An Immunization

Strategy for Futures Contracts

on Government Securities
Donald R.Chambers

F inancial futures markets provide vehicles for the transfer of interest rate risks.
It is important from a public policy perspective, and presumably from the
perspective of most market participants, that the interest rate risks are reasonabIy
understood and potentially controllable. Substantial effort has been devoted to-
wards the development of hedging and immunization strategies to reduce and to
control interest rate risks.
The purpose of this study is to extend a previously formulated immunization strat-
egy for bonds into an immunization strategy for futures contracts on U.S. Govern-
ment securities. The bond immunization strategy appears rather successful in re-
ducing and virtually eliminating interest rate risks for US. Treasury notes. This
study demonstrates that the immunization strategy is tractable in the case of futures
contracts but does not perform an empirical test.

I. INTRODUCTION
The purpose of this study is to demonstrate an immunization approach which uti-
lizes futures contracts’ on U S . government securities. The approach permits either
control or elimination of interest rate risk. The approach may be used to hedge
(spread) futures contracts against each other or to utilize futures contracts to hedge a
position in cash securities. The framework is developed by extending an immuniza-
tion approach set forth by Chambers (1981)which did not discuss futures contracts.
Positions in US. government securities and in futures contracts on U.S. govern-
ment securities contain risk since the value of the positions respond to interest rate
changes. Several approaches to risk control including duration and historic price

‘ Throughout most of the text, the differences between forward contracts and futures contracts are ignored. The
important difference between these contracts for the purposes of this article is the daily settlement (i.e.,mark-to-
market) required with futures contracts. The pricing equations which follow are strictly correct only in the case of
forward contracts. Since the entire article is based on approximation techniques, it is reasonable to view the use of
futures as a further approximation which should not distort the usefulness of the model’s application. This issue is
briefly discussed in the conclusions. For a further discussion of these issues, see Kamara (1982), especially pages
283-284.

Donald R. Chambers is an Assistant Professor of Finance at

The Pennsylvania State University.

The Journal of Futures Markets, Val. 4, No. 2, 173-187 (1984)

0 1984 by John Wiley & Sons, Inc. CCC 0270.73 141841020173,15$04.00
volatility ratios are discussed in Section 11. It is shown that each approach requires
restrictions on the behavior of interest rate changes. Numerous studies analyze the
effectiveness of these approaches and demonstrate that they are of substantial value
in the control of interest rate risk. However, to the extent that actual interest rate
behavior deviates from the assumed interest rate behavior, these approaches fail to
provide complete protection from interest rate risk. Empirical evidence indicates
that there is still significant need for improved interest rate risk control approaches.
An obvious improvement to interest rate risk control is the development of an ap-
proach which permits more general interest rate behavior. Chambers (1981) derives
an immunization strategy for U S . government securities which permits interest rate
risk control for any type of interest rate behavior. Empirical testing of this strategy
by Carleton, Chambers, and McEnally (1982) supports the generality of the model
using U S . Treasury note returns. This immunization strategy is summarized in Sec-
tion 111. Despite the success of the immunization strategy for US. government
securities, the extension of the strategy to futures or forward contracts has not been
presented. Section IV derives this extension. Section V summarizes the implications
of the approach, provides examples, and discusses its application to futures con-
tracts (as opposed to forward contracts).

11. REVIEW OF PREVIOUS IMMUNIZATION AND

HEDGING APPROACHES
Values of U S . government securities and of futures contracts on U S . government
securities change as a result of the passage of time and of changes in interest rates.
These values often move in the same direction. Immunization strategies typically at-
tempt to control risk by utilizing this tendency towards similar directional move-
ments. There are three types of immunization strategies: historic price volatility
ratios, duration models, and stochastic process models. Each approach derives one
or more risk measures for each security. The risk measures for a portfolio are simply
a weighted average of the risk measures of the assets within the portfolio. The de-
sired riskiness of the portfolio is obtained by varying the proportions of the secu-
rities within the portfolio.
In order to derive risk measures for the securities, each approach makes restric-
tions on the relative behavior of the security prices. Since the price changes are tied
directly to interest rate changes, each approach explicitly or implicitly is imposing
restrictions on the behavior of interest rate changes and thus on the behavior of the
term structure through time.

