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The first mistake is usually the cheapest mistake.
- A trader adage
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Outline
Introduction
Interest rate futures contracts
Concept of immunization
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Introduction
A portfolio is interest rate sensitive if its
value declines in response to interest rate
increases
• Especially pronounced:
– For portfolios with income as their primary
objective
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Interest Rate
Futures Contracts
Categories of interest rate futures contracts
U.S. Treasury bills and their futures
contracts
Treasury bonds and their futures contracts
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Categories of Interest Rate
Futures Contracts
Short-term contracts
Intermediate- and long-term contracts
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Short-Term Contracts
The two principal short-term futures
contracts are:
• Eurodollars
– U.S. dollars on deposit in a bank outside the U.S.
– The most popular form of short-term futures
– Not subject to reserve requirements
– Carry more risk than a domestic deposit
• U.S. Treasury bills
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Intermediate- and
Long-Term Contracts
Futures contract on U.S. Treasury notes is
the only intermediate-term contract
The principal long-term contract is the
contract on U.S. Treasury bonds
Special-purpose contracts:
• Municipal bonds
• U.S. dollar index
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U.S. Treasury Bills and
Their Futures Contracts
Characteristics of U.S. Treasury bills
Treasury bill futures contracts
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Characteristics of
U.S. Treasury Bills
U.S. Treasury bills:
• Are sold at a discount from par value
Days to maturity
Discount amount = Face value ( ) Ask discount
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Characteristics of
U.S. Treasury Bills (cont’d)
The T-bill yield on a bond equivalent basis
adjusts for:
• The fact that there are 365 days in a year
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Characteristics of
U.S. Treasury Bills (cont’d)
The T-bill yield on a bond equivalent basis:
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Characteristics of
U.S. Treasury Bills (cont’d)
Example
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Characteristics of
U.S. Treasury Bills (cont’d)
Example (cont’d)
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Characteristics of
U.S. Treasury Bills (cont’d)
Example (cont’d)
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Characteristics of
U.S. Treasury Bills (cont’d)
Example (cont’d)
• Of 90-day T-bills
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Treasury Bill
Futures Contracts (cont’d)
Example
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Treasury Bill
Futures Contracts (cont’d)
Example (cont’d)
$1,000,000/(1.0188) = $981,546.92
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Treasury Bonds and Their
Futures Contracts
Characteristics of U.S. Treasury bonds
Treasury bond futures contracts
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Characteristics of U.S.
Treasury Bonds
U.S. Treasury bonds:
• Pay semiannual interest
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Characteristics of U.S.
Treasury Bonds (cont’d)
U.S. Treasury bonds differ from U.S.
Treasury notes:
• T-notes have a life of less than ten year
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Treasury Bond
Futures Contracts
U.S. Treasury bond futures:
• Call for the delivery of $100,000 face value of
U.S. T-bonds
• With a minimum of fifteen years until maturity
(fifteen years of call protection for callable
bonds)
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Sample
Conversion Factors
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Treasury Bond
Futures Contracts (cont’d)
The invoice price is the amount that the
deliverer of the bond receives when a
particular bond is delivered against a
futures contract:
Invoice price = (Settlement price on position day Conversion factor)
+ Accrued interest
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Treasury Bond
Futures Contracts (cont’d)
Position day is the day the bondholder
notifies the clearinghouse of an intent to
delivery bonds against a futures position
• Two business days prior to the delivery date
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Treasury Bond
Futures Contracts (cont’d)
At any given time, several bonds may be
eligible for delivery
• Only one bond is cheapest to delivery
– Normally the eligible bond with the longest duration
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Cheapest to
Deliver Calculation
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Concept of Immunization
Definition
Duration matching
Immunizing with interest rate futures
Immunizing with interest rate swaps
Disadvantages of immunizing
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Definition
Immunization means protecting a bond
portfolio from damage due to fluctuations
in market interest rates
