CHAPTER 7 INTEREST RATE FUTURES

In this chapter, we explore one of the most successful innovations in the history of futures markets; that is, interest rate futures contracts. This chapter is organized into the following sections: 1. Interest Rate Futures Contracts 2. Pricing Interest Rate Futures Contracts 3. Speculating With Interest Rate Futures Contracts 4. Hedging With Interest Rate Futures Contracts

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Interest Rate Futures Introduction
Interest rate futures contracts are one of the most successful innovations in futures trading. Pioneered in the United States, they have expanded internationally with strong presence in Great Britain and Singapore. The CBOT specializes in contracts with long-term maturity (e.g., 2-year, 5-year and 10-year T-notes, and 5-year LIBOR-based swaps). The CME International Monetary Market (IMM) specializes in contracts with short-term maturity (e.g., 1-month, and 3month Eurodollar deposits).

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Short-Term Interest Rates Contracts
In this section, four short-term interest rate futures contracts will be examined: 1. Eurodollar Futures 2. Euribor Futures 3. TIEE 28 Futures 4. Treasury Bill Futures

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to 5: 00 p. June..m.005=$12. Trading Hours: Floor: 7:20 a. Shutdown period from 4:00 p.0025=$6.-4:00 p.Eurodollar Futures Product Profile Product Profile: The CME= Eurodollar Futures s Contract Size: Eurodollar Time Deposit having a principal value of $1. 100 minus the yield on an annual basis for a 360-day year with each basis point worth $25. 0. Deliverable Grades: Cash Settled to 3-month Dollar LIBOR Tick Size: 0. Globex: Mon/Thurs 5:00 p.m. Contract Months: March.m.m.-4:00 p. Sunday & holidays 5:30 p. Price Quote: Price is quoted in terms of the IMM 3-month Eurodollar index.-2:00 p. Chicago Time (11:00 a.50 Months 2 thru 10.m .00 Months 11 thru 40. 0. nightly.25 for nearest expiring month. and December cycle for 10 years Expiration and final Settlement: Eurodollar futures cease trading at 5:00 a.m.m. final settlement price is based on the British Bankers=Association Interest Settlement Rate.000.000 with a threemonth maturity. September. London Time) on the second London bank business day immediately preceding the third Wednesday of the contract month. Daily Price Limit: None Chapter 7 4 .m.m.01=$25.m.

3-month Eurodollar) 6. ± LIBOR is the rate at which banks are willing to lend funds to other banks in the interbank market. A Eurodollar futures contract is based on a time deposit held in a commercial bank (e.S. 5. Chapter 7 5 .S.g.S.. market for short-term futures contracts.Eurodollar Futures 1. dollar denominated deposits held in a commercial bank outside the U. Eurodollars are U.000. The Eurodollar contracts is for $1. Eurodollar contracts are non-transferable. 2. 4. 3. Eurodollar futures currently dominate the U.000. Rates on Eurodollar deposits are usually based on LIBOR (London Interbank Offer Rate).

Eurodollar Futures 7. 10. 9. The yield on the Eurodollar contract is quoted on an add-on basis as follows: Chapter 7 6 . This settlement rate is then used to compute the amount of the cash payment that must be made. Eurodollar futures were the first contract to use cash settlement rather than delivery of an actual good for contract fulfillment. 8. To establish the settlement rate at the close of trading. the IMM determines the three-month LIBOR rate.

Eurodollar Add-on Yield Add  on Yield ! ( $ Discount Price )( ) 360 DTM In order to calculate the add-on yield. the price and discount must be computed as follows: DY ( Face Value)( DTM ) 360 $ Discount ! rice ! Face Value  $ Discount Or equivalently Price ! ace Value  DY ( ace alue)( DTM ) 360 Chapter 7 7 .

000  20.000.000. rice ! Face Value  Price ! 1.000 )(90) 360 Price ! 1.200 $Discount ! $20.Eurodollar Add-on Yield Suppose you have a 90-day Eurodollar deposit with a discount yield of 8.800 Price ! $979. Step 1: Compute the discount and the price.32%.000.800 Chapter 7 8 .0832(1.000  DY ( Face Value)( DTM ) 360 0.

