Interest Rate Futures

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 Features of Interest Rate Futures
Contracts
Short Term Interest Rate Futures
Priced on an index basis
Quoted as 100 minus the implied interest rate
Eg. 3M LIBOR Future at 93.00 implies a rate of 7%
Long Term Interest Rate Futures
Priced similar to the underlying Cash (Bond)
market
Quoted in points and 32nd of a point per USD 100
nominal
Eg. 98-22 means a futures price of 98-22/32

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 Features of Interest Rate Futures
Contracts
Short Term Interest Long Term Interest
Rate Futures Rate Futures
The Contract CME 3 M Euro Dollar Bond Future

Contract Size USD 1,000,000 USD 100,000

Tick Size 0.01 = 1 bp move = 1/32nd of a point =

USD 25 USD 31.25
Delivery Method Cash settlement of the Physical Delivery of a
difference Specified T-Bond or
any other bond (as per
Conversion factors
provided)

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 Features of Interest Rate Future
Contracts
Short Term Interest Long Term Interest
Rate Futures Rate Futures
Contract Months Mar, Jun, Sep, and Mar, Jun, Sep, and
Dec Dec
Last Trading Day 7 Business days prior 7 Business days prior
to the last Bus day to the last Bus day
Delivery Day Last Business Day Last Business Day

Other details Daily Price Limit, Maximum Position Limit,

Trading Hours, Margin Requirements etc...

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 Pricing of Deposit Rate Futures
Price is a function of the underlying cash
market interest rates
e.g. 3M CME Sep EuroDollar Future depends
on the implied 3M rate in September
3M Rate in Sep is the implied forward-
forward rate (say, 6.16%)
The Futures price is then calculated as 100 -
6.16 = 93.84

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 Zero Rates & Forward Rates

A zero rate (or spot rate), for maturity T, is the

rate of interest earned on a risk-free investment
that provides a payoff only at time T
The forward rate is the future zero rate implied
by today’s term structure of interest rates
The zero rates can be obtained from bond prices
using the bootstrap method

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 Calculation of implied forward-
forward rates

EuroDollar 3M (91 day) rate today (Mar end) -

5.75%

EuroDollar 6M (182 day) rate today - 6.00%

What is the implied 3M rate beginning 3 months

(Jun end) from today?

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 Calculation of implied forward-
forward rates

Borrow USD 1 Mn at 5.75% for 3 Months

Lend USD 1 Mn at 6.00% for 6 Months

Amount repayable after 3 months =

(1Mn * 0.0575 * 91/360) = 1,014,535

Amount receivable after 6 months =

(1Mn * 0.0600 * 182/360) = 1,030,333

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 Calculation of implied forward-
forward rates

Forward-Forward implied rate is that rate at

which USD 1,014,535 borrowed for 3
months would amount to USD 1,030,333

Forward-Forward Rate is 6.16%

If actual rates differ, then arbitrage is possible

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Arbitraging using Short Term Futures
If 3M Jun futures is trading at 93.5, implying a
3M Forward-Forward rate of 6.5%
Then Arbitrage by:
Borrow 6 Months at 6.00%, amount payable =
1,030,333
Lend 3M at 5.75%, amount receivable = 1,014,535
Buy Jun futures at 93.5 (Lock in a 3M Deposit rate
of 6.5%)
Amount receivable on the 6.5% deposit = 1,031,204
Arbitrage profit = USD 871

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Arbitraging using Short Term Futures
Long Arbitrage involves purchase of Futures
Short arbitrage involves sale of Futures

Rules for identifying arbitrage:

If Implied Futures rate > Forward Rate,
Then Futures Price < Fair Value
“Long Arbitrage”
If Implied Futures rate < Forward Rate,
Then Futures Price > Fair Value
“Short Arbitrage”

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Pricing and valuation of Swaps

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Pricing and Valuation of Interest
Rate Swaps

How is the fixed rate determined?