Historic Price Volatility Ratios

One method for controlling interest rate risk is to derive hedge ratios based upon
historic price changes. If a particular position has demonstrated price volatility
which is some proportion of the volatility of another security, then a hedge may be
formed by holding the two securities in the opposite proportion. Additionally, the
correlation may be taken into account (see Hegde, 1982).
This method fails to differentiate among various types of term structure shifts of
the past, and it implicitly assumes that the shifts are identical in their effects. The
usefulness of the hedges depends on the degree to which future term structure shifts
resemble the historic shifts upon which the ratio was determined. Hence, this

174 / CHAMBERS
method assumes that future term structure shifts will be identical to historical term
structure shifts.

Duration
It is also possible to derive risk measures using hypothetical rather than historical
term structure shifts. Duration is perhaps the most popular example of this approach
to immunization. Macaulay (1938), Hicks (1939), and Samuelson (1945) derived dura-
tion as the responsiveness of a bond price to a change in its yield. As Cooper (1977)
demonstrates, traditional duration assumes that the term structure is flat and that all
shifts in the term structure are both infinitesimal and additive. Hence, there is only
one factor (the level of the term structure) which creates interest rate risk.
Extensions of traditional duration generally examine the effects of nonadditive
single-factor shifts in the term structure (e.g., Bierwag, Kaufman, and Khang, 1978).
Cooper (1977) extends duration to incorporate more than one factor. Empirical
testing of these extensions has failed to demonstrate that they improve the perfor-
mance of hedging activities.

Stochastic Process Models

Another approach to immunization utilizes stochastic processes and continuous time
models. The stochastic element of the term structure is assumed to result from
changes in one or more underlying stochastic processes (e.g., the instantaneous in-
terest rate). The absence of arbitrage opportunities is used to prove that all securities
will also be stochastic processes whose diffusion coefficients measure the response of
the security prices to the corresponding changes in the underlying factors. Single
factor models are discussed by Merton (1974), Vasicek (1977), Dothan (1978), and
Cox, Ingersoll, and Ross (1978). Brennan and Schwartz (1980, 1981) utilize a two-
factor model (“short” and “long” term interest rates). Langetieg (1980) derives a
vector of duration measures using multiple stochastic factors, but leaves the factors
undefined.
The underlying assumptions regarding the stochastic behavior of the term struc-
ture are explicit in these approaches. Superior performance has yet to be demon-
strated with the prescribed immunization approaches which result from the stochas-
tic process models.

Summary of Review
Chance (1982), Wardrep and Buck (1982), and Hegde (1982) discuss the duration
model and historic volatility approaches in detail. Two primary conclusions may be
drawn from previous research. First, immunization approaches which make restric-
tive term structure assumptions leave substantial room for improvement of perfor-
mance. In the spirit of positive economics it is not appropriate to reject these
approaches due to the lack of their assumptions’ realism. However, since the ap-
proaches fail to demonstrate excellent performance, the development of models with
less restrictive assumptions regarding the term structure should be considered.
Second, most immunization approaches attempt to express interest rate risk using
a single measure. Oldfield and Rogalski (1981) demonstrate that even U S . Treasury
bills contain more than one source of price volatility. Hence, immunization ap-

FUTLJRES CONTRACTS O N GOVERNMENT SECURITIES / 175

proaches must consider multiple risk measures if they are to explain more fully the
effects of realistic term structure shifts.

