over larger parts of the curve
An interest rate swap (IRS) is a series of FRAs linked together, so two
counterparties agree to exchange a series of cash flows over an agreed period
(the tenor) at an agreed frequency on a notional principal
This is one of the biggest markets in the world, there is 100’s of trillions of dollars
notional outstanding of these, more than 4-5 times all the other derivatives
combined
Fixed

Payer Receiver

Floating
Duration hedging or speculation
FRAs, STIRs, and IRS all have DV01, and so you can figure out your net position
when adding them to a portfolio
FRAs and IRSs have negative duration, so entering a pay fixed will reduce your
portfolios duration, and entering a receive fixed will increase it
You can think about a IRS as being two bonds (one fixed and one floating) and the
duration of the IRS is just the net duration of the two bonds durations