Hedging With Futre

David Dubofsky and 9-1
Thomas W. Miller, Jr.

Chapter 9
T-Bond and T-Note Futures
Futures contracts on U.S. Treasury securities have
been immensely successful.

But, the outlook for Treasury bond futures contracts
is bleak, as the government has not issued any new
30-year bonds since October 2001.
CBOT Treasury Volume,
Contract Jan - Aug 2002
Treasury Bond 38.0 million
10-year Tnote 59.4 million
The T-bond Futures Contract
Underlying asset is: $100,000 (face value) in
deliverable T-bonds.

Futures prices are reported in the same way as are
spot T-bonds, in "points and 32nds of 100%" of face
value.

A T-bond futures price of 112-15 equals 112 and
15/32% of face value, or $112,468.75.

A change of one tick, say to 112-14, results in a
change in value of $31.25.
T-Note Futures Prices
For T-bonds, a tick is 1/32
nd
. The resulting quote of 112-15
equals 112 and 15/32.

But, for 5 and 10-year T-notes, a tick is of a 32
nd
, or
$15.625 per tick. The resulting quote, say, of 98.095 = 98 and
9.50/32.

For 2-year T-Notes, however, tick sizes are of a 32
nd
. So,
A quote of 92.072 = 92 and 7.25/32.
A quote of 109.017 = 109 and 1.75/32.
But, the contract size is $200,000 of deliverable T-Notes, so a
tick = $15.625.

For CBOT futures prices for T-bonds and T-notes, see:
http://www.cbot.com/cbot/www/page/0,1398,12+31,00.html .
What Determines T-bond and T-note
Futures Prices, Basically?
In a very simple sense, the futures price is the forward
price of a Treasury bond, such that it has a forward yield
[fr(t1,t1+30)] consistent with:

[1+r(0,t1+30)]
t1+30
= [1+r(0,t1)]
t1
[1+fr(t1,t1+30)]
30

t1 = time until delivery, in years.
0 t1 t1+30
What is Deliverable? And When?

Under the terms of the T-Bond futures contract:
Any Treasury Bond that has fifteen or more years to first call, or at
least 15 years to maturity (whichever comes first), as of the first day
of the delivery month, is deliverable.
Therefore, the seller of the futures contract has the option of
choosing which bond to deliver.
Delivery can take place on any day in the delivery month, and the
short chooses.
Under the terms of the 10-year T-note futures contract:
Any U.S. T-note maturing at least 6 1/2 years, but not more than 10
years, from the 1
st
day of the delivery month is deliverable.
Which T-bond will the Short
naively Choose to Deliver?
Assuming the short will receive the same dollar
amount (invoice amount) upon delivery:
The short will select the T-bond that costs less than
any other deliverable T-bond.
So, to fix this problem, the CBOT adjusts the invoice
amounts to try to make all T-bonds equally deliverable.
If the short delivers a low priced bond, the short will receive
less (low conversion factor)
If the short delivers a high priced bond, the short will receive
more (high conversion factor).
The Invoice Amount and Conversion Factors

A conversion factor for a given T-bond is its price if it had a $1 face
value, and was priced to yield 6%.

For a file of conversion factors, see:
http://www.cbot.com/cbot/www/cont_modular/0,2291,14+479+12,00.html#a.

So a cheap, low coupon bond will have a small conversion factor.

Therefore, the short will receive less.
( ) ( )( )( ) ( )
interest
accrued
factor
conversion
price settlement
contract futures
size
contract
amount
invoice
+ =
So NOW, Which T-bond Will
the Short Choose to Deliver?
The one that costs the least.

.and at the same time gets the short the most money upon
delivery (i.e., the highest invoice amount).

That is, the Max [invoice amount quoted spot price]

(Accrued Interest is ignored because it is included in both the
invoice amount and the gross cash bond price)

Max [(CF)(F) (S)]

During the delivery month, the amount in brackets will always be
negative, for every deliverable bond.. WHY?
Another Method to Identify the
Cheapest to Deliver T-bond
Before the delivery month, find the T-bond with the highest
Implied Repo Rate. This is given by:

Can be used to identify the most likely to be delivered T-bond.
When coupons will be paid between today and the delivery day,
include them, and the interest earned on them, in the carry
return (see eqn. 9.5b).
| |
T
365
]
0
AI [S
]
0
AI [S ]
T
AI [(CF)(F)
IRR
+
+ +
=
(
A Good Concept Check

Identify three T-bonds that are deliverable into the
nearby T-bond futures contract.

Which of these three bonds is the cheapest to
deliver?

