Chapter 7

Derivatives and Risk Management

By Rajiv Srivastava

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 Interest Rate Futures on T-Bills
Eurodollar Futures
Treasury Bonds Futures

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 Futures Contract on T-Bills
Pricing T-Bills
Quoting T-Bills Futures
Hedging with Futures on T-Bills
Speculation with T-Bills Futures
Arbitrage with T-Bills Futures
Implied Repo Rate
Pricing T-Bills Futures

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  A futures contract on T-bills on expiry calls
for delivery of T-bills maturing 91 days
thereafter.
 The price of T-bill, a function of interest
rate determines the price of futures on it.
Futures Contract on T-Bills
t=0 t = T (Maturity) t = T + 91 days
Futures position Futures contract matures T-Bill matures
Initiated T-Bill delivered
T-Bill

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  One determinant of interest rate is the
default risk. The yields on corporate
debt (bonds) also include the risk
premium for default.
 T-bills is sovereign debt and can be
assumed to have no risk of default.
 Also the liquidity in the sovereign debt is
high as compared to corporate bonds.
 T-bills serve as an ideal instrument as an
underlying asset for interest rate futures.

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  T-Bills are issued at discount to face value
and redeemed at face value on maturity.
 For discount yield of 6% the amount of
discount, D on the T-bill with 90 days to
maturity would be:
d xT 0.06 x 90
D =V x = 100 x = Rs 1.50
360 360
 The purchase price of T-bill, P would be:
P=V–D V = Face value
The price of the T-bill with 6% yield would be
100 – 1.50 = Rs 98.50.

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  Futures on T-bills are priced on index
basis because of
 Inverse relationship of price with interest
rate, and
 Convention of long position gaining with
price rise in other futures markets.
 Futures Price, F is stated as 100 – I
 The quoted price of futures on T–bill of
Rs 92 implies a yield of 8%.

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  With 8% yield on T-bills the futures price
would be Rs 92.
 If hypothetically we assume one futures
contract for Rs 10 lacs of face value of T-
bills the discount would be 2% (8 x 90/360).
(100 - Futures Price, F) x Nos of days to maturity, T
D=
100 x 360
T
or D = T - bill Yield x
360
 For a long position on futures the buyer has
to pay 10 x (1 - 0.02) = Rs 9.80 lacs.

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 Discount Yield =
7.9200%

Actual Yield =
8.1022%

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  With discount yield of 10% the current price of
the T-bill maturing after 90 days would be
 0.10 x 90 
Price of T - bill = 100 x  100 x  = Rs 97.50
 360 
 The actual yield would be:
100 - 97.50 360
Actual Yield = x = 10.526%
97.50 90
 If yield mentioned on add-on basis is 10% it
simply means that if the current price is Rs 100,
after 90 days one would get Rs 102.50.

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  T-bill futures are used for hedging the
short term interest rate risk.
 Depending upon the position of funds
one may need protection against rising
or falling interest rates.

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  As prospective investor one faces the
risk of falling interest rates.
 Rather than investing funds today
(invest in T-bills) one can buy futures on
T-bills.
 One is short on funds and to hedge
investor takes opposite position in
futures i.e. go long on T-bill futures.

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  You have to invest Rs 10 crore after 3 months
from now for next 3 months. The current yield on
T-bills is attractive 7.80% and is likely to
fall. Futures on T-bill trades at 92.20. Size of the
futures contract is Rs 10 lacs.
 To hedge you can buy a futures contract on T-bills and
lock-in the yield of 7.80%.
 Nos of contracts bought = 1000 lacs/10 lacs = 100
 Amount committed to pay = 100 x 9,80,500 = Rs 9,80,50,000
 By buying 100 futures contract on T-bills you have
undertaken to pay Rs 9,80,50,000 and receive T-bills
with face value of Rs 10 crore (100 contracts x Rs 10
lacs per contracts)

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 HEDGING INVESTMENT RETURN WITH INTEREST RATE FUTURES
Scenario Yield falls to 7.00% Yield rises to 8.50%
T-bill futures price 93.00 91.50
Futures contract sold at 93.00 91.50
Implied yield 7.00% 8.50%
Value to be received on the futures
contracts sold Rs 9,82,50,000 Rs 9,78,75,000
Amount to be received (+) /paid (-) Rs 2,00,000 - Rs 1,75,000
on futures contracts
Amount of interest earned on actual 0.07 x 90/360 x 0.085 x 90/360 x
deployment of Rs 10 crore in T-bills 10,00,00,000 = 10,00,00,000 =
Rs 17,50,000 Rs 21,25,000
Actual earnings after adjusting for
profit/loss on T-bill futures (ignoring Rs 19,50,000 Rs 19,50,000
time value of the gain/loss on futures)
Effective yield 7.80% 7.80%

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  Protection against falling interest rate is
covered by selling interest rate futures.
 Risk against rising interest rate is hedged
by selling interest rate futures. It is called
short hedge.
 By going short on T-bill futures the yield
in the futures price can be locked as
the cost of borrowing irrespective of the
interest rate scenario at the time of
actual borrowing.