Swaps as a series of forwards

Difference between a floating rate bond and fixed

rate bond

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Pricing and Valuation of Interest
Rate Swaps (continued)
A digression on floating-rate securities. The price
of a LIBOR zero coupon bond for maturity of ti
days is
1
B0 (t i ) =
1 + L 0 (t i )(ti /360)

Starting at the maturity date and working back,

we see that the price is par on each coupon
date.

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Pricing and Valuation of Interest
Rate Swaps (continued)
By adding the notional principals at the end, we
can separate the cash flow streams of an interest
rate swap into those of a fixed-rate bond and a
floating-rate bond.
The value of a fixed-rate bond (q = days/360):
n
VFXRB =  RqB (t ) + B (t )
i =1
0 i 0 n

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 Pricing and Valuation of Interest
Rate Swaps (continued)
The value of a floating-rate bond
VFLRB = 1 (at time 0 or a payment date)

At time t, between 0 and 1,

1 + L 0 (t1 )q
VFLRB = (between payment dates 0 and 1)
1 + L t (t1 )(t1 − t)/360
The value of the swap (pay fixed, receive floating)
is, therefore,
VS = VFLRB − VFXRB

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 Pricing and Valuation of Interest
Rate Swaps (continued)
To price the swap at the start, set this value to zero and
solve for R  
 
 1  1 − B 0 (t n ) 
R =   n 
 q  
 
 i =1
B (t
0 i )

Note how dealers quote as a spread over Treasury rate.
To value a swap during its life, simply find the
difference between the present values of the two
streams of payments. Market value reflects the
economic value, is necessary for accounting, and
gives an indication of the credit risk.
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 Swap Valuation Example
Today is t = 0 = March 1, 2001. Consider a firm that sold a piece of
equipment to a highly rated corporation, and it is then due to
receive payments in 10 equal installments of $5.5 million each
over 5 years. The firm would like to use these $5.5 million semi-
annual cash flows to hedge against the coupon payments the firm
must make to service a $200 million, floating rate bond that it
issued some time in the past, and also expiring in 5 years.
Suppose that the floating rate on the corporate bond is tied to the
LIBOR, at LIBOR + 4 bps. The 6-month LIBOR on March 1,
2001 is currently at 4.95% and so the next interest rate payment
the firm must make is (4.95+0.04)%/2×200 million= $4.9 million.
So, the next floating rate coupon payment is covered. However,
if the LIBOR were to increase by more than 0.51% in the next 5
years, the cash flows from the installments would not be
sufficient to service the debt.
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 Swap Valuation Example
A solution is to enter into a fixed-for-floating swap with an
investment bank, in which the firm pays the fixed semi-annual
swap rate c, over a notional of $200 million, and the bank pays
the 6-month LIBOR to the firm. On March 1, 2001, the swap rate
for a 5-year fixed-for-floating swap was quoted at c = 5.46%. So,
in this case, the net cash flow to the firm from the swap contract
is

Net cash flow to the firm at Ti

= $200 million × (1/2) × [r2 (Ti-1) − 5.46%]
where r2 (t) is the six month LIBOR at time t.

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 Swap Valuation Example
Why does this swap resolve the problem?
Consider the net position of the firm:

At every Ti the firm

1. receives 5.5 million;
2. pays (r2 (Ti-0.5) + 4bps)/2 × 200 million on its outstanding floating
rate debt;
3. receives r2 (Ti-0.5)/2 × 200 million from the bank as part of the
swap;
and
4. pays 5.46% × 0.5 × 200 million to the bank as part of the swap.

