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Interest Rate Forwards and Futures

Chapter 7
Acknowledgement: The content of this presentation is based on Chapter 7 of Derivatives Markets (Third Edition) - Robert L. McDonald


Bond Basics
• Notation – rt0 (t1,t2): interest rate from time t1 to t2 prevailing at time t0 – Pto(t1,t2): price of a bond quoted at t = t0 to be purchased at t = t1 maturing at t = t2 – Yield to maturity: percentage increase in dollars earned from the bond

881659 .943396 • Pay $0. must satisfy 4 .2))2=>r(0.Bond Basics • Zero-coupon bonds make a single payment at maturity – One year zero-coupon bond: P(0.065=6.1=0.5% 3 Bond Basics • Zero-coupon bond price that pays Ct at t: • Yield curve: graph of annualized bond yields against time • Implied forward rates – Suppose current one-year rate r(0.06 = 6% = r (0.943396 .1) – Two year zero-coupon bond: P(0.2)=0. r0(1.1)=0.2) – Current forward rate from year 1 to year 2.1) and two-year rate r(0.2).1 = 0.134225=(1+r(0.2)=0.943396 today to receive $1 at t=1 • Yield to maturity (YTM) = 1/0.881659 • YTM=1/0.

Bond Basics 5 Discussion • In general • Example 7.1 – What are the implied forward rate r0(2.3) from year 2 to year 3? (use Table 7.3) and forward zero-coupon bond price P0(2.1) 6 .

• Can be settled at maturity (in arrears) or the initiation of the borrowing or lending transaction: – FRA settlement in arrears: (rqrtly.Bond Basics • Coupon bonds – The price at time of issue of t of a bond maturing at time T that pays n coupons of size c and maturity payment of $1 where ti = t + i(T .rFRA) x notional principal – At the time of borrowing: notional principal x (rqrtly.t)/n – For the bond to sell at par the coupon size must be 7 Forward Rate Agreements • FRAs are over-the-counter contracts that guarantee a borrowing or lending rate on a given notional principal amount. 8 .rFRA)/(1+rqrtly) • FRAs can be synthetically replicated using zero-coupon bonds.

To get $1.211)=.018 we buy 1.95836 We want to lock in a rate of 1.97561 at t=0 To have zero cash flow at t=0 we short-sell .018xP(0.5% P(0.8% from day 120 to 211 i.Synthetic FRA P(0.e.97561 of P(0.211) = .120).120) = .97561 => y = 2.018 on day 211. 9 Ignore Section on Eurodollar Futures 10 . we invest $1 on day 120 and receive $1.

81% 11 Duration Average life of a bond.0229/81.07)3 = 81.01% P=81.06069 PVBP = .01%? At 7.6298 What is the Price if y=7. 12 .Price Value of a Basis Point (PVBP) If y=7% then the P = 100/(1. Approximate ratio of the proportional change in bond price to the absolute change in yield.0229 per $100 Therefore for a 1% change in y the change in price is approximately 100 x (.6298) = 2.

Discussion P = Sum [CFi x (1 + y/m)-i/m] What is the first derivative wrt to y of the price function P? 13 Duration • Duration is a measure of sensitivity of a bond’s price to changes in interest rates – Duration $ Change in price for a unit change in yield divide by 10 (10.000) for change in price given a 1% (1 basis point) change in yield – Modified Duration % Change in price for a unit change in yield – Macaulay Duration Size-weighted average of time until payments – y: yield per period. to annualize divide by # of payments per year – B(y): bond price as a function of yield y 14 .

058 – Using ordinary bond pricing: B(7.25%) = $81.060 • The formula is only approximate due to the bond’s convexity 16 .Duration • What is the new bond price B(y+ε) given a small change ε in yield? – Rewrite the Macaulay duration – And rearrange 15 Duration • Example 7.25%? – B(7.0725)3 = $81.63. a yield of 7% and Macaulay duration of 3 – What will be the price of the bond if the yield were to increase to 7.25%) = $100 / (1.63 – ( 3 x $81.63 x 0.07 ) = $81.0025 / 1.7 – Consider the 3-year zero-coupon bond with price $81.

432.5% – You can verify that B1= $94.297 17 Convexity The curvature in the relationship between bond prices and bond yields. and Macaulay duration D2 do we need to short to eliminate sensitivity to interest rate changes? The hedge ratio – The value of the resulting portfolio with duration zero is B1+NB2 • Example 7. D1=5.8 – We own a 7-year 6% annual coupon bond yielding 7% – Want to match its duration by shorting a 10-year.Duration • Duration matching – Suppose we own a bond with time to maturity t1. 18 .611. B2=$103. price B1. and D2=7. Basically the second derivative the price function wrt the interest rate.882. and Macaulay duration D1 – How many (N) of another bond with time to maturity t2. price B2. 8% bond yielding 7.

19 Repurchase Agreements • A repurchase agreement or a repo entails selling a security with an agreement to buy it back at a fixed price. • The underlying security is held as collateral by the counterparty => A repo is collateralized borrowing • Can be used by securities dealers to finance inventory. 20 . • Speculators and hedge funds also use repos to finance their speculative positions • A “haircut” is charged by the counterparty to account for credit risk.

19 to 7.Suggested Problems Problems 7.1 to 7.22 21 End Section 22 .15 and 7.