800 )(360) 200 90  Yi l ! 0.085 A one basis point change in the Add-on Yield.000 v .Eurodollar Add-on Yield Step 2: Compute the add-on yield using: Add  on Yield ! 360 ($Discount )( DTM ) Price  Yi l ! $20 (979.000..00 .0001v 90 v 360 ! $25 Eurodollar futures contract prices are quoted using the IMM Index which is a function of the 3-month LIBOR rate: IMM Index = 100.3-Month LIBOR Chapter 7 9 . This amount can be compute using: ace Value v ( Add  on Yield v DTM v 360 $1. on a 3-month Eurodollar contract implies a $25 change in price.

± Contracts are cash settled at expiration . Euribor futures are traded at: Euronex.000 notional value.000 notional value.000.000. ± Contracts are cash-settled at expiration. Eurex ± Contracts are based on a 3-month time deposit with a ¼3.liffe ± Contracts are based on a 3-month time deposit with a ¼1.Euribor Futures Euribors are Eurodollar time deposits. Chapter 7 10 . Swaps dealers use Euribor futures to hedge the risk resulting from their activities.

Final settlement is based on Euopean BankersFederation= s Euribor Offered Rate (EBF Euribor) for three-month euro time deposits at 10:00 a. Trading Hours: 7:00 a.5. with the nearest six expirations being consecutive calendar months.m. Contract Months: March. September. to 6:00 p.000 with a three-month maturity. and December and four serial months so that 24 delivery months are available for trading. Daily Price Limit: Chapter 7 11 . Deliverable Grades: Cash Settled to Euopean Bankers Federation= Euribor Offered Rate s (EBF Euribor) for three-month euro time deposits.m. Expiration and final Settlement: The last trading day is two business days prior to the third Wednesday of the contract month. Tick Size: .005 percent representing A 12. London time on the last trading day. Price Quote: 100 minus the Euribor rate of interest carried out to three decimal places.Euribor Futures Product Profile Product Profile: Euronext-Liffe Euribor Futures Contract Size: A 1.m.000. June.

TIEE 28 Futures The TIEE 28 futures contract is based on the short-term (28-day) Mexican interest rate. calculated by Banco de México. The contract is cash settled based on the 28-day Interbank Equilibrium Interest Rate (TIIE). or MexDer) A 28-day TIIE futures contract has a face value of 100. The contract is traded on the Mexican Derivatives Exchange (Mercado Mexicano de Derivados. Chapter 7 12 .000 Mexican pesos.

Tick Size: One basis point of the annualized percentile rate of yield Price Quote: Trading of 28-Day TIIE futures contracts use the annualized percentile rate of yield expressed in percentile terms. Contract Months: MexDer lists different Series of the 28-Day TIIE Futures Contracts on a monthly basis for up to sixty months (five years). Mexico City time. to 3:00 p.. Trading Hours: Bank businessdays from 7:30 a.m. with two decimal places. eliverable Grade Cash settled based of the 28-Day Interbank Equilibrium Interest Rate (TIIE).m. calculated by Banco de México based on quotations submitted by full -service banks using a mechanism designed to reflect conditions in the Mexican Peso Money Market. Expiration and final Settlement: The last trading day is the bank business day after Banco de México holds the primary auction of government securities in the week corresponding to the third Wednesday of the Maturity Month. aily Price Limit: None Chapter 7 13 .TIEE 28 Futures TIEE 28 Futures s Product Profile: he Mex er= IEE Futures Contract Size: Each 28-Day TIIE Futures Contract covers a face value of One Hundred Thousand Mexican Pesos.

± Treasury bills have original maturities of 13 weeks and 26 weeks. 2. The Treasury bill futures contract calls for the delivery of T-bills having a face value of $1.S. Chapter 7 14 . government borrowing money for a short period of time. September. A T-bill is the U. ± 91-day and 92 day T-bills may also be delivered with a price adjustment.000.Treasury Bill Futures 1. and December. ± The contracts have delivery dates in March. June. ± The delivery dates are chosen to make newly issued 13 week T-bills immediately deliverable against the futures contract.000 and a time to maturity of 90 days at the expiration of the futures contract.

Treasury Bill Futures Price quotations for T-bill futures use the International Monetary Market Index (IMM).1 IMM Index = 92. IMM Index = 100 .1% implies an IMM Index of: IMM Index = 100 .9 Chapter 7 15 .7.DY Where: DY = Discount Yield Example A discount Yield of 7.