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Swap Valuation Example

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 Swap Valuation Example
Summing up, the firm’s net cash flow position from the receivable,
debt, and swap is

Total cash flow at Ti = 5.5 million (Receivable)

− (r2 (Ti-0.5) + 4bps)/2 × 200 million (Debt)
+0.5 × [(r2 (Ti-0.5) − 5.46%] × 200 million (Swap)
= 5.5 − 0.04% × 100 − 5.46% × 100
=0
That is, the firm is perfectly hedged: The risk in the fluctuations of
the LIBOR stemming from its liabilities has been eliminated by
the swap (the firm receives the LIBOR from the bank, and pays
the LIBOR + 0.04% to bond holders). The remaining fixed
components sum up to zero.
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 Swap Valuation Example
Value of swap = Value of floating rate bond − Value of fixed rate
bond
i,.e.,
V swap (t; c, T) = PFR(t, T) − Pc (t, T)
Value of a floating rate bond:
Let T1 , T2 , ... Tn be the floating rate reset dates and let the current
date t be between time Ti and Ti+1: Ti < t < Ti+1. The general
formula for a semi-annual floating rate bond is
PFR(Ti , T) = Z(t, Ti+1) × 100 × [1 + r2 (Ti)/2]
where Z(t, Ti+1) is the discount factor from t to Ti+1.
At reset dates, Z(Ti , Ti+1) = 1/(1 + r2 (Ti)/2), which implies
PFR(Ti , T) = 100
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 Swap Valuation Example
At payment dates Ti , the value of the floating rate bond is PFR(t, T) =
100. Also, using the price of the fixed rate bond Pc (Ti , T) we then
obtain

Using the discount factor in the next slide, we obtain

V swap (t; c, T) = 100 – ((0.0546/2) x 100 x 8.69 + 0.7628 x 100)
= 100 – (23.7237 + 76.28)
= 100 – 100.0037
0
This means that the swap doesn’t cost anything
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 Swap Valuation Example
LIBOR Discounts and Swap Curve from Federal Reserve

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 Swap Valuation Example
The swap rate c is given by that number that makes V swap (0; c, T)
equal to zero. Rewriting the equation generically for any
payment frequency n and payment dates T1 , ... TM , we have

Solving this, we get

From the table, one can observe that the swap rate is 5.46%, which
is exactly the rate given by the bank. 26
 Additional Slides on
Interest Rate Futures

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 Pricing of Bond Futures
Bond Future Prices represent arbitrage rates
implied by the current market rates

Example of 6 Month future price of a Bond

Bond having a coupon rate of 8% p.a. payable
semi-annually on 30/360 basis
Present Bond price is 98.00
Buy bond at 98
Coupon receivable is USD 4

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 Pricing of Bond Futures
Cost of funding the purchase of bond is at 6 M
rate (say, 6%)
= 0.06 * 182/360 * 98.00 = USD 2.97

Therefore, carry = USD 4.00-2.97 = USD 1.03

(positive)

Price of 6M future is 98.00-1.03 = 96.97 = 96-31

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 Arbitrage using Bond Futures
A range of bonds are deliverable into Bond futures
In order to equate the different bonds, conversion
factors are applied
The difference between the cash price of the
deliverable bond and the related future represents
the cost of carrying the deliverable bond into the
futures contract
Arbitrage exists when the carry cost is not factored
into the price of the future

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 Arbitrage using Bond Futures

Sale of futures and buying the deliverable

bonds with borrowed funds is called
Short Cash and Carry Arbitrage

Purchase of futures and short sale of the

deliverable bonds is called Long Cash
and Carry Arbitrage

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 Arbitrage using Bond Futures
In the previous example
Bond having a coupon rate of 8% p.a. payable semi-
annually on 30/360 basis
Future Price is 96-31
If Present price of the bond is 97.00 (instead of 98.00)
Buy bond at 97, sell Future at 96-31(96.97)
Receive coupon of USD 4
Cost of funding the purchase of bond is at 6 M rate of
6%
= 0.06 * 182/360 * 98.00 = USD 2.97
Therefore, Profit = 96.97 - 97 + 4.00 - 2.97 = USD 1
“Short Cash and Carry Arbitrage”
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 Hedging with Interest Rate Futures
Hedging helps to lock in the rate of interest at a
future date
This is because of convergence of the future
price and the cash price on the date of
expiration of the future
Long Hedge - Purchase of a future to hedge
against falling interest rates
Short Hedge - Sale of a Future to hedge against
rising interest rates
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Hedging with Interest Rate Futures