Be able to show your work, and be able to explain
why one of the T-bond is more likely to be delivered
than the other two.
Questions

The implied repo rate for every deliverable T-bond
must be less than interest rates available in the market
(WHY?)

Reverse cash and carry arbitrage will (almost never)
be possible (WHY?)
The Options Held by the Short
Quality option: can deliver any eligible bond.

Timing option: can deliver on any day of the delivery
month.

Wild card option: futures cease trading at 2PM, but the
short can announce intent to deliver as late as 8PM.

End of month option: futures cease trading 8 business
days before the end of the delivery month, but the short
can deliver on any day of the month.
Theoretical T-bond Futures Price
Once the C-T-D T-bond has been identified,
F = S + CC - CR (- value of shorts options)

( )
( )
( )
( )
(
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+ + |
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=
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+
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+ + =
(

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+ +
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.
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=
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+ + =
T 0
T 0
0
AI
365
t) r(T
1
2
C
365
rT
1 ) AI (S
CF
1
F
AI
365
t - T r
1
2
C
-
365
rT
1 AI S (CF)(F)
T
AI
365
rT
1
0
AI S
CF
1
F
T
AI
365
rT
1 AI S (CF)(F)
Using T-bond and T-note Futures to
Hedge Interest Rate Risk
Buy T-bond or T-note futures to hedge against falling interest
rates. Sell them to hedge against rising interest rates.
(Remember that when interest rates fall, bond prices rise, and
when interest rates rise, bond prices fall.)
Use T-bond futures to hedge against changes in long-term (15+
years) rates. Use 10-year T-note futures to hedge against
changes in 8-10 year rates.
Ar
Inherent risk
exposure
Aprofits
Long T-bond futures
Short T-bond futures
Ar
Aprofits
Dollar Equivalency
Estimate the loss in value if the spot YTM adversely changes by one
basis point, denoted AV
S.
Estimate the AYTM of the CTD Treasury security if the spot YTM
changes by a basis point; assume the CTDs YTM will change by b
basis points. Compute the change in the CTDs price if its YTM changes
by b basis points. Denote this as AS
CTD.

Estimate the change in the futures price if the CTDs price changes by
AS
CTD
, denoted AF per $100 face value. It can be shown that:

The profit, AV
F
, is then $1000 AF.
Compute the number of futures contracts to trade, N, so that

N AV
F
= AV
S
CTD
S
CF
T) h(0, 1
F
+
=
Bond Pricing, I
U.S. Treasury bonds and notes are coupon bonds. Their values
are computed using:

C is the semiannual coupon payment.
F is the face value.
Y is the unannualized, or periodic, 6-month yield.
N is the number of 6-month periods to maturity.
This assumes that the first coupon payment is 6 months hence.
( ) ( ) ( ) ( )
N N 2 1
y 1
F
y 1
C
...
y 1
C
y 1
C
Value
+
+
+
+ +
+
+
+
=
Bond Pricing, II
To calculate the value of a bond , one must discount each cash flow
at the appropriate zero rate.
For example, let r(0,t) be the annual spot rate for a zero coupon
bond maturing t years from today. Then,
Let r(0,0.5) = 2%, r(0,1) = 2.5%, r(0,1.5) = 3%, and r(0,2) = 3.3%.
The semiannual coupon amount is $25, and face value is $1000.
Maturity is 2 years hence.
The bonds value is:
1033.098
1.0165
1000
1.0165
25
1.015
25
1.0125
25
1.01
25
4 4 3 2
= + + + +
Yield to Maturity (YTM)
The YTM is the discount rate that makes the present value of the
cash flows on the bond equal to the market price of the bond.

Input PV = -1033.098, FV = 1000, PMT = 25 (semiannually), N = 4
(this is four semiannual periods) => CPT I/Y = 1.63838% (per six-
month period). (1.63838%) (2) = 3.277% = YTM

With Excel, use =YIELD("9/15/02","9/15/04",0.05,103.3098,100,2,0)

With FinCAD, use aaLCB_y
Duration
Duration is the weighted-average of the time cash flows are
received from a bond. Example:

Verified with Excel:
=DURATION("6/25/2001","6/25/2003",0.06,0.068755,2,0)
We will see that Modified Duration is handy for hedging
purposes.
Modified Duration: D/(1 + YTM/2) = 1.9135 / (1.03438) = 1.85.
Time Cash Flow P Value Weight Time * Wgt
0.50 3.00 2.9003 0.0295 0.0147
1.00 3.00 2.8039 0.0285 0.0285
1.50 3.00 2.7107 0.0276 0.0413
2.00 103.00 89.9747 0.9145 1.8289
Sum: 98.3897 1.0000 1.9135
U.S. Treasury Bond Price Quotes
U.S. T-bond and T-note prices are in percent and 32nds of face value.