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 SITUATION STRATEGY

When interest rates are expected

to go up more than what futures
market suggests– The price of Sell futures now and buy later
underlying asset as well as futures
on them would fall

When interest rates are expected

to go down more than what the
futures market suggests– The price Buy futures now and sell later
of underlying asset as well as
futures on them would go up

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  If futures are mispriced one can execute “cash and
carry” or reverse cash and carry arbitrage as follows:

OVER PRICED FUTURES - CASH AND CARRY ARBITRAGE

Today On Maturity
• Sell the future • Deliver asset against the futures contract
• Buy the underlying asset • Receive value equal to futures price
• Borrow equivalent sum • Repay borrowing along with cost of borrowing

UNDER PRICED FUTURES - REVERSE CASH AND CARRY ARBITRAGE

Today On Maturity
• Buy the future • Acquire asset against the futures contract
• Sell the underlying asset • Receive the funds lent with interest
• Lend equivalent sum • Pay for the asset as agreed in futures contract

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  Futures contracts on interest rate are like repo
transactions and therefore futures price imply
a repo rate.
 The repo rate implied in futures price is
Implied Repo Rate
Futures Price - Spot Price 365
= x
Spot Price Nos of days remaining for futures

 Arbitrage with interest rate futures is

determined by the implied repo rate and the
actual yield in the market.

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  Consider T-bill futures sells for Rs 90.00. Note that
 Contract has exactly 90 days to mature.
 On maturity of futures it warrants delivery of T-bills that
have 90 days to mature. Hence 180-day T-bill is the
deliverable.
 Yield of 180-day bill is relevant spot price.
 180-day T-bill is quoting at yield of 8%. The price of
180-day T-bill and the futures contracts are:
Price of 180-day T-bill = 100 – 0.08 x 180/360 = Rs 96.00
Invoice price of futures contract = 100 - 0.10 x 90/360 = Rs 97.50
The implied repo rate is 6.25%
97.50 - 96.00 360
Implied Repo Rate = x = 0.0625 ≡ 6.25%
96.00 90
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  If implied repo rate is different than the actual repo rate
it presents an arbitrage opportunity. This would force the
implied repo rate to converge to actual repo.
ARBITRAGE WITH INTEREST RATE FUTURES
Cash And Carry Arbitrage Reverse Cash And Carry Arbitrage
When Implied Repo Rate When Implied Repo Rate
> Financing Cost, Say 4% < Financing Cost, Say 8%
Action Cash flow Action Cash flow
Today Today
Sell the Interest rate futures - Buy the Interest Rate Futures -
Buy 180-day T-bill in cash - 96.00 Sell 180-day T-bill in cash + 96.00
Borrow equivalent sum + 96.00 Lend equivalent sum - 96.00
Cash flow today 0.00 Cash flow today 0.00
On maturity after 90 days On maturity after 90 days
Deliver T-bill and realise futures +97.50 Acquire T-bill and pay - 97.50
contract value - 96.96 futures contract value +97.92
Repay borrowing with interest Receive funds lent with interest
Cash flow on maturity + 0.54 Cash flow on maturity + 0.42

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 Eurodollars
Futures Contract on Eurodollars
Pricing Eurodollar Futures
Hedging with Eurodollar Futures

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  Eurodollar deposit is the US dollar deposit held by banks
outside USA by non USA banks or foreign branches of US
banks.
 Eurodollar deposits came into existence when during
1950s and 1960s the erstwhile USSR and East European
countries parked their US dollar deposits with banks in
London, Paris and other non US locations so that they
could not be confiscated by USA.
 Eurodollars are not subject to regulation and control by
US government.
 These made Eurodollar deposits and lending rates purely
determined by market forces.