111. A GENERALIZED IMMUNIZATION APPROACH

The purpose of this section is to summarize the generalized duration approach of
Chambers (1981). This approach will be extended to futures contracts in Section IV.
As discussed in Section 11, the primary difficulties with conventional immunization
strategies appear to be that they impose restrictive assumptions on the behavior of
the term structure and generally utilize only one risk measure. Chambers (1981) has
developed a vector of risk measures which responds to both difficulties and appears
to permit near perfect immunization for any term structure behavior. Briefly, this ap-
proach requires that immunization be performed with respect to N risk measures
rather than one risk measure. It is contended that if more than one risk measure is
used ( N > l), the results will be more general (in terms of permitted interest rate
behavior) and will typically generate more precise immunization. Appendix A pro-
vides an alternative discussion of the model. This discussion is designed to link the
concepts of the model with the concepts used by bond and futures traders.
The models utilized in Sections IV and V of this article are based on Chambers’
duration vector. Readers familiar with traditional duration should find that the dura-
tion vector approach is a straightforward extension of the scalar approach. This sec-
tion reviews this extension as background material. The vector is extended to incor-
porate futures contracts in Section IV and then an application is demonstrated in
Section V.

Development of Duration Vector

Chambers (1981) defines a vector of N risk (or duration) measures for each security:2
OD

D(n) = c w,.tn;
,=1
n = 1, . . . , N

where
D(n) = nth duration measure,
c,.e-R(‘).t
w, =
Price ’
C, = security’s promised cash flow in t periods,
Price = current price of the security.
Equation (1)utilizes the weights, w,, each of which is the proportion of the security’s
price which can be attributed to the present value of the cash flow due in t periods. In
the case of n = 1,the risk measure is the weighted average of the times-to-maturity of
the security’s future cash flows. Hence, D(1) is traditional duration. D(2)is a weighted
average of the “times-to-maturity squared” of the security and so on.
D(1)measures the responsiveness of a particular security’s price to an additive shift

‘The duration vector can be derived using a multiple variable Taylor series expansion on a bond price. The bond’s
price is expressed as a function of a set of variables in which each variable is a polynomial coefficient in a polynomial
approximation to the term structure of interest rates. Readers interested in this underlying derivation are welcome to
contact the author at The Pennsylvania State University, University Park, PA 16802.

176 / CHAMBERS
in the term structure. D(2) measures the responsiveness of the security’s price to a
slope change in the term structure. D(n) for n > 2 measure price responsiveness to
curvature and shape changes. Used simultaneously, the measures can capture nearly
all of the effects of any term structure shift.
Implementing an Immunization Strategy with the Duration Vector
Carleton, Chambers, and McEnally (1982)empirically test the above approach using
quarterly U.S. Treasury note returns over the period 1976-1980 and find that it
creates near-perfect immunization. In order to implement the approach it is neces-
sary to construct a portfolio with a desired duration vector. As Eq. 2 demonstrates,
the duration vector of the portfolio is simply a weighted average of the duration mea-
sures of the constituent securities. For example, an equally weighted portfolio of
securities would have a duration vector with values equal to the equally weighted av-
erage of the duration elements of the constituent securities.
rn
D,(n) = c v;
i= 1
* Di(.), n = 1,. . . , N (2)

D,(n) = nth duration measure of the portfolio,

Vi = proportion of portfolio invested in asset i, and
D,(n) = nth duration measure of asset i.
The first step is to select a desired interest rate risk exposure. For example, to
eliminate interest rate risk entirely one would select a desired duration vector in
which each element was zero. The response of the portfolio to each type of term
structure shift would be eliminated. The problem can be expressed as a simultane-
ous equations system with N + 1 securities and N 1 equations:+
Vl.Dl(l) + V2.D2(1) + . * . + VN+&+,(l) = 0
V,.D,(2) + V,.D,(2) + * * * + VN+,D).v+1(2) = 0

VI.D,(N) + VZ*D,(N) + * * - + VN+lDN+l(N) = 0

v, + v, + * * . + VN+1 = 1
The final constraint merely serves to scale the variables. To select an alternative
risk exposure, one would simply change the right-hand side of the above equations.
For example, to immunize with a one year horizon an investor could purchase a one
year U.S. Treasury bill. This bill would have the following duration vector: D(1) = 1
year, D(2) = l 2year, . . . ,D(N) = l Nyear. Alternatively, the investor could create an
equivalent risk exposure with N + 1 securities by solving the above system of equa-
tions with the right-hand side set to a column of P.~.A. A value of this approach is
most apparent for investors with horizons greater than one year since Treasury bills
do not have such maturities.
The number of duration measures considered, N, can vary with the degree of pre-
cision desired. Empirical testing by Carleton, Chambers, and McEnally (1982) re-
veals that N = 3 provides rather precise immunization. However, higher values of N
(tested up to N = 7) provided slightly better performance. The Carleton, Chambers,
and McEnally study compared the performance of immunized Treasury note port-