125. the delivery price would be $979. A one basis point shift implies a $25 change on a $1.200 and a $discount of $20.35%. the price to be paid for the T-bill at delivery would be $979.Treasury Bill Futures Recall that a bill with 90 days to maturity and a 8.000. 3-month futures contract. If the futures yield rose to 8. Chapter 7 16 . has a price of $979. For a futures contract with a discount yield of 8.200.800.000.32% discount yield.32%.

Other Short-Term Interest Rate Futures Insert Figure 7.1 here Chapter 7 17 .

Longer-Maturity Interest Rate Futures Longer-maturity interest rate futures are based on couponbearing debt instruments as the underlying good. These instruments require the delivery of an actual bond. Treasury Note Futures 3. Treasury Bond Futures 2. long-term interest rate futures contracts will be examined. including: 1. Non-US Longer Maturity Interest Rate Futures Chapter 7 18 . In this section.

This may occur on the first position day or some other later day. Delivery Day Clearinghouse matches the short and long traders and requires them to fulfill their responsibilities. T-bond contracts trade for delivery in March.000 face value and with at least 15 years remaining until maturity or until their first permissible call date. with delivery taking place 2 business days later. Chapter 7 19 . ± Position Day Short declares his/her intentions to make delivery.Treasury Bond Futures Traded at the CBOT. Requires the delivery of T-bonds with a $100. the Treasury bond futures contract is one of the most successful futures contracts. Delivery against the T-bond contract is a several day process that the short trader can trigger to cause delivery on any business day of the delivery month. and December. September. June. ± First Position Day First permissible day for the short to declare his/her intentions to make delivery.

Treasury Bond Futures Price Quotation for Major Interest Rate Futures Contracts Insert Figure 7.1 Here Chapter 7 20 .

2 here Chapter 7 21 .Treasury Bond Futures Delivery Process Insert Figure 7.

FridayElectronic: 7:00 pm . and December Expiration and final Settlement: The last trading day is the seventh business day preceding the last business day of the delivery month.Treasury Bond Futures Product Profile s Product Profile: he BO = 30 Year reasury Bond Futures Contract Size: One U. September.S. Central Time.FridayTrading in expiring contracts closes at noon. Price Quote: Points ($1.000) and thirty seconds a point. The contract is settled with physical delivery. if callable. Monday .25/contract). i. Contract Months: March. have a maturity of at least 15 years from the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor plus accrued interest. Sunday . Treasury bonds that. par is on the basis of 100 points. rading Hours: Open Auction: 7:20 am . June.. Daily Price Limit: None. on the last trading day.4:00 pm.S. The conversion factor is the price of the delivered note ($1 par value) to yield 6 percent. Treasury bond with face value at maturity of $100. Central Time.e.000 Deliverable Grades: U. Chapter 7 22 . Chicago time.2:00 pm. 84-16 equals 84 16/32. are not callable for at least 15 years from the first day of the delivery month or. ick Size: 1/32 of a point ($31. if not callable. The last delivery day is the last business day of the delivery month.

the short trader will want to deliver the bond that is least expensive for him/her to obtain. and which bond to deliver. Chapter 7 23 . Rather. Because the short trader chooses whether to make delivery. a number of different bonds can be delivered to fulfill the futures contract. This bond is called the cheapest-to-deliver bond.Treasury Bond Futures Conversion Factor The T-bond contract does not specify exactly which bond must be delivered to fulfill the futures contract. To address this issue. a conversion factor is computed to equate the bonds.

000)(C )  AI Where: DSP = Decimal Settlement Price (The decimal equivalent of the quoted price) CF = Conversion Factor (the conversion factor as provided by the CBOT) AI = Accrued Interest (Interest that has accrued since the last coupon payment on the bond) This system is effective as long as the term structure of interest rates is flat and the bond yield is 6%. if the term structure of interest rates is not flat. However.Treasury Bond Futures Conversion Factor Invoice mount ! DSP ($100. Chapter 7 24 . or if bond yields are not 6%. some bonds will still be less expensive to deliver against the futures contract than others.

1 shows key dates in the delivery process for Tbond and T-note futures contracts in 1997.T-Bond and T-Notes Delivery Sequence Table 7. TheD eliveryS equencefor T-B & T-N utures ond ote 1997 C ontract irst irst irst ast piration osition N otice D elivery Tradin 97 B27 B2 21 N 29 N2 N2 S T 2 29 S T2 S 19 DC N V2 N V2 D C1 D C19 Table 7.1 pirin in ast D elivery 1 N S DC 1 Chapter 7 25 .