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  Like contract on futures on T-Bill requires
seller to deliver T-bills that matures 91 days
thereafter, a future contract on Eurodollar
requires delivery of deposit that matures 3
months thereafter.
 Eurodollar deposits are not deliverable
being non-transferable.
 However, we use Eurodollar futures for
hedging, speculation and arbitrage in the
same way as futures on T-bills.

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  There are two key differences between
the futures contracts on T-bills and
Eurodollar deposits as below:
 Eurodollar deposits are non-transferable and
hence cannot be delivered. Therefore futures
on Eurodollar deposits are necessarily cash
settled.
 Yield on Eurodollar deposit is on add-on basis.
 Add-on yield is related to discount yield.
Discount Yield 360
Add - on Yield = x
Price T
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  Like futures on T-bills the futures on
Eurodollar deposits too are quoted on
index basis. Price of Eurodollar futures is
given by:
Eurodollar Futures Price, F =
100 – 3-m LIBOR rate
 Because of free pricing futures contract
on Eurodollars are extremely popular in
international markets.

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  Eurodollar futures are necessarily cash
settled i.e. difference of initial price F0
and final price F1 exchanged in cash.
 The cash profit/loss for long and short
position is given by:
Profit/loss on Eurodollar Futures
F1 - F0 90
For initial long position = $ 1,000,000 x x
100 360
F0 - F1 90
For initial short position = $ 1,000,000 x x
100 360

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  3 months from now DFL needs to raise US $
2 million for 6 months. Current LIBOR is 6.50%
and the Eurodollar futures contract with 3
months to expire is quoted at 93.00. DFL
expects the interest rate to rise to 8%.
 How can DFL hedge against rising interest rates?
 What would be the effective cost if the interest
rate actually rises to 8%.
 Also analyse the interest cost if LIBOR actually
falls to 6%.

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  DFL faces risk of rising interest rate for its
contemplated borrowing 3 months.
 Since futures contract provides cash flow
based on 3 months and loan required is for
6 months the compensation would be
equal if the exposure in futures is for twice
the actual borrowing.
 DFL can therefore sell 4 futures contracts
on Eurodollar futures equivalent to $ 4
million.

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 If LIBOR rises to 8%
Eurodollar price would fall to 92.00. The profit of each futures is
Profit/loss on Eurodollar Futures (For Short Position)
F -F 90
= $ 1,000,000 x 0 1 x
100 360
93.00 - 92.00 90
= $ 1,000,000 x x = $2,500
100 360
The borrowing cost for 6-m loan on $ 2 million
= 2 m x 0.08 x 180/360 = $ 80,000
Less: Profit earned from 4 Eurodollar futures contracts
= 2,500 x 4 = $ 10,000
Effective interest paid = $ 70,000
70,000 360
Effective Interest Rate = x = 7.00%
2,000,000 180
The rate implicit in the futures contract is locked in.

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 If LIBOR falls to 6%
Eurodollar price would rise to 94.00. The loss of each futures is
Profit/loss on Eurodollar Futures (For Short Position)
F -F 90
= $ 1,000,000 x 0 1 x
100 360
93.00 - 94.00 90
= $ 1,000,000 x x = -$2,500
100 360
The borrowing cost for 6-m loan on $ 2 million
= 2,000,000 x 0.06 x 180/360 = $ 60,000
Loss from 4 Eurodollar futures contracts = 2,500 x 4 = $ 10,000
Effective interest paid = $ 70,000
70,000 360
Effective Interest Rate = x = 7.00%
2,000,000 180
With fall in the interest rates the firm would not benefit. It still has
to pay the same cost of 7% the rate implicit in the futures.
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 Pricing T-Bonds
Futures Contract on T-Bonds
Pricing T-Bond Futures
Conversion Factor
Cheapest-To-Deliver Bonds
Hedging Principle
Duration and Modified Duration
Duration Based Hedging

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  Futures contracts on treasury bonds are used for
hedging long term interest rate risk, while futures on
T-bills cover interest rate risk over short term.
 Like T-bills, treasury bonds are also regarded as free
of default risk.
 The futures contract on treasury bonds would
require delivery of an equivalent government
security, during the delivery period specified.
 However, settlement by delivery may not arise
because most contracts would be negated by the
offsetting contracts prior to the maturity.