FUTURES CONTRACTS ON GOVERNMENT SECURITIES / 177

folios to a portfolio of all Treasury notes (equally weighted) for a horizon of three
months. Using only traditional duration (N = 1) 75% of the interest rate risk was
eliminated. However, performance improved to 85% interest rate risk elimination
for N = 2,and 93% interest rate risk elimination for N = 3. Strategies with N = 4,
N = 5, N = 6, and N = 7 removed 94%, 96%,96%, and 97%, respectively, of the
interest rate risk.

Examples Using U.S. Treasury Bills

The purpose of these examples is to demonstrate how the model can be used for
elimination of interest rate risk in a portfolio of U.S. Treasury bills.
The following examples use four U.S. Treasury bills (13 week, 26 week, 39 week,
and 52 week) and hence allow immunization with respect to 1,2 or 3 elements of the
duration vector. Table I shows the duration vector for each of the securities. The
solution to interest rate elimination with N = 1 is (using the 13 week and 26 week
bills):
V,*DI(l) + V2*D2(1) = 0
Yl + v
2 = 1

(0.25)V1 + (o.50)V2 = 0
Vl + v
2 = 1

v, = 2
vz = -1
where
Vl = portion of portfolio invested in 13-week T-bill, and
V, = portion of portfolio invested in 26-week T-bill.
This is equivalent to the traditional duration (or maturity) approach and assumes
that the term structure experiences an additive shift.
In order to incorporate more general shifts, one could immunize with respect to

'rabie I
EXAMPLE OF UIJRATION VECTOR FOR US. TREASITR'L BILLS
~~
~~ ~~

Elements of Duration Vector

Security D(1) D 12) D (3) D(N)

_..
13 week T-bill 0.25 ((1.25)2= 0.0625 (0.25)3= 0.015625 (0.25)'
26 week T-bill 0.50 (0.50)2 = 0.25 (0.SO)3= 0.125 (0.50)"
29 week T-bill 0.75 (0.75)2 = 0.5625 (0.75)3= 0.421875 (0.75'j
52 week T-bill 1.oo (1.0)2 = 1 (1.0)3 = I (1 .OF
the first three duration elements (where V3 and V4 are, respectively, the proportion
of the portfolio invested in 39-week and 52-week bills):

0
0
0
1

4
-6
4
-1

While the above solution utilizes unreasonable shortselling, Carleton, Cham-

bers, and McEnally (1982) demonstrate that more reasonable solutions can be gen-
erated by admitting more securities and selecting an objective function which dis-
courages concentration in any securities.

Summary of Vector Approach

The duration vector approach developed by Chambers (1981) appears to permit im-
munization regardless of the form of the term structure shift. In order to utilize the
approach it is necessary to consider three or more distinct “duration-type” mea-
sures simultaneously. Each of the measures is similar in form to traditional duration
(which is the first element of the vector). Each measure reflects the effects of various
types of term structure shifts. Used simultaneously, the measures permit approxi-
mate immunization. The following section derives the corresponding duration
measures for futures contracts on U.S. Government securities.

IV. EXTENSION OF DURATION VECTOR TO FUTURES PRICES

The purpose of this section is to derive the vector of duration measures (analogous to
the vector from Section 111) which may be used for immunization of futures con-
tracts. To derive this vector it is helpful to review fhe derivation of the vector in the
case of discount bonds. Both the results of this section and the intuition of the results
are summarized at the beginning of Section V. Section V demonstrates the applica-

F U T U R E S CONTRACTS ON GOVERNMENT SECURITIES / 179

tion of the approach. Accordingly, the reader may elect to skip the remaining portion
of this section if the vector's derivation is not of interest.