For example (see fig. 9.1), on 12/01/00, the bid price of the 6 3/8% of
Sep 01 T-note was 100 and 4/32% of face value.

If the face value of the note is $1000, then the bid price is $1001.25.

The asked price of this note is $1001.875.

N.B. These prices are based on transactions of $1 million or more. In
other words, a trader could buy $1 million face value of these notes for
about $1,001,875 from a government securities dealer.

These prices are quoted flat; i.e., without any accrued interest.
Cash price = Quoted Price + Accrued Interest.
On December 1, 2000, the 6 3/8% of
September 2001 was quoted to yield 6.12%.
You can verify by using the YIELD function in Excel:
=YIELD("12/01/00","9/30/01",0.06375,100.1875,100,2,1)
To Calculate the cash price (quoted price + AI), you would pay:
The ask price is 100:06, or $1001.875 for a $1000 par bond.
Coupons on this note are paid every March 31 and September 30.
The last coupon was paid on September 30, 2000, which is 62 days
before December 1, 2000.
There are 182 days between the last coupon payment date and the
next one on March 31, 2001.
Interest accrues on an actual/actual basis. Thus the buyer pays the
seller accrued interest equal to:
AI = (62/182)*(63.75/2) = $10.859
The cash price (quoted price plus accrued interest) is:
QP + AI = $1001.875 + $10.859= $1012.73.
Some Extra Slides on this Material
Note: In some chapters, we try to include some extra
slides in an effort to allow for a deeper (or different)
treatment of the material in the chapter.

If you have created some slides that you would like to
share with the community of educators that use our
book, please send them to us!
Hedging With T-Bond Futures:
Changing the Duration of a Portfolio
Hedging decisions are essentially decisions to alter a portfolios
duration.
By buying or selling futures, managers can lengthen or shorten
the duration of an individual security or portfolio without
disrupting the underlying securities (an overlay).
That is, adding (buying) T-bond or T-note futures to a portfolio
increases its interest rate sensitivity, while selling futures
decreases the interest rate sensitivity of the portfolio.
A portfolio manager will want to decrease (increase) the
duration of the portfolio if the manager expects interest rates to
increase (decrease).
A completely hedged portfolio lowers the duration to the
duration of a short-term riskless Treasury bill.

The Key Concept:
Basis Point Value (BPV).
The bond portfolio manager can change the duration
of the existing portfolio to the duration of a target
portfolio. This immunizes the portfolio against a
change in interest rates.
That is, if the portfolio manager knows:
how the current and target portfolios respond to interest rate
changes.
how T-bond (or T-note) futures contracts respond to interest
rate changes.
Fortunately, if interest rates change by a small
amount, say one basis point, the value of the portfolio
will change predictably.
BPV, II.
Using the bond pricing formula, the duration formula, and some
algebra, the change in the value of a bond or a portfolio of
bonds if interest rates change by one basis point can be written:

When dy = 0.0001 (1 basis point), then dB is called the basis
point value (BPV).
dy B
y) (1
Duration
dB
+
=
BPV, III.
If y is defined to be one-half of the bonds annual yield to
maturity (YTM), then for a bond, or a portfolio of bonds:

0.0001 Bond of Value Market
YTM/2) (1
Duration
dB BPV
+
= =
BPV, IV.
The portfolio manager chooses a target duration so that it will
have a particular BPV; i.e., a targeted change in value if interest
rates change by one basis point.

Assuming that the CTD bond and the bond portfolio will both
experience a one basis point change in yield, the goal is to
choose to buy or sell N
F
futures contracts so that

BPV (target) = N
F
BPV (futures) + BPV (existing)

Thus, the BPV of the existing portfolio, the target portfolio, and
the futures contract must be computed.
BPV, V.
To determine the BPV for either a T-bond or T-note futures
contract, the cheapest-to-deliver (CTD) security must first be
identified.
The futures price generally tracks the CTD security.
The BPV of the futures price is generally written as a present
value BPV(futures)/[1+h(0,T)] where BPV(futures) is the BPV of
the cheapest-to-deliver instrument divided by the CTDs
conversion factor.
To solve for the appropriate number of futures contracts needed
to change the duration of an existing portfolio to a target
duration:
N
F
= [BPV (target) - BPV (existing) ] / BPV (futures)
Example Using BPV
Facts:
On December 1, 2000, a fixed-income portfolio manager
expects a steep decline in bond yields over the next six
weeks.
Because of these strong beliefs and aggressive
management, the manager decides to more than double the
duration of his fixed-income portfolio.
The manager wants to avoid disrupting his carefully
constructed bond portfolio to profit from the belief that
interest rates will decline only over the next six weeks.
Therefore, the manager decides to buy T-bond futures to
increase the duration.
Inputs:
Existing Portfolio Duration: 5.7
Target Duration: 12.0
March T-Bond Futures Price: 102-03
Portfolio Value: $100,000,000
Portfolio Yield to Maturity: 6.27%

