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Chapter 6

Interest Rate Futures

SOLUTIONS TO QUESTIONS AND PROBLEMS

There are 33 calendar davs between J ul v 7 ~ 20()4 and Auaust 9" 2004. There arc 184 calendar

J "" . L·

days between July 7, 20()4 and January 7., 2005r The interest earned J)cr \$l()O of principal is

therefore 3.5 .x ~3./184 == \$0.6277. l-or a corporate bond we assume 32 days between Ju1)/ ·7 and August 9; 2004 (111d ] 80 days between .luly 7~ 2004 and January 7., 200j. The interest

,- d .. ') ~ "J / 1 80 - \$() 67;.)

earne lS .. ) ... )X_)_J - . ~ •

.'

Problem 6.2.

There are 89 days between October 12., 2004, J11d J anuary 9 ~ 2005. There are .18·) days between Oct.oher 12, 20041 and April 12., 2005. The cash price of the bond is obtai ned by adding the accrued interest to the quoted price. The quoted price is 102 3~ or 102.21875. The cash price lS therefore

89

1 OJ .J 1 87 ~ .r, . 6 - d' 1 0 ~ 1 r

._,~._, ) I X - J') ).)

182

Problem 6.3.

The conversion factor tor a bond is equal to the quoted price the bond would have per dollar of principal 011 the first day of the. deli very month 011 the assumption that the interest rate for all maturities equals 69{;· per annum (with semiannual compounding). The bond maturity and the ti mes to the coupon payment dates (lre rounded down to the nearest three months for the purposes of the calculation. The conversion factor defines how much all i nvestor with ,.t short b011d futures contract receives when bonds are de] ivered. I r the conversion factor is 1.2345 the amount investor receives j s calculated by' multi plying 1.2345 by the 1110S1 recent futures price and adding accrued interest.

Problem 6.4.

The Eurodollar futures price has increased by 6 basis points. TIle investor makes a. g(lirl per contract of 25 x 6 ~ \$1 SO or 5300 ill total ~

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35

Problem 6.5.

S Ll pp()Se that a Ell rodo llar fuiu res q II ore is 95. ()(). Th is g i \,\~S ,1 I'll turcs rate o r 5 r;~: lor t 11C th rec-m on t 11 peri od covered by.' the C() ntracr. The conve xi t)' adj II strne 111 is the amount by w II i ell futures rLlte has to be reduced to give an estimate of tile forward rate for the period The COl1- vex i t:y ad] list men tis neccs sar y becau se ~l) the fu tu res COIl tract is set t led dai 1)/ and b) the fLI tu res contract expi res at the beginning of the three months. Both of these lead to the futures rate bci 11 ~ zrcater than the forwa rei rare.

,,~. ..__

From equati (_)J1 ((). 4) the rate is

'1'J (_lO -+- ') "") ,_ ()

~1. ~ X '/ ~"' X _,)

.. ' -,-.' == J. ()409

440

Problem ().7.

The value of a contract is I o8l~ x 1.000 == \$1 ()8. 468.75~ The number of contracts that should

~~ .

be shorted is

6,000,000 .8.2 1"""9

~~-~X ~).7

108.468.7) 7.()

Rounding to the nearest \\'~1101e number, 6() contracts should be shorted. The position should be closed out at tile end of Julv,

,.J

Problem 6.8.

The cash price of the Treasury bill is

90

1 O() ~- -- x ] 0 ~ \$97 ~ 50

360

The annualized continuously compounded return is

~)6S ~-lJl

90

'! - ~.)

] --~-~-

, 97.5

== ) O.27O/c

Problem 6.9"

TI1e number of days between January' 27 ~ 20()3 and May 5, 2003 is 98. The number of days between J anuary 2'7, 2003 and July 27 ~ 2003 is ] 8.1. The accrued interest 1 S therefore

98 .

6 x == 3.2486

181

..

36

Chapter 6. Interest Rate Futures

1 I C).53 12 - 3~248f) == I ] 3.77lJ8

or S 1] l.7S.

Problem 6.10.

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~

~

I

"

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:1 ~

l

.:

B o n d 1: 1! r- l'- 6' - - 1 0 I ') 7 - 1 1) 1 '] _.. J 1 7 8

T __ ) • ) ~ ) • _1 .) X . ~ _) -.~ . _ ~ (

B o nd ?: l 4' ! 4("... 0 7"'" - J O 1 '7 r+ 1 "7 c .. / - IJ 6 ~ !