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  Following is term structure
Investment Horizon(m) 6 12 18 24 30 36
Yields (%) 5.70 6.00 6.40 6.70 6.90 7.20

 The value of the GoI security with 8% semi-annual

with 3 years to maturity is given by:
6
Ct R
P0 = ∑ ( 1 + rt / 2 ) t /2
+
( 1 + r3 ) 3
1

 The price of the security is Rs 102.63

4.00 4.00 4.00 4.00 4.00 104.00
P0 = 0.5
+ 1.0
+ 1.5
+ 2.0
+ 2.5
+ 3.0
= Rs 102.63
(1.057) (1.060) (1.064) (1.067) (1.069) (1.072)

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  Futures contract on treasury bonds requires
delivery of a long term bond with minimum
specifications decided by the exchange.
 Different exchanges adopt different
practices for delivery of the underlying
instrument on which the prices are quoted.
 Any instrument meeting minimum
specifications can be delivered by the
seller of futures contracts on treasury
bonds.

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  The price of a futures contract on treasury
bond uses the concept of cost of carry, as is
the case with pricing of other futures
contracts.
 However, in case of treasury bonds we also
earn the dividend in the form of accrued
interest.
 Fair price of futures on treasury bonds must
reflect true cost of financing.
Fair Price of futures
= Spot price + Cost of financing – Accrued interest

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 Futures contract price represents a repo transaction; selling a security
and buying it later at the price determined today.
Assume 8% GoI security sells for 96.0291 at YTM of 8.60%.
Financing cost is 10%. Futures with 45 days to maturity sells for
Rs 96.5000.Then we have:

Spot price of the bond (at YTM of 8.60%) = Rs 96.0291

Accrued interest for 45 days = 4 x 45/182 = Rs 0.9890
Cost of financing for 45 days = 96.0291 x 0.10 x 45/365 = Rs 1.1839
Net amount to be paid = 96.0291+1.1839 – 0.9890 = Rs 96.2240
Amount receivable against the futures contract sold = Rs 96.5000
Arbitrage profit = Rs 0.2760

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 For no arbitrage:
Futures fair price
= Spot price + Cost of financing – Accrued interest.
The repo rate implied in the futures price is 12.33% while the
actual financing cost is 10%

Implied Repo Rate

Futures Price - Spot Price + AI 365
= x
Spot Price Nos of days remaining for futures
96.50 - 96.02 + 0.9890 365
= x = 0.1233 ≡ 12.33%
95.66 45

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  For financial futures market the requirement of the
delivery forces the convergence of futures price to spot
price.
 The futures contract on any long term securities would
warrant a delivery of the underlying asset.
 Government securities issued at various points of time
have different coupon rates and maturities.
 Futures exchange would need to identify some
government security on which the futures contracts may
be traded.
 This standardized futures contract on specific security
could be notional and may not be available for
delivery.

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  While the futures is quoted on a notional
asset, the asset actually may not be
existing and hence is non-deliverable.
 Instead there are many other securities that
may be deliverable.
 Despite same face/nominal value the YTMs
of securities would not be same as these
securities issued at different points of times
have varying coupon rates and maturities.

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  Price of the bonds is dependent upon, interalia, on
the coupon rate and the time remaining for
maturity.
 A bond with higher coupon is worth more than the
bond with lower coupon given all other features of
the two bonds same.
 For example if the futures contract requires delivery of
bond with 6% coupon the seller who chooses to deliver
a bond with 8% coupon would need adjustment of
price for making the contract good.
 The seller who delivers high coupon rate bond needs to
be compensated more than the one who chooses to
deliver the bond with lower coupon.

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  The conversion factors for deliverable
bonds are determined against the
standard bond with 6% coupon rate. It is
 greater than 1.00 when coupon is more than 6%
 lesser than 1.00 when coupon is less than 6%.
 Conversion factor of the deliverable bond
is its value relative to the notional bond
underlying the futures contract.
 Conversion factor for each deliverable
security is computed by the exchange
prior to maturity of contracts.
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  Of the many deliverables the seller has to
choose which bond must be delivered.
 Not all deliverable bonds would have
same value.
 The seller would like to deliver the one
which costs him the least i.e. identify the
cheapest-to-deliver (CTD) bond.
Profit/loss = Invoice amount – cost of acquisition
= Settlement price x conversion factor
– Current market price
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  Hedging principle with futures on T-bonds
remains same, i.e. taking opposite position
in the futures to that of in the spot market.
 One who is long on portfolio would need to
go short on futures.
 The value of portfolio falls with rise in yields.
 Risk from rising yield causing portfolio value
to fall can be covered by going short on
interest rate futures.