Derivation of Duration Vector for Discount Bonds

The nthelement of Chambers' (1981) duration vector in the case of discount bonds
may be expressed as in Eq. (3):
D,(n) = t", n = 1, . . ., N (3)
where
t = length of discount bond's time-to-maturity (in years), and
DXn) = nthduration measure of discount bond with maturity t.
This vector may be found by assuming that the term structure of interest rates is a
simple N-degree polynomial in t. Hence, the price of a $1 discount bond is (using con-
tinuous compounding)

~ ( t=) exp [ -
N
c x, -1.1
n=l
(4)

where
B(t) = the price of a discount bond with maturity t,
exp = the exponential function,
N = length of polynomial, and
x, = nth polynomial coefficient.
Term structure shifts may be viewed as changes in the polynomial coefficients. The
derivative of the discount bond price with respect to a change in a polynomial coeffi-
cient may be expressed as:

-- - -(t")*B(t), n = 1, . . . , N . (5)
ax,
Division through Eq. ( 5 ) by -B(t) generates the duration vector expressed in Eq.
(3). The extension of the model to coupon bonds and portfolios of bonds is straight-
forward.

Derivation of Duration Vector for Futures Contracts

Consider a futures contract which calls for delivery i n s years of a discount bond with
a time-to-maturity o f t years. The price of the futures contract may be expressed as:
F(s, t ) = B(s + t)/B(s) (6)
where
F(s,t) = price of futures contract on t year discount bond to be delivered in s
years , and
B( .) = price of discount bond with given time-to-maturity.
Expressing the term structure of interest rates (as above) as a polynomial the fu-
tures contract price may be expressed as

180 / CHAMBERS
 The derivative of the futures contract price with respect to the polynomial coeffi-
cients is expressed as

Dividing through Eq. (8)by - F(s,t), the duration vector for a contract is:
D J n ) = (s + t)" - s", n = 1, . . . , N (9)

where

D J n ) = nthduration measure for a futures contract on a t year discount bond to

be delivered in s years.

Higher Order Derivatives

In order to approximate more closely finite (as opposed to infinitesimal) changes the
higher order derivatives (second derivative, third derivative, etc.) may be incorpo-
rated. Traditional duration approaches are precise measures of price volatility only
for infinitesimal (and additive) term structure shifts since duration is a first deriva-
tive. Chambers incorporates higher order derivatives in approximating the effects of
finite term structure shifts. Thus, the duration approach developed by Chambers is
designed to immunize both for any type of term structure shift and for any size shift.
However, the higher order derivatives of futures contract prices (with respect to
changes in the x,) are not as conducive to use as in the case of bonds. For exposi-
tional purposes (and because the higher order effects are likely to be small) this
study ignores such higher 0rde1-s.~In summary, the above duration vector for fu-
tures contracts ignores the higher order derivatives and hence is measuring the ef-
fects of infinitesimal shifts only.

V. IMPLEMENTING THE DURATION VECTOR APPROACH FOR

FUTURES CONTRACT IMMUNIZATION
The purpose of this section is to demonstrate the implementation of the duration
vector approach for immunization using futures contracts. An example is developed
using a simulation of Treasury notes and bonds. Each implementation requires that
(1) the duration vector of each security andlor contract be computed, and (2) the
securities and contracts be combined in such a manner so as to produce a total (or
portfolio) duration vector of desired values. As shown in Section IV, the duration
vector in the case of discount bonds may be expressed as
D,(n) = t", n = 1, . . . ,N (10)

3The higher order derivatives enter the approximation function as coefficients of deviations raised to a power cor-
responding to the order of the derivative. Thus, a second order derivative would be multiplied by the squared value
of the deviation. Even a large interest rate change (0.02) has a small squared value (0.0004).

