FIXED-INCOME SECURITIES

Chapter 11

Forwards and Futures

 Outline

• Futures and Forwards

• Types of Contracts
• Trading Mechanics
• Trading Strategies
• Futures Pricing
• Uses of Futures
 Futures and Forwards

• Forward
– An agreement calling for a future delivery of an asset at an agreed-
upon price
• Futures
– Similar to forward but feature formalized and standardized
characteristics
• Key differences in futures
– Secondary market - liquidity
– Marked to market
– Standardized contract units
– Clearinghouse warrants performance
 Key Terms for Futures Contracts

• Futures price: agreed-upon price (similar to strike

price in option markets)
• Positions
– Long position - agree to buy
– Short position - agree to sell
• Interpretation
– Long : believe price will rise
– Short : believe price will fall
• Profits on positions at maturity (zero-sum game)
– Long = spot price ST minus futures price F0
– Short = futures price F0 minus spot price ST
 Markets for Interest Rates Futures

• The International Money Market of the Chicago Mercantile

Exchange (www.cme.com)
• The Chicago Board of Trade (www.cbot.com)
• The Sydney Futures Exchange
• The Toronto Futures Exchange
• The Montréal Stock Exchange
• The London International Financial Futures Exchange
(www.liffe.com)
• The Tokyo International Financial Futures Exchange
• Le Marché à Terme International de France (www.matif.fr)
• Eurex (www.eurexchange.com)

CME
Eurodollar Futures
13-Week Treasury Bill Futures
Libor Futures
Fed Funds Turn Futures
10-Year Agency Futures
5-Year Agency Futures
Argentine 2X FRB Brady Bond
Futures
Argentine Par Bond Futures 30-Day Federal Funds Mortgage
Brazilian 2 X C Brady Bond
Futures
Brazilian 2 X EI Brady Bond
Futures
Mexican 2 X Brady Bond
Futures
Euro Yen Futures
Japanese Government Bond
Futures
Euro Yen Libor Futures
Mexican TIIE Futures
Mexican CETES Futures
Instruments
CBOT LIFFE
30-Year US Treasury Bonds Long Gilt Contract
10-Year US Treasury Notes German Government Bond
Contract
5-Year US Treasury Notes Japanese Government Bond
Contract
2-Year US Treasury Notes 3-Month Euribor Future
10-Year Agency Notes 3-Month Euro Libor Future
5-Year Agency Notes 3-Month Sterling Future
Long Term Municipal Bond 3-Month Euro Swiss Franc
Index Future
3-Month Euroyen (TIBOR)
Future
3-Month Euroyen (LIBOR)
Future
2-Year Euro Swapnote
5-Year Euro Swapnote
10-Year Euro Swapnote
 Characteristics of Future Contracts

• A future contract is an agreement between two

parties

• The characteristics of this contract are

– The underlying asset
– The contract size
– The delivery month
– The futures price
– The initial regular margin
 Underlying Asset and Contract Size

• The underlying asset that the seller delivers to the buyer at the
end of the contract may exist (interest rate) or may not exist
(bond)
– The underlying asset of the CBOT 30-Year US Treasury bond future is a
fictive 30-year maturity US Treasury bond with 6% coupon rate

• The contract size specifies the notional principal or principal

value of the asset that has to be delivered
– The notional principal of the CBOT 30-Year US Treasury bond future is
$100,000
– The principal value of the Matif 3-month Euribor Future to be delivered is
euros 1,000,000
 Price

• The futures price is quoted differently depending on

the nature of the underlying asset
– When the underlying asset is an interest rate, the future price is
quoted to the third decimal point as 100 minus this interest rate
– When the underlying asset is a bond, it is quoted in the same way
as a bond, i.e., as a percentage of the nominal value of the
underlying
• The tick is the minimum price fluctuation that can
occur in trading
• Sometimes daily price movement limits as well as
position limits are specified by the exchange
 Trading Arrangements

• Clearinghouse acts as a party to all buyers and sellers

– Obligated to deliver or supply delivery
• Initial margin
– Funds deposited to provide capital to absorb losses
• Marking to market
– Each day profits or losses from new prices are reflected in the account
• Maintenance or variation margin
– An established margin below which a trader’s margin may not fall
• Margin call
– When the maintenance margin is reached, broker will ask for additional
margin funds
 Conversion Factor

• When the underlying asset of a future contract does no exist, the

seller of the contract has to deliver a real asset
– May differ from the fictitious asset in terms of coupon rate
– May differ from the fictitious asset in terms of maturity
• Conversion factor tells you how many units of the actual asset
are worth as much as one unit of the fictive underlying asset
• Given a future contract and an actual asset to deliver, it is a
constant factor which is known in advance
• Conversion factors for next contracts to mature are available on
web sites of futures markets
 Conversion Factor (Cont’)

• Consider
– A future contract whose fictitious underlying asset is a m year maturity bond
with a coupon rate equal to r
– Suppose that the actual asset delivered by the seller of the future contract is
a x-year maturity bond with a coupon rate equal to c
• Expressed as a percentage of the nominal value, the conversion
factor denoted CF is the present value at maturity date of the
future contract of the actual asset discounted at rate r
• Example
– Consider a 1 year future contract whose underlying asset is a fictitious 10-
year maturity bond with a 6% annual coupon rate
– Suppose that the asset to be delivered is at date 1 a 10-year maturity bond
with a 5% annual coupon rate
10
50 1,000
CF    $926.3991
i 1 (1  6%)
i
1  6% 10
 Invoice Price