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  To what extent the loss in the value of the portfolio
would be offset by the gains in the futures position
depends upon the positions in the futures and
portfolio value.
 Hedge ratio depends upon the sensitivities of the
portfolio and the futures with respect to changes in
the interest rates.
 Where asset underlying the futures contract and cash
position is same the optimal hedge ratio is unity.
 In case of portfolio of bonds, due to different sensitivities
of the values of the assets underlying the futures
contract and those in the cash position the optimal
hedge ratio is would not be equal to 1.

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  Duration of the bond is the measure of sensitivity of its
value with respect to changes in the interest rates.
 Duration of the bond is computed by dividing the time
weighted cash flows of the bond by its current value.
Σ t x DCFt
Duration of the bond, D =
P0
 Modified duration is more accurate measure of sensitivity
of bond prices given by:
D
Modified Duration, MD = −
1 + r/m
D
For semi - annual payment m = 2 and MD = −
1 + r/2

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  A bond with three years remaining for maturity
bearing a semi-annual coupon of 10% is
trading at YTM of 12%. Find out the value of the
bond, its duration and modified duration.

Period, t 1 2 3 4 5 6 Total
Cash flow 5.00 5.00 5.00 5.00 5.00 105.00
Present Value at
12%, DCF 4.7170 4.4500 4.1981 3.9605 3.7363 74.0209 95.0827
t/2 x DCF 2.3585 4.4500 6.2971 7.9209 9.3407 222.0626 252.4299
Value of the Bond 95.0827
Duration 2.6548
Modified Duration 2.5046

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  Optimal hedge ratio for position in long
term futures depends upon the duration of
bonds portfolio and the duration of
perceived CTD bond in the futures
contract.
 The optimal hedge ratio would be one that
offsets the changes in the value of the
portfolio of bonds. It may be expressed as:
Change in value of bond portfolio
= h x Change in value of Treasury bond
futures

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 Change in value of bond portfolio, ΔB
= Value x ΔrB x Modified duration
= B x ΔrB x MDB
= B x ΔrB x DB/(1+rB/mB)
Change in the value of CTD bond (Govt
Security), ΔG
= Value x ΔrG x Modified duration
= G x ΔrG x MDG
= G x ΔrG x DG/(1+rG/mG)

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  Hedge ratio for portfolio of bonds
Change in the value of bond portfolio ΔB
Hedge Ratio = =
Change in value of futures on T − bonds ΔF
ΔB
= x Conversion Factor
ΔG
B x ΔrB x DB (1 + rG /mG )
= x x Conversion Factor
G x ΔrG x DG (1 + rB /mB )

 Ignoring differences in the coupon payments

B x DB (1 + rG )
Hedge Ratio = x x Conversion Factor
G x DG (1 + rB )

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 Interest Rate Futures – Contract Specifications
10 Year Notional Coupon bearing Government of India (GOI)
Underlying security.
(Notional Coupon 7% with semi annual compounding.)
Tick size Rs 0.0025
Contract trading cycle Four fixed quarterly contracts for entire year ending March, June,
September and December.
Last trading day Seventh business day preceding the last business day of the
delivery month.
Daily settlement MTM: T + 1 in cash
Settlement Delivery settlement : In the delivery month i.e. the contract
expiry month.
Daily settlement price Closing price or Theoretical price.
Mode of settlement Daily Settlement in Cash
Deliverable Grade Securities GOI securities
The conversion factor would be equal to the price of the
Conversion Factor deliverable security(per rupee of principal) on the first calendar
day of the delivery month, to yield 7% with semi-annual
compounding
Invoice Price Daily Settlement price times a conversion factor + Accrued
Interest
Source: www.nseindia.com on August 28, 2009

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 EXAMPLE
 A mutual fund is holding bonds worth Rs 5.00 crore.
YTMs in next 3 months are expected to rise. The
portfolio of bonds has duration of 6.63 years.
Futures contract on notional 10-year, 7% semi-
annual Government of India (GoI) security is
trading at Rs 104.3425. The cheapest-to-deliver GoI
security is expected to have duration of 7.72 years.
 How many contracts should the mutual fund trade
to hedge against the risk of rising yields? Assume
that the YTMs of the CTD bond and the portfolio
are same.

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 Price in the futures market for bond
with face value of Rs 100 = 104.3425
Value of one futures contract
(Bonds with face value of Rs 2,00,000)
= 104.3425 x 2,000 = Rs 2,08,685
Therefore the number of interest rate futures contracts that
must be booked:
B x DB (1 + rG )
Hedge Ratio = x
F x DG (1 + rB )
5,00,00,000 x 6.63
=
2,08,685 x 7.72
= 205.766 say 206 contracts

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