Solution:
1. Find the BPV of the existing portfolio and the target
portfolio:

BPV(existing) = (5.7 /(1 + 0.0627/2)) * $100,000,000 * 0.0001 = $55,267.36
BPV (target) = 12 /((1+0.0627/2)) * $100,000,000 * 0.0001 = $116,352.35
2. Calculate the BPV of the T-Bond futures contract.

It has a face value of $100,000.
Using well-known techniques, one can determine that the
CTD T-bond on December 1
st
for March futures is the
8.875% of August 2017.
On December 1
st
, the conversion factor of this T-bond is
1.2957, duration is 9.83, and YTM is 5.80%. So,if interest
rates change by one basis point, then the value of the CTD
T-Bond will change by

BPV of CTD = 9.83 / (1+0.0580/2) * $100,000 * 0.0001 = $95.53.

If the interest rate on 6-week treasury bills is 5%, then h(0,T)
= (0.05)(6)/52 = 0.0058. Thus, we find
BPV of Futures: $95.53(1.0058) / 1.2957 = $74.156

Finally,
3. Determine the number of contracts required to
achieve the desired portfolio duration:

N
F

($116,352.35 - $55,267.36) / $74.156= 823.736

The bond portfolio manager should buy 824 March T-Bond
futures contracts in order to increase the portfolios duration to
12 years.
Note that the portfolio manager can choose any target duration.
Finally, (Really)
Suppose the manager chooses to have a target
duration of zero. This makes the BPV of the target
equal zero. Then,

N
F

(0 - $55,267.36) / $74.156= -745.285

The bond portfolio manager should sell 745 March T-
Bond futures contracts in order to decrease the
portfolios duration to 0 years.
Reading Treasury Bond Futures Prices
Delivery dates exist every 3 months.
Delivery months are in March, June, September, and
December.
On December 1, 2000, the Dec T-bond settle price is 102-02.
This equals 102 and 2/32% of face value, or $102,062.50.
The December 2000 futures price was down 17 ticks, or 17/32.
This means that on December 14, 2000, the December contract
settled at 102-19.
A price change of one tick (1/32) will result in a daily
resettlement cash flow of $31.25.

Treasury Bond Futures, Delivery
The Delivery Process is Complicated. But, in sum:
Any Treasury Bond that has fifteen or more years to
first call, or at least 15 years to maturity (whichever
comes first), as of the first day of the delivery
month.
The seller of the futures contract, I.e., the short,
has the option of choosing which bond to deliver.
Delivery can take place on any day in the delivery
monththe short chooses.
Cash received by the short = (Quoted futures price
Conversion factor) + Accrued interest.
Conversion Factor? Wha?
The Necessity for the Conversion Factor
At its website, the CBOT lists deliverable T-bonds and T-notes,
by delivery date.
For example, as of November 29, 2000, there were 34 T-bonds
deliverable into nearby T-bond futures contracts.
By allowing several possible bonds to be delivered, the CBOT
creates a large supply of the deliverable asset.
This makes it practically impossible for a group of individuals
who are long many T-bond futures contracts to corner the
market by owning so many T-bonds in the cash market that the
shorts cannot fulfill their delivery obligation.
Recall that the invoice price equals the futures settlement price
times a conversion factor plus accrued interest.
The conversion factor is the price of the delivered bond ($1 par
value) to yield 6 percent.
The purpose of applying a conversion factor is to try to equalize
deliverability of all of the bonds.
If there were no adjustments made, the short would merely
choose to deliver the cheapest (lowest priced) bond available.
In theory, if the term structure of interest rates is flat at a yield of
6% then, by applying conversion factor adjustments, all bonds
would be equally deliverable.
In practice, however, there is a cheapest to deliver or CTD T-
bond. This is the T-bond used to price futures contracts on T-
bonds.

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Hedging With Futre

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David Dubofsky and 9-1

Thomas W. Miller, Jr.

A Good Concept Check

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