FUTURES CONTRACTS ON GOVERNMENT SECURITIES / 181

where
t = length of discount bond’s time-to-maturity (in years), and
D,(n) = n t h duration measure of discount bond with maturity t .
For example, a 26-week T-bill has a vector with values 0.5,0.25,0.125, and so forth
since t = 0.5 years (the time-to-maturity).
Section IV develops an analogous duration vector for a futures contract on a dis-
count bond.

where
s = time in years to futures contract’s delivery,
t = time-to-maturity of discount bond to be delivered, and
D,.,(n) = nthduration measure of a futures contract on a t year discount bond to
be delivered in s years.
Note that securities in the cash market may be viewed as futures contracts with
no time to delivery (s =O). Substituting s = O into Eq. (1 1) confirms its consistency
with Eq. (10). Table TI simulates values of the duration vector for futures contracts.
The portfolio immunization strategy developed in Section I11 may now be ex-
panded to incorporate futures contracts. The duration measures from Eq. (11) are
used for futures contracts simultaneously with the use of duration measures from
Eqs. (1) and (10) in the case of bonds. The proportion of the portfolio invested in a
futures contract would be measured as the price of the contract divided by the sum
of the portfolio’s positions in futures contracts and net purchases of bonds. The
constraints on the portfolio weights could be altered to suit investor desires.

Calculating the Duration Vector for Futures Contracts on Coupon Bonds

Equation (1 1) demonstrates that the duration vector for a futures contract on a dis-
count bond is a relatively simple function of the time-to-delivery, (s), and the time-

Table I1
EXAMPLES OF DURATION VECTOR FOR DISCOUNT BONDS
AND THEIR FUTURES CONTRACTS

Approximate Duration Values

Element 0.25 Year Discount Bond’s Futures 1.0 Year Discount Bond’s Futures
of Contract Delivered in Contract Delivered in
Duration
Vector (n) 0 years 0.5 years 1 year 2 years 0 year 0.5 years 1 year 2 years
~~ ~~

1 0.2500 0.2500 0.2500 0.2500 1.oooo 1.oooo 1.oooo 1.oooo

2 0.0625 0.3125 0.5625 1.0625 1.OOOO 2.0000 3.0000 5.0000
3 0.0156 0.2969 0.9531 3.3906 1.OOOO 3.2500 7.0000 19.0000
4 0.0039 0.2539 1.4414 9.6289 1.0000 5.0000 15.0000 65.0000
5 0.0010 0.2061 2.0518 25.6650 1.OOOO 7.5625 3 1.OOOO 2 1 1.OOOO

182 / CHAMBERS
to-maturity of the deliverable bond, (t).The purpose of the subsection is to derive
the duration vector for a futures contract on a coupon bond. The subsequent sub-
section demonstrates the use of the vector.
Consider an 8% coupon bond due in T years. The bond promises cash flows of
$104 in Tyears, $4 in T - ‘ / a years, $4 in T - 1 years, and so forth. A futures con-
tract on this bond may be viewed as a portfolio of futures contracts, e.g.,
$104 face value futures contract on T year discount bond
$4 face value futures contract on T - ‘12 year discount bond

$4 face value futures contract on l/2 year discount bond. Or, more generally:

T
Fi(S) = c C(t)
t=1/2
* F(s, t )

where
Fi(s)= the futures contract price of coupon bond i to be delivered in s years,
C ( t ) = the cash flow (coupon or principal) promised by coupon bond i in t
years from delivery, and
F(s, t ) = the futures contract price of a $1 t year discount bond to be delivered
in s years.

Similarly, the duration vector for the futures contract on the coupon bond may
be expressed as an average of the duration vectors of the futures contracts on the
corresponding discount bonds.

where
Di,,(n) = nthelement of the duration vector of coupon bond i to be delivered in
s years,

w, =
c(t)’ F(s7t) ,and
Fi(s)
D J n ) from Eq. (1 1).
Equation (13) expresses the futures contract’s duration vector as a weighted av-
erage of the duration vectors corresponding to hypothetical futures contracts on
each of the bond’s promised cash flows (coupon and principal). The weights, w,,
sum to one and depend on the size of the cash flows and interest rates. The final
cash flow dominates the average since it contains the principal payment. The w, are
identical to the weights used in Eq. (1) and in the traditional duration approaches.
The first element of the duration vector, traditional duration, is independent of s
[as seen by inspection of Eq. (11) for n = 11 and equals the traditional duration of
the spot securities. All other elements contain s, and their derivation is somewhat
cumbersome. The remaining portion of this section demonstrates the use of the
first two elements of the duration vector and assumes that their values are given.

