Interest Rate Futures
Prepared By: Prof. Divyesh
Gandhi
Introduction
An interest rate future is a financial
derivative (a futures contract) with an
interest-bearing
instrument
as
the
underlying asset.
Examples include Treasury-bill futures,
Treasury-bond futures and Eurodollar futures.
Interest rate futures are used to hedge
against the risk that interest rates will move
in an adverse direction, causing a cost to the
company.
WHO FACES INTEREST RATE
RISK?
1. Investors in fixed income securities
2. Organizations and individuals who
borrow money
3. Institutions and individuals that
lend money
HOW DOES INTEREST RATE
AFFECT TO DIFFERENT PARTIES
Investors Reinvestment rate risk arises, as reinvestment of interim
future coupon payments is uncertain
Price risk arises as the value of an investment is inversely
related to interest rates
Lenders
For lenders on a floating rate, the future reset rate is uncertain
For lenders on fixed rate, reinvestment rates are uncertain
Borrowers
For borrowers on floating rate, future reset rates are uncertain
Interest rate risk also affects investors, lenders and borrowers
who plan future activities
BANK & INTEREST RATE RISK
Banks assets, which
are loan
portfolios, are generally long-term
Liabilities or deposits are short-term
The impact of interest rate changes
is different on assets and liabilities
Asset liability management or gap
management using derivatives
INTEREST RATE FUTURES
IN INDIA
First introduced in 2003
Short-term futures on notional 91-day T-bills
Long-term futures on notional 10-year bond with 6% coupon
Long-term futures on notional 10-year zero-coupon bond
All these were settled through cash
Interest in these futures was low, and the trade was suspended in
2005
Interest Rate Futures in India (2009)
Notional 10-year 7% coupon (compounded semi-annually) GOI
bonds
Settlement through physical delivery
Since there may be no 7% coupon bond available, delivery is
possible with maturity between 8 and 10.5 years
Settlement date is the last day of the month
CONVERSION FACTOR
The conversion factor will be known on the day trading starts
on futures
The maturity of the bond and period of coupon payment is
rounded to the nearest 3 months
The first coupon is assumed to be paid in 6 months time, if
the rounded
maturity is a multiple of 6 months
If it is not a multiple of 6 months, the first coupon is assumed
to have been paid in 3 months; accrued interest is subtracted
Using the above, the value of a deliverable bond can be
calculated
The conversion factor is the value calculated, divided by the
face value
CHEAPEST-TO-DELIVER (CDT)
BONDS
When many bonds are available for delivery, everybody
who participates in delivery will choose the cheapest
option
CDT bonds are ones in which the difference between the
quoted price of the bond and (the futures settlement
price * the conversion factor) is the smallest
The Cheapest-to-Deliver (CDT) Bonds is a bond in which
the difference between the quoted price of bond & the
product of the settlement price & the conversion factor
(Future settlement price* conversion factor) is the least,
making the most beneficial to seller.
Pricing of Bond Futures
Very difficult to calculate, as many bonds can be delivered
including the CTD bond
Futures price will be the price based on the CTD bond
Exchange will provide a list of eligible securities and the
conversion factor at the start of futures trading.
If the CTD Security & delivery date are known, it is easy to
calculate the future
price, because the future contract is a contract which is traded
on security.
CTD bonds can be found on the date that trading starts
Theoretical
futures
price
=
forward
price
of
CTD
bond/conversion factor
Forward price = Cash price of bond+funding cost income from
cash position
FORWARD PRICE OF CTD BOND
Forward price of a CTD bond is
calculated as:
Cash price of CTD bond + funding cost
income on cash position
The cash price of the bond is the
market price of a CTD bond
Opportunity cost of investing in the
bond at a 91-day T-bill rate is the
funding cost
Uses of Long-term Interest Rate
Futures
1. Directional trading
2. Arbitrage
3. Calendar spread trading
4. Hedging
5. Fixed-income portfolio
management
1. Directional Trading
It is Speculative
Expect interest rate to move in a certain direction
If interest rates are expected to increase, the value of
a CTD bond will decrease, causing futures prices to fall
it would be best to take a short position in this case
If interest rates are expected to decrease, the value
of the CTD bond will increase, causing futures prices to
increaseit would be best to take a long position
2. Cash-and-carry Arbitrage
If the actual futures price is different from the theoretical futures
price, arbitrage opportunity exists
If the actual price is greater, one would take a short position in
futures and a long position in CTD bonds
If the actual price is lower, one would take a long position in futures
and a short one in CTD bonds
Theoretical future price = Bond future price / Conversion factor
Forward price = future price of Bond++Accrued interest on all time
bond being brought future value of interim coupon received-Accured
interest from the last coupon to the future maturity
3. Calendar Spread Trading
One would take a long position in one futures
contract and a short position in another with a
different maturity
If the bid-ask spread between the short and longterm contract is not reasonable
Through calendar spread trading, one can make
money without taking risk
4. Hedging
Institutions, corporations and investors who plan to borrow or invest at
a future time can hedge the risk of changing interest rates by using
interest rate futures
5. Fixed Income Portfolio Management
If interest rates increase, the value of a portfolio will fall
To hedge this risk, there are two possible alternatives:
Use interest rate futures to hedge value
Use interest rate futures to change duration of a portfolio
HEDGING THE VALUE OF A
PORTFOLIO
May have to be changed dynamically
CTD bonds are used in futures,
whereas portfolio may contain bonds of
different coupons and maturity
Loss from a portfolio will be partially
offset by gains from futures
HEDGING USING BILL FUTURES
A borrower planning a future loan will
take a short position in futures
An investor planning for future
investment will take a long position in
futures
A portfolio manager will take a short
position in futures
Uses of Short-term Interest Rate
Futures
1.
To hedge borrowing costs Short term
Interest rate future contracts are used when an
organization is planning to borrow within a very
short time period. It can also be used to hedge the
future interest rate under a variable borrowing.
2. To hedge investment yield An Investor is
planning to invest in near future can hedge the
yield on investment by trading in future contract.
3.
To create synthetic swaps Short term
interest rate future can be used to hedge floating
rate loans, as any increase in interest rate will
increase the interest payments.
4.
Directional trade - Directional trade is a speculative
activity. If the speculator believes that the interest rate is
expected to change, they can speculate on this information. This
can be done in two ways. First, using physical securities & by
entering into future markets.
5. Spread trade - Spread trade are undertaken on the basis of
the anticipation that the shape of yield curve may change. The
typical spread contracts are calendar- spread where a trader
takes a position in a near-term contract.
6. Arbitrage An Arbitrage opportunity occurs when physical
assets & future contracts written on physical assets are not
priced according to the theoretical relationship.
7. Adjust duration of portfolio Short term future contract
can also be used to adjust the duration of portfolio in a way
similar to the manner in which long term interim future are used.
