Interest rate Futures and Swaps

1. Interest rate Futures and Swaps • Interest-rate futures contracts • Pricing Interest-rate futures • Applications in Bond portfolio management • Interest rate Swap Ch26

2. Basics of Futures • Definition • A futures contract is an agreement between a buyer (seller) and an established exchange or its clearinghouse in which the buyer (seller) agrees to take (make) delivery of an asset at a specified price at the end of a designated period of time. • Opening position • Liquidating a position • Liquidation before settlement • Hold until settlement • delivery • Cash settlement Ch26

3. Basics of Futures • Role of Clearinghouse • When an investor takes a position in the futures market, the clearinghouse takes the opposite position and agrees to satisfy the terms set forth in the contract. • Give instruction of delivery in the day of settlement • Margin requirement • Initial margin • Maintenance margin • Variation margin • Leverage is involved when taking position in futures • Marking to market • As futures price changes, the proceeds accrue to the trader’s margin account immediately. • Difference from Forwards • More standardized and low default risk Ch26

4. Risk and Return Characteristics • Page 613 • Leverage aspect Ch26

5. Treasury Bill Futures • It is based on 13-week treasury bill with a face value of $1 million • Seller needs to deliver to the buyer at the settlement date a Treasury with 13 weeks remaining to maturity • Index price = 100 – (yd*100) • Where yd = D/F*(360/t) • A change of one basis point will change the dollar discount, and the invoice price, by Ch26

6. Example • The index price for a Treasury bill futures contract is 92.52. Then • Yd • D • Invoice price (how much the buyer needs to pay) Ch26

7. Eurodollar CD Futures • Traded on • International Monetary Market of Chicago Mercantile Exchange • London International Financial Futures Exchanges • Underlying asset: 3-month Eurodollar CD • Face value is &1 million, price quoted as: 100 – annualized futures LIBOR Ch26

8. Treasury Bond Futures • Underlying asset is $100,000 par value of a hypothetical 20-year 6% coupon bond • CBOT allows the seller to deliver one of several Treasury bonds that the CBOT declares is acceptable for delivery. • Conversion factor: • Invoice price (example see page 618) • Invoice price = contract size*futures contract settlement price*conversion factor + accrued Interest Ch26

9. Pricing Interest Rate Futures • A 20-year 100-par-value bond with a coupon rate of 12% is selling at par. • The bond is the deliverable for a futures contract that settles in three months. • Current 3-month interest rate is 8% per year • What should be the price of the futures contract? Ch26

10. What will you get from the futures contract? • If you take long position in the futures • After 3 months, pay futures price • Get the bond • Pay accrued interest • If you take short position in the futures • Deliver the bond after 3 month • Get futures price and accrued interest Ch26

11. Cash-and-carry trade • You decide to hold the hold the bond and take a short position in futures • Sell futures at P • Get accrued interest • Purchase bond by borrowing money Ch26

12. Reverse cash-and-carry trade • Buy the futures contract at P • Sell the bond for ? • Invest the proceed for 3 months at 8% per year Ch26

13. Theoretical Futures Price • F=P[1+t(r-c)] • Where r is financing rate, c is current yield, P is cash market price, and F is futures price and t is time, in years to the futures delivery date • R-c is the net financing cost Ch26

14. Bond Portfolio Management Applications • Speculating on the movement of interest rate • Controlling the interest rate risk of a portfolio • Creating synthetic securities for yield enhancement • Hedging Ch26

15. Creating Synthetic Securities for Yield Enhancement • Consider an investor who owns a 20-year treasury bond and sells treasury futures that call for the delivery of that particular bond 3 months from now. • Synthetic 3-month T bill. • Yield on the synthetic 3-month t-bill and yield on the cash market treasury bill. Ch26

16. Hedging • Hedging: taking a futures position as a temporary substitute for transactions to be made in the cash market at a later date. • The outcome of a hedge will depend on the relationship between the cash price and the futures price • The difference between cash price and futures price is basis • The risk that the basis will change in an unpredictable way is basis risk Ch26

17. Hedging • Cross hedging • Short hedge • Long hedge • Hedge ratio Ch26

18. Allocating Funds between Stocks and Bonds • An alternative way to reallocate assets is to buy and sell interest rate futures and stock index futures • Benefits • Transaction costs are lower • Market impact costs are avoided • Activities of the money managers employed by the pension sponsor are not disrupted Ch26

19. Interest rate Swap Basics • Two parties agree to exchange periodical interest payments. The dollar amount fo the interest payments exchanged is based on a predetermined dollar principal, notional principal amount. (example: page 590) • Fixed-rate payer • Floating-rate payer • Viewed as a package of forward contracts Ch26

20. Exercise • Chapter 26, Problem 4, 11. Ch26