Treasury Bond Futures Conversion Factor
Ta le 7 Conversion Factors or Treasury-Bond Futures or eptem er and Decem er 2

Coupon

Maturity Date 2 2 2 2 26 27 2 2 27

ep2 7 7

Dec6 2 7

2 2 6 6 6 6 6 6 6 6 6 67 7 7 7 7 7 77 2 2 2 2 2 2

27 2 6 6 6 76 2 2 6 2 7 77 2 2 22 6 222 2 7 27 277

277 22 6 6 2 7 2 22 72 7 7 2 2 22 6 2 272 27

26 27 26 2 2 22 2 22 2 2 2 2 2

2

2

2 2 2

ource Chica o Board o Trade we site www c ot com

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Treasury Note Futures
Treasury note futures are a shorter maturity version of a Treasury bond. ‡ T-note Futures are very similar to Treasury bond futures. ‡ T-note futures contracts are available for 2-year, 5-year, and 10-year maturities. Contract Size 2-year contract 5-year $200,000

10 year contract $100,000

Deliverable Maturities 2-year contract 5-year contract 10-year contract 21 -24 month 4 yrs 3 mos. to 5 yrs 3 mos. 6 yrs 6 mos. to 10 years

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CBOT¶s 10-Year Treasury Note Futures Product Profile

s Product Profile: The BOT= 10 Year Treasury Note Futures
Contract Size: One U.S. Treasury Note with face value at maturity of $100,000 Deliverable Grades: U.S. Treasury notes maturing at least 6.5 years, but not more than 10 years, from the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor plus accrued interest. The conversion factor is the price of the delivered note ($1 par value) to yield 6 percent. Tick Size: One half of 1/32 of a point ($15.625/contract) rounded up to the nearest cent; par is on the basis of 100 points. Price Quote: Points ($1,000) and one half of 1/32 of a point; i.e., 84-16 equals 84 16/32, 84165 equals 84 16.5/32

Contract Months: March, June, September, and December Expiration and final Settlement: The last trading day is the seventh business day preceding the last business day of the delivery month. The contract is settled with physical delivery. The l li i l i li Trading Hours: Open Auction: 7:20 am - 2:00 pm, Central Time, Monday - FridayElectronic: 7:00 pm - 4:00 pm, Central Time, Sunday - FridayTrading in expiring contracts closes at noon, Chicago time, on the last trading day. Daily Price Limit: None.

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m. change or delete orders and quotes in preparation for trading.m. The invoice price equals the futures settlement price times a conversion factor plus accrued interest. and 7:00 p. and 8:00 p. Expiration and final Settlement: The last trading day is two trading days prior to the delivery day of the contract month.m. Price Quote: In a percentage of par value. The main trading period is between 8:00 a. the immediately following exchange trading day. and December delivery cycle. The delivery day is the 10th calendar day of the contract month. . This period is between 7:30 and 8:00 a. otherwise. June. carried out two decimal places. if this day is an exchange trading day.Non-US Long Maturity Interest Rate Futures Product Profile: Eurex= Euro Bund Futures s Contract Size: One German bund with a par value of 100.m. representing 10 euros. Trading Hours: Eurex operates in three trading phases. Trading ends with the post-trading period between 7:00 p. Daily Price Limit: None Chapter 7 29 . Deliverable Grades: A long-term debt instrument issued by the German Federal Government with a term of 82 to 102 years and an interest rate of 6 percent.m.01 percent. Contract Months: The three successive months within the March. In the pre-trading period users may make inquiries or enter. September. Tick Size: 0.000 euros.

including: 1. interest rate futures trade in a full carry market. Features that Promote Full Carry 4. Cost-of-Carry Rule 6 3. Cost-of-Carry Rule 3 2. the foundation for pricing interest rate futures is the Costof-Carry-Model that we discussed in Chapter 3. This section introduces a review of the Cost-of-Carry Model as discussed in Chapter 3. Repo Rates 5. Cash-and-Carry Arbitrage for Interest Rate Futures Chapter 7 30 . Cost-of-Carry Model in Perfect Market 6.Pricing Interest Rate Futures Contracts Because.

t ! S 0(1  Where: S0 = F0.t = C0.t= The current spot price 0.Cost-of-Carry Rule 3 Recall: the cost-of-carry rule #3 says: F 0. t ) The current futures price for delivery of the product at time t The percentage cost required to store (or carry) the commodity from today until time t Chapter 7 31 .