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Duration Matching
An independent portfolio
Bullet immunization example
Expectation of changing interest rates
An asset portfolio with a corresponding
liability portfolio
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An Independent Portfolio
Bullet immunization is one method of
reducing interest rate risk associated with
an independent portfolio
• Seeks to ensure that a set sum of money will be
available at a specific point in the future
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Bullet Immunization
Example (cont’d)
If interest rates increase over the next 6
years:
• Reinvested coupons will earn more interest
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Bullet Immunization
Example (cont’d)
Reduce the interest rate risk by investing in
a bond with a duration of 6 years
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An Asset Portfolio With
A Liability Portfolio
A bank immunization case occurs when
there are simultaneously interest-sensitive
assets and interest-sensitive liabilities
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An Asset Portfolio With
A Liability Portfolio (cont’d)
A bank can immunize itself from interest
rate fluctuations by restructuring its balance
sheet so that:
$ A DA $ L DL
where $ A, L dollar value of rate-sensitive
assets and liabilities
DA , L dollar-weighted average duration
of assets and liabilities
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An Asset Portfolio With
A Liability Portfolio (cont’d)
If the dollar-duration value of the asset side
exceeds the dollar-duration of the liability
side:
• The value of RSA will fall to a greater extent
than the value of RSL
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An Asset Portfolio With
A Liability Portfolio (cont’d)
To immunize if RSA are more sensitive
than RSL:
• Get rid of some RSA
• Reduce the duration of the RSA
• Issue more RSL or
• Raise the duration of the RSL
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Immunizing With
Interest Rate Futures
Financial institutions use futures to hedge
interest rate risk
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Immunizing With
Interest Rate Futures (cont’d)
To hedge, first calculate the hedge ratio:
Pb Db
HR CFctd
Pf D f
where Pb price of bond portfolio as a percentage of par
Db duration of bond portfolio
Pf price of futures contract as a percentage
D f duration of cheapest-to-deliver bond eligible for delivery
CFctd conversion factor for the cheapest-to-deliver bond
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Immunizing With
Interest Rate Futures (cont’d)
Next, calculate the number of contracts
necessary given the hedge ratio:
Portfolio value
Number of contracts HR
$100, 000
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Immunizing With
Interest Rate Futures (cont’d)
Example
A bank portfolio manager holds $20 million par value in
government bonds that have a current market price of $18.9
million. The weighted average duration of this portfolio is 7
years. Cheapest-to-deliver bonds are 8.125s28 T-bonds with
a duration of 10.92 years and a conversion factor of 1.2786.
Pb Db
HR CFctd
Pf D f
0.945 7
1.2786
0.9446875 10.92
0.8199
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Immunizing With
Interest Rate Futures (cont’d)
Example
$18,900,000
Number of contracts 0.8199
$100, 000
154.96
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Immunizing With
Interest Rate Swaps
Interest rate swaps are popular tools for
managers who need to manage interest rate
risk
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Immunizing With
Interest Rate Swaps (cont’d)
A basic interest rate swap involves:
• A party receiving variable-rate payments
– Believes interest rates will decrease
• A party receiving fixed-rate payments
– Believes interest rates will rise
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Immunizing With
Interest Rate Swaps (cont’d)
Interest rate swaps introduce counterparty
risk:
• No institution guarantees the trade
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Disadvantages of Immunizing
Opportunity cost of being wrong
Lower yield
Transaction costs
Immunization is instantaneous only
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Opportunity Cost
of Being Wrong
With an incorrect forecast of interest rate
movements, immunized portfolios can
suffer an opportunity loss
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Lower Yield
The yield curve is usually upward sloping
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Transaction Costs
Buying and selling bonds requires
brokerage commissions
• Sales may also result in tax liabilities
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Immunization Is
Instantaneous Only
A portfolio is theoretically only immunized
for an instant
• Each day, durations, yields to maturity, and
market interest rates change
It is not practical to make daily adjustments
for changing immunization needs
• Make adjustments when conditions have
changed enough to make revision cost effective
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