FUTURES CONTRACTS ON GOVERNMENT SECURITIES / 183

An Example of the Duration Vector Approach to Immunization with Futures
Contracts: The Case of Coupon Bonds
The purpose of this example is to demonstrate the application of the approach to
coupon bonds. For simplicity, consider three 8 % coupon bonds which promise an-
nual coupon payments. The maturities of the bonds (from delivery date) are 5
years, 10 years, and 15 years. Assuming that the yield on all securities is 8 % , the
coupon bonds and their futures contracts (deliverable in one year) would have the
following first two elements of their duration vector:
5 year maturity 10 year maturity 15 year maturity
D(1) of spot security 4.3 7.2 9.2
D(2) of spot security 20.2 63.4 112.7
D(1) of futures contract 4.3 7.2 9.2
D(2) of futures contract 28.9 77.9 131.2
These values are found by solving Eqs. (10)-(13). As discussed above, the first du-
ration measure (traditional duration) is the same for both a spot and futures con-
tract. The D(2) differ between spot and futures contracts because s, time to deliv-
ery, affects the value.
Consider a market participant who currently holds $10 MM in the 10-year note
and wishes to hedge this risk in the futures market. The traditional duration ap-
proach would suggest either a short position of $16.7 MM in the 5-year note futures
contract or $7.8 MM in the 15-year bond futures contract. These figures can be
obtained by multiplying the position ($10 MM) by the ratio of the durations (e.g.,
1.67 = 7.214.3 and 0.78 = 7.219.2).
As discussed in Section 11, this approach will be valid as long as the term struc-
ture experiences a parallel shift. In this example, the term structure was flat with all
securities yielding 8%.Hence, if all yields moved up or down by the same amount,
the above hedge strategy would be rather successful.
Table I11 lists the spot prices for various levels of the term structure of the three
bonds. Because all interest rates are the same across maturities (there is a flat term
structure) the futures contract prices will equal the spot prices. Using the prices
from Table I11 the performance of the above hedges can be analyzed.
By netting the short position from the long position the usefulness of the tradi-
tional duration strategy is demonstrated provided that all interest rates change by
the same amount. For example, if all interest rates rose from 8% to 9%, the $10
MM in 10-year notes would fall in value to $9.4 MM. However, this loss would be
hedged by either the $16.7 MM short position in the 5-year futures or the $7.8 MM
short position in the 15-year futures shown using prices from Table 111:

Table 111
PRICES ASSUMING ALL INTEREST RATES ARE:

Maturity 4% 5% 6% 7% 8% 9% 10% 11% 12%

5 year spot 118 113 108 104 100 96 92 89 86

10 year spot 132 123 115 107 100 94 88 82 77
15year spot 144 131 119 109 100 92 85 78 73

184 / CHAMBERS
 -9616.7 MM X (961100) = -$16.0 MM (profit of $0.7 MM)
-$7.8 MM x (921100) = -957.2 MM (profit of $0.6 MM)
The profit from either futures position would offset the loss from the $10 MM
long position in 10-year bonds. There are many combinations of these positions
which would also conform to the traditional duration approach.
The difficulty with the traditional duration approach is that not all interest rates
are likely to shift by the same amount. It is more likely that the short term interest
rate will shift by more than the long term interest rate. For example, a more likely
scenario would be that all interest rates shift from 8 % to:
yield = 12% for the 5-year note,
yield = 11% for the 10-year bond, and
yield = 10% for the 15-year bond.