Cost-of-Carry Rule 6 Recall: the cost-of-carry rule #6 says: 0.d = F .d=   the futures price at t=0 for the the distant delivery contract maturing at t=d the futures price at t=0 for the nearby delivery contract maturing at t=n the percentage cost of carrying the good from t=n to t=d Chapter 7 32 .n= Cn. d ! 0. n (1  Cn . d ) F0.

Ease of Short Selling 2. Chapter 7 33 .Full Carry Features Recall from Chapter 3 that there are five features that promote full carry: 1. High Storability Interest rates futures have each of these features and thus conform well to the Cost-of-Carry Model. Non-Seasonal Production 4. Large Supply 3. Non-Seasonal Consumption 5.

we must take into account some of the peculiar aspects of debt instruments. t ! 1 S0 0. we can compute the implied repo rate as: 0. t Interest rate futures conform almost perfectly to the Costof-Carry Model.Repo Rate Recall from Chapter 3 that if we assume that the only carrying cost is the financing cost. t S0 or  1 ! C 0. t F 0. Chapter 7 34 . However.

4. Ignore the differences between forward and futures prices. Markets are perfect. 2. Ignore the options that the seller may possess such as the option to deliver differing securities. The financing cost is the only cost of carrying charge.Cost-of-Carry Model in Perfect Market Assumptions 1. 3. Chapter 7 35 .

Cash-and-Carry Arbitrage for Interest Rate Futures Recall from Chapter 3 that in order to earn an arbitrage profit. Then you would deliver the commodity against the futures contract. buying the commodity and storing it until the futures delivery date. The interest rate instrument must have this maturity on the delivery date. Chapter 7 36 . Each of the interest rate futures contracts specifies the maturity of the interest rate instrument to be delivered. Applying the cash-and-carry arbitrage to interest rate futures requires careful selection of the commodity¶s interest rate (T-bill. T-bond etc) that will be purchased. a trader might want to try a cash-and-carry arbitrage. Recall further that a cash-and-carry arbitrage involves selling a futures contract.

Cash-and-Carry Arbitrage for Interest Rate Futures Example. Sell futures Contract.2 and 7. That is. Buy T-bill Futures contract w/ 167 days to maturity. Deliver T-bill (that has now 90 days to maturity) against futures contract. 0 77 167 1. we must purchase a T-bill that will have 90 days to maturity. 2. in order to meet your obligations.3 further develop this example. Chapter 7 37 . a T-bill futures contract requires the delivery of a T-bill with 90 days to maturity on the delivery date. So. if you sell a T-bill futures contract that calls for delivery in 77 days. 77 days from today. 4. 3. T-bill matures Table 7. you must purchase a T-bill that has 167 days to maturity today.

000 Face Value) $968.000. Suppose that you have gathered the information in Table 7.611 987.2 Interest Rate Futures and Arbitrage Today's Date: January 5 Discount Yield Futures MAR Contract (Matures in 77 days on March 22) Cash Bills: 167Bday TBbill (Deliverable on MAR futures) 77Bday TBbill 12.2 calculated? Chapter 7 38 .167 from Table 7.2 and wish to determine if an arbitrage opportunity is present.750 953.00 6.00 Price ($1.167 How was the bill price of $987.50% 10.Cash-and-Carry Arbitrage for Interest Rate Futures Assume that markets are perfect including the assumption of borrowing and lending at a risk-less rate represented by the T-bill yields. Table 7.

000.000  Bill Price ! 968.611 0.000.Cash-and-Carry Arbitrage for Interest Rate Futures The bill prices were calculated as follows: Bill Price ! Face Value  DY ( Face Value)( DTM ) 360 For the March Futures Contract ill rice ! 1.000  Bill Price ! 987 .000.000)(167) 360 For the 77-day T-bill with $1.125(1.000.166 Chapter 7 39 0.000.000)(90) 360 For the March 167-day T-bill Bill Price ! 1.000)(77) 360 .000  Bill Price ! 953.06(1.10(1.000 face value Bill Price ! 1.750 0.000.000.