For any change in rates, loss (gain) on the

underlying cash transaction is offset by
gain (loss) on the hedge

If the date of the cash exposure exactly

matches the date of expiration of the
future, then there is no basis risk and the
future exactly hedges the transaction

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 Hedging with Interest Rate
Futures - Example

An investor wants to lock in a rate for a 6M

investment of USD 1 Mn in end-June

June futures are quoting at 94.00, implying

a rate of 6%

Investor buys 1 contract of Face Value USD

1,000,000 at 94.00

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 Hedging with Interest Rate
Futures - Example
On June 30, if the cash market rate is 5%, the investor
realizes an interest rate of 5% p.a.
Loss on cash market transaction = 1%*1Mn*182/360
= USD 5055.55
Futures price on 30 June is 95.00 (100 less 5)
Gain on the futures transaction =
1 (contract) * 50 (tick value) * 100 (ticks)= USD
5,000
Thus, investor realizes an interest rate of 6% (almost)

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 Hedging with Interest Rate Futures

The accuracy of the hedge can be improved

by weighing the number of contracts

If we use 1.0111 contracts, then loss in the

cash market exactly hedges gain in the
futures market

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Hedging with Interest Rate Futures
If dates of cash market exposure and futures expiry
do not coincide, it is still possible to use futures
for hedging
Effectiveness of the hedge depends upon change in
the “basis”
“Basis” is defined as the difference between the cash
market price and the futures price
If this difference remains constant, then a future
allows effective hedging even if the dates do not
coincide

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 Hedging with Interest Rate Futures
Effectiveness of the hedge can be improved by
Using the correct futures contract
High co-efficient of correlation between the
underlying exposure and available futures contract
Using the correct number of futures contracts
“Money equivalency” of a futures contract
Using the correct futures contract month
The first contract to expire after the date of the cash
market exposure

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 Advantages of Hedging using
Futures

Ease and flexibility in closing out positions

Negligible credit risk
Liquidity
No price discrimination between trade sizes
Anonymity
Leverage

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 Disadvantages of Hedging using
Futures
Structuring hedges can be complex due to the
standardized nature of futures contracts

Cash flow impact due to daily margin calls

Opportunity costs arise if rates do not move as

expected

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 Hedging with Bond Futures
Long Hedge
Involves Purchase of Long Term Interest Rate
Futures
Protects against a reduction in interest rates
For investors with cash surplus looking to buy
bonds at a future date
Short Hedge
Involves Sale of Long Term Interest Rate Futures
Protects against an increase in interest rates
For investors already holding bonds and
anticipating a decline in value of the bonds due to
an increase in interest rates
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 Hedging with Bond Futures

How to weigh the hedge?

Number of futures contracts obtained by:

(Par Value of the cash position) / (Face
Value of Futures) * Conversion Factor

The Conversion Factor depends upon the

bond to be hedged

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 Duration of a Bond Portfolio
Another way to determine the weighing of a
hedge
Duration is defined as
 (Ci x Ti)  (1+YTM)Ti
Price
Ci - Cash Flows
Ti - Time
What is the duration of a Bond?

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 Duration of a Deposit Future
Equal to the duration of the underlying
deposit

Example:
3M Future - Duration is 3 M

Implies a 1 bp change in the 3M yield would

change price by
1*3/12 = 0.25 bps

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 Duration of a Future on a Bond

Equal to the duration of the underlying bond

(actually the duration of the forward bond)

Example:
Future on a 10 year bond - Duration is 10 Years

Implies a 1 bp change in the 10 year yield would

change price by 10 bps

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 Adjusting Duration of a Portfolio
Assume a portfolio of value USD 10 Mn with a
duration of 5 Years

What would be the number of Bond Futures required

to hedge the above portfolio?

Face value of the future is USD 100,000

Underlying bond duration is 8 years

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 Adjusting Duration of a Portfolio
Duration of Bond Portfolio * Value
+ Duration of Bond Future * Value
= Net Duration * Value

For Net Duration = 0,

5yrs * 10,000,000 = 8yrs * 100,000 * N

Therefore, N = 62.5 contracts

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