• The conversion factor is used to calculate the invoice

price
– Price the buyer of the future contract must pay the seller when a
bond is delivered
– IP = size of the contrat x [futures price x CF]
• Example
– Suppose a future contract whose contract size is $100,000, the
future price is 98. The conversion factor is equal to 106.459 and the
accrued interest is 3.5.
– The invoice price is equal to
IP = $100,000 x [ 98% x106.459% + 3.5% ] = $104,329.82
 Cheapest-to-Deliver

• At the repartition date, there are in general many bonds that

may be delivered by the seller of the future contract
• These bonds vary in terms of maturity and coupon rate
• The seller may choose which of the available bonds is the
cheapest to deliver
• Seller of the contract delivers a bond with price CP and receives
the invoice price IP from the buyer
• Objective of the seller is find the bond that achieves
Max (IP - CP) = Max (futures price x CF – quoted price)
 Cheapest-to-Deliver (Example)

• Suppose a future contract

– Contract size = $100,000
– Price= 97
• Three bonds denoted A,B and C
Quoted Price Conversion Factor IP-CP

Bond A 103.90 107.145% 3,065$

Bond B 118.90 122.512% -6,336$
Bond C 131.25 135.355% 4,435$

• Search for the bond which maximises the quantity IP-CP

• Cheapest to deliver is bond C
 Forward Pricing

• Consider at date t an investor who wants to hold at a

future date T one unit of a bond with coupon rate c
and time t price Pt
• He faces the following alternative
– Either he buys at date t a forward contract from a seller who will
deliver at date T one unit of this bond at a fixed price Ft
– Or he borrows money at a rate r to buy this bond at date t

Date t T
Buy a forward contract written on 1 unit of bond B 0 Ft
Borrow money to buy 1 unit of bond B Pt -Pt  1 r Tt
360

Buy 1 unit of bond B Pt AC 100 c  Tt

365
 Forward Pricing

• Given that both trades have a cost equal to zero at

date t, in the absence of arbitrage opportunities, the
cash-flows generated by the two operations at date T
must be equal
• From this we obtain
  T  t  T t 
Ft  Pt  1  r    100  c   
  360   365 
or
  T  t 
Ft  Pt  1  R  C  
  365 

with R = 365r/360 and C = 100c/Pt

 Forward Pricing - Example

• On 05/01/01, we consider a forward contract

maturing in 6 months, written on a bond whose
coupon rate and price are respectively 10% and $115
• Assuming a 7% interest rate, the forward price
F05/01/01 is equal to
  184   184 
F05/ 01/ 01  115  1  7%   100  10%     114.07
  360   365 
 Forward Pricing – Underlying is a Rate

• Simply determine the forward rate that can be guaranteed now

on a transaction occurring in the future
• Example
– An investor wants now to guarantee the one-year zero-coupon rate for a
$10,000 loan starting in 1 year
• Either he buys a forward contract with $10,000 principal value maturing
in 1 year written on the one-year zero-coupon rate R(0,1) at a
determined rate F(0,1,1), which is the forward rate calculated at date
t=0, beginning in 1 year and maturing 1 year after
• Or he simultaneously borrows and lends $10,000 repayable at the end
of year 2 and year 1, respectively
• This is equivalent to borrowing $10,000x[1+R(0,1)] in one year,
repayable in two years as $10,000x(1+R(0,2))2.
– The implied rate on the loan given by the following equation is the forward
rate F(0,1,1)

F 0,1,1 
1  R0,2 2

1  R0,1
 Futures Pricing
• Price futures contracts by using replication argument, just like
for forward contracts
• Let’s consider two otherwise identical forward and futures
contracts
– Cash-flows are not identical because gains and losses in futures trading are
paid out at the end of the day
– Denoted as G0 and F0, respectively, current forward and futures prices
• When interest rates are changing randomly
– Cannot create a replicating portfolio
– Cannot price futures contracts by arbitrage
• However, short term bond prices are very insensitive to interest
rate movements
– Replication argument is almost exact
 Futures versus Forward Pricing

Date Forward Contract Futures Contract

0 0 0
1 0 F1 F0
2 0 F2 F1
3 0 F3 F2
...
...
...
T 1 0 FT1 FT2
T PT G 0 PT FT1
Total PT G 0 PT F0
 Uses of Futures

• Fixing today the financial conditions of a loan or

investment in the future
• Hedging interest rate risk
– Because of high liquidity and low cost due to low margin
requirements, futures contracts are actually very often used in
practice for hedging purposes
– Can be used for duration hedging or more complex hedging
strategies (see Chapters 5 and 6)
• Pure speculation with leverage effect
– Like bonds, futures contracts move in the opposite direction to
interest rates
– This is why a speculator expecting a fall (rise) in interest rates will
buy (sell) futures contracts
– Advantages : leverage, low cost, easy to sell short
 Uses of Futures – Con’t

• Detecting riskless arbitrage opportunities using

futures
• Cash-and-carry arbitrage
– Consists in buying the underlying asset and selling the forward or
futures contract
– Amounts to lending cash at a certain interest rate X
– There is an arbitrage opportunity when the financing cost on the
market is inferior to the lending rate X
• Reverse cash-and-carry
– Consists in selling (short) the underlying asset and buying the
forward or futures contract
– Amounts to borrowing cash at a certain interest rate Y
– There is an arbitrage opportunity when the investment rate on the
market is superior to the borrowing rate Y