- T } _. ~ l) 0) ~. ~ ~ ) x . ~ -, '/ A-I _." .....,. ) _

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:' :0

II

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!

1 i

Bond J: 1 I ).96R75 _.- 1 OJ ~37S x ].1 ] 49 == 2~94(-) B()nd4: 144.()625()-1()1~37Sx 1~4()26== 1.874

Bond 4 is therefore tile cheapest to deliver.

Problem 6.11.

There are 177 days between February 4 and July 30 and 182 days between February 4 and August 4. The cash price of the bond is. tbcrcfore:

177

] 1 O + x 6.5 == ] 16.32

182

The rate of interest with continuous compounding is 2ln 1.06 = 0.1165 or I 1.65C;(, per annum. A coupon of 6.5 will be received in 5 days (= 0.0 1366 years) lime. The present value of the

~

coupon IS

6~5e ·O.OlJ66>-:O, 1165 == 6.490

The futures contract lasts for 62 days (= O. I 694 years). The cash futures price if the contract \~/ere wri tten (JO the 13 (1(.:' bond would 11e

(1.1 (1.32 - 6.490)eO.1694xO.1165 = 112.02

At delivery there are 57 days of accrued interest. The quoted futures price if the contract were written ()I) the l 3o/c.) bOI1d would therefore be

') '1 _ .) 57 - O·

11_.0_ 6.Sx -11 .. ()}

184

Taking tile conversion factor into account the quoted futures price should be:

I 10.0 I

-~ ~= 73.34

I .5

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37

\V ard r When t 11c fu t II res IJri cc is roo J1 j gIl ~ the a rb j tragcu r buy S bo nds (inti shorts ~lll eqll i \.1 ,1J en t nu rn ber 0 f bond futures CO]11 rae t s. When t J1C fut u res IJrl ce is too ) ow, tile arbi trasc ur sel J s 110 [Id S and goes ") o llg an cq u i vale 11 i nu III be r o f ho nd fu tu res COIl tracts ~

U 11 C e rl (1 i n t Y' ,1 S t o 'v\-; 11 i C 1-) b o (1 d wi] I be (i e ] j v t~ r c (1 i n t r odu C esc o [11 I) lie ~11 i o 1"1 S . Th C bon d th ,1 t appears CI·1C(11)eSt -to-de J iver now may not i 11 fact be cheapest -to-dcl iver at maturi 1)/. 111 the C<lSC where the fu ttl res pr: c e is too 11 i g 1-1., tIl i sis 11 ot ~l maj or prob lcm s i nee the parry w i til the short posi ti ()11 (i. e. ~ t lle arbi t rageu r) de term i ncs \Iv 11 i ch bond is to be de] i vc red. III the c ,tse \\:' here the futures price is too I()\\/, the arbitrageurs position is far lll()re difficult since ue or SI1C does not k n ow \V 11 i c h bond to buy ~ it is un li keI)/ that ,1 pro fl t can be locked i J1 for at 1 possi b lc ou tcomes 4

Problem 6.13.

1~11e forward i nt ere s t r,lte for the ti 111e peri od between III on ths Ci and 9 is 9 (;(: per annu III \V' i tIl conrinuoux compoundi ng. This is because 99c pCI' annum for three months when combi ned with 7 ~ o/c per annum for six months gives an average interest rate of 8% per annum for the ni ne-mon th peri od.

With quarterly compounding the forward j merest [Lite is

4(etl.OC)j4 - 1) == {).091()2

or 9. 1 ()2 (Ji 4 Thi S ass II III es that the day C ()1.1 n tis actual/ ac tual. \\1 j th (1 day' C()U 11 t 0 f actual/J 6() the rate is 9.102 x 36()i/]()S == 8.977. The three-month Eurodollar quote for a contract maturing ill six months is therefore

1 ()O ~.- 8.977 == 91.02

This assumes Ill) difference between futures and forward prices.

The forward rates calculated form the first two Eurodollar futures arc 4~ 17O/C aJl(14~38(7c.:. These ,Ire ex pressed with an actlla)/3()() day count and quarterly compounding. With continuous compounding and all acttlal/3()S day count they' are (365/90)ln(1 -~·-().04]7/'4) == 4.2060(7c. and (l65 ,/90) In( I + O.()43 8,/4) == 4~4 I 6 7o/c. It follows fr01TI equation (6.4) that tile 398 day

rate IS

4 x 300 "1- 4. 206() x 98

---~-.. _ ... - := 4.()S07

398

or 3.0254%~. The 48~) day rate is

4.0507 x J98+4.41(j·7 x 9] ~-~~------ == 4~ 1 188

489

or 44 11889(::. \''f.le Lire assuming that the first futures rate applies to 98 days rather than the usual 91 days. The third futures quote is 110t needed.