In this situation, the futures positions based on traditional duration discussed

above would provide rather poor protection from interest rate shifts.
The approach introduced in this article attempts to remedy this difficulty by con-
sidering more than one duration measure. In the following example, the futures po-
sition considers both traditional duration [D(l)] and D(2). The requirements for a
hedge would be:

risk of 10-year bond = combined risk of futures contracts

D(1): $10 MM x 7.2 = (Ys x 4.3) + (Yl5 x 9.2)
D(2): $10 MM x 63.4 = (Y5 x 28.9) + (Y15 x 131.2).
By solving the above equations in terms of Y5(the short position in futures con-
tracts on the 5-year note) and Y I 5(the short position in futures contracts on the
15-year bond), an improved solution will result. The solution may be found, as be-
fore, by solving the simultaneous equations problem. The solution is:
short $12.1 MM 5-year futures contracts
short $2.2 MM 15-year futures contracts.
While the solution to the problem is straightforward, it is difficult to derive the
hypothetical futures contract prices because the term structure is no longer flat.
Because the term structure is downward sloping, the following futures prices are
reasonable (assuming a one year financing rate of 13%):
Futures Price on 5-year note = 1.01 x Spot Price = 86.9
Futures Price on 15-year bond = 1.03 x Spot Price = 87.6
Using these hypothetical prices, the net gain becomes:
Loss on $10 MM 10-year note = ($1.8 MM)
Gain on $12.1 MM 5-year futures = 1.6 MM
Gain on $2.2 MM 15-year futures = 0.3 MM
0.1 MM

FUTURES CONTRACTS O N GOVERMENT SECURITIES / 185

 The success of the strategy using both D(1) and D(2)results from the use of a hy-
pothetical term structure shift which was linear. More realistic term structure shifts
can be accommodated using more risk measures. For practical purposes, the use of
three measures [D(l), D(2) and D(3)]should provide excellent protection. The num-
ber of distinct futures contracts which must be used will be equal to the number of
risk measures used.

Caveats and Conclusions

The above approach attempts to extend the generality of the duration vector ap-
proach for bonds into an approach for both bonds and futures contracts. If success-
ful, the strategy would permit elimination or control of interest rate risk to nearly
any desired level of precision regardless of the form of the interest rate changes.
In its current form, the duration vector for futures contracts ignores the effects
of finite as opposed to infinitesimal changes in interest rates. Also, the approach
has not distinguished between forward contracts (which are tractable) and futures
contracts (which are available). Finally, there is no guarantee that reasonable val-
ues of N (the length of the duration vector) will provide adequate precision.
The usefulness of the approach must be determined empirically before the above
factors can be ignored. Beyond the normative implications of the study discussed
above, the approach may be of use in analyzing historic price changes, evaluating
market efficiency, and developing strategies to identify and exploit arbitrage
opportunities.

Appendix A
Government bond traders and financial futures traders commonly discuss three
types of yield curve shifts:
(1) a general change in interest rate levels,
(2) a change in the slope of the yield curve, and
(3) a change in the curvature of the yield curve.
A position in one bond or one futures contract is most affected by Type 1: a rise
or fall in the general level of interest rates. Traders recognize that this interest rate
risk can be greatly reduced by simultaneously taking a long position and a short po-
sition in securities of similar maturities. The resulting risk is a Type 2 risk: that the
yields of the two positions will shift by different amounts because of their slight dif-
ferences in time-to-maturity. One method to lessen Type 2 risk is to utilize a “but-
terfly spread” in which a long (or short) position is offset by two opposite positions
with surrounding times-to-maturity (e.g., short 4.9-year note, long 5.0-year note,
short 5.1-year note). While the Type 1 and Type 2 risks are virtually eliminated,
there is still the possibility of an imperfect hedge due to Type 3 risk: a change in
curvature.
This study develops risk measures corresponding to each of these three types of
risk. The measures are denoted D(1), D(2), and D(3), respectively. Additional mea-
sures (beyond 3) are also developed which would be useful for further refinement-
although in most cases they would be unnecessary. By analyzing these three risk
measures and making appropriate adjustments, a trader can eliminate all three

186 / CHAMBERS
types of risk. However, t h e trader will not be limited to specific positions such as
butterfly spreads-rather, t h e trader will only b e concerned with the a g g r e g a t e d
risks of his positions as m e a s u r e d b y D(l), D(2), a n d D(3).

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