',:

38

Chapter 6. I nterest Rate Futures

Problem 6.15.

Duration-based 11edgiJlg schemes assume paral lel shi rt~ ill the )/ieJd curve. S i flee tJ1C ] 2~ye(lr rate tcnd-, to move hy' less than the -l-ycar [LIte, the portfolio manager may fiI1CJ that he or she is over-hedged.

, :. ,

;

,

}

'I

Problem 6.16.

The company treasurer C(111 llecige tile company's CXI)()SLlrC by' shorting EUf()(Ic)IIar futures c{)nt ra c t s . ~ l h e ·E Ll rod 0 II a r fu tu res 11 o sit 1 o 11 1 e(_l c] S 1. 0 ~l P r o f t i f r Ll t e sri s c ~111 d Ll I os s if t} 1 C)' fa I L

The duration of rhc commercial paper 1 S twice that or the Eurodollar deposit undcrlyi 1"1g the Eurodo Ilar fu tures C() t11 ract. The C()I1 tract pri ce o f a Eu rodo II ar fut ures contract is 9 8() ~ 000.

~

The number of contracts that should be shorted is, therefore,

4~ 820. 000

- .. - x :2 == 9.84

98(). ()()O

Rounding to the nearest whole number 10 contract-, should he shorted.

,--_.

The treasurer Sl1011Id short Treasury bond futures contract. If bond prices go dO\V'1~ thix futures position will provide offsetting gains. The number of contracts, that Sl10l1Jd be shorted is

I O. 000 ~ OO() x 7. 1

. == 88.30

9]~375x8.8

Rounding to the nearest whole number 88 contracts should be shorted.

Problem 6.18.

The answer in Problem 6.17 is desisned to reduce the duration to zero. To reduce the duration

L./

Irorn 7.1 to 3.() instead of from 7.1 to (), the treasurer should short

4.1

x 88.30 ~ S().99

7. I

or 51 contracts.

Problem 6.19.

You would prefer to own the Treasury bond. Under the ~O/360 day count convention there is one day bet ween October 30, 20()6 (loci N overu ber 1 ~ 2()06. U ndcr the actual/ actual (i 11 peri od) day count convention, there are two days. Therefore you would earn approximately twice as much interest by holding the Treasury bond. Thi s assumes that the quoted prices of the two bonds are the same.

;1. -I ,,.

=:.~.

39

Problem 6.2().

TI-le Lu rodo 1 J ar f1"J ttl res contrac t tJfJ ce of 8 R means thar the E urodo II ar fu t Ll res rate 1 S 12 ()(. I)er [t11 num. Til j sis the fa rward rat e for the ()o~ t o 1:; O-d~l)' l)eri {Jcj wi th (} uarrerl y' compound ill g and (11] acrual/.' ()O da \/ count conven t. i on _

_ '

r

IS

I_ . ~) - __ ! J C

! X 0.011 x 6 x 6.-.) - O.OO~~6}

-

or about 21 h~lSis points. The futures rate is 4_8(,Ir·· with quarterly compounding and an <:lCtua 1/_) C)() da y' cou Il t _ 1~11 is bcco mes 448 x 3 ()) //3 6C) =-~ 4 r 86 7 (It.: \A/ i tIl (111 actual/actual da ~y coun t. It j s 4 11) ( 1 --, r ()48 67/' 4) .; = 4.84 9} \At' i t 11 COIl ti nuous C()n1 pou ndi 11 g. The forward f,lle j s t hercfore 4.84 - ()423 == 4.() 1 {If·· with continuous compounding.

SUPI10SC that the contracts cl11I)I)i to the interest rate between timc-. ·7~1 and 1].4 There are two reasons Ior a difference between the forward [cite and tile futures r<1te. TIle first is tha: the futures contract is settled daily whereas the forward contract is settled once at time 724 The second i s that wi thout dai I~' senlerncnt ,1 futures contract wou ld be settled at time T, not T", _

..I

Both reasons tend to make the futures r~lt.e greater than the forward rate.

. (._.