3 calculated? Chapter 7 40 .50% for $968. Profit: $968. Table 7.750 B 966.611.3 CashBandBCarry Arbitrage Transactions January 5 Borrow $953.750.Cash-and-Carry Arbitrage for Interest Rate Futures The transactions necessary to earn an arbitrage profit are given in Table 7. Buy 167Bday TBbill yielding 10% for $953.742 How was the $966.3.750.611 for 77 days by issuing a 77Bday TBbill at 6%. March 22 Deliver the originally purchased TBbill against the MAR futures contract and collect $968. Repay debt on 77Bday TBbill that matures today for $966.008 from Table 7.008.008 $ 2. Sell MAR TBbill futures contract with a yield of 12.

To calculate this value. rearrange the bill price formula: DY ( Face Value)( DTM ) 360 Bill Price ! Face Value  Rearranging the equation results: Face Value ! 360 Bill Price 360  DY ( DTM ) 360($953.611.Cash-and-Carry Arbitrage for Interest Rate Futures The $966.06(77) 343.611) 360  0.008 is the face value of a 77-day T-bill with a current price of $953.299.008 .38 Face Value ! Face Value ! ace Value ! 966.10 Chapter 7 41 .960 355.

7 2 Combined. Buy 167-day T-bill 3.7 0 6 5 (th t n wh s9 d ysto a o a 0a mtu a a st th a rity) g in e fu re co tra tu s n ct R p yd b o 7 a e a e t n 7-d y 96 0 6 . Sell a futures contract 4. these transactions appear as follows on a timeline: 0 1 1.0 T ill th t mtu sto a -B a a re d y 24 . you deliver the T-bill (which now has 90 days to maturity) against the futures contract. Deliver the T-bill against the futures contract 5.Cash-and-Carry Arbitrage to Interest Rate Futures When delivery is due on the futures contract on March 22. Pay off the loan Chapter 7 42 . Borrow money 2. Time Mar 22 Mar 22 Profit/contract Transaction Cash Flow D live 1 7-d yT ill e r 6 a -b 9 .

Pay $998.50% for $968. now assume that the rate on the 77-day T-bill is 8%. June Collect $1.000 B 998.000. Pay $968.174 by issuing a 167 Bday TBbill at 10%. March 22 Collect $968.507 Chapter 7 43 . Profit: $1.493 $ 1.4 follow the steps shown for the previous cash-and-carry example.493 debt on the maturing 167 Bday TBbill.Reverse Cash-and-Carry Arbitrage to Interest Rate Futures Using the same values as shown in Table 7.4 Reverse Cash Band BCarry Arbitrage Transactions January 5 Borrow $952. Buy a 77Bday TBbill yielding 8% for $952. Table 7. Given this new information and Table 7.000. To calculate the values in Table 7.174 that will pay $968.750 from the maturing 77Bday TBbill. Buy one MAR futures contract with a yield of 12.750. Table 7. a reverse cash-and-carry arbitrage opportunity is present.2 prices.750 on March 22.2.000 from the maturing 90Bday TBbill that was delivered on the futures contract.4 shows the result.750 and take delivery of a 90 Bday TBbill from the MAR futures contract.

Pay off loan Chapter 7 44 . Borrow money 2. Collect 1 M from mature T-bill 7. these transactions appear as follows on a timeline: Jan 5 Mar 22 Jun 20 1. Buy a futures contract 4. Collect from maturing T-bill 5. Buy 77-day T-bill 3.Reverse Cash-and-Carry Arbitrage to Interest Rate Futures Combined. Accept delivery on 90-day contract 6.

These investment appear as follows on a timeline. Buy a futures contract for delivery of a 90 day T-bill in 77 days. Chapter 7 45 . Use the futures contract to buy a 90-day T-bill.Interest Rate Futures Rate Relationships Rate relationship that must exist between interest rates to avoid arbitrage: Consider two methods of holding a T-bill for 167 days. Method 1: Buy a 167 day T-bill Method 2: Buy a 77 day T-bill.

Buy a future contract for 90-day T-bill w/ 77 days to maturity 3. Collect from maturing T-bill Either of these two methods of investing in T-bills has exactly the same investment and exactly the same risk. Chapter 7 46 . Buy a 90-day T-bill using the futures contract 5. they must have exactly the same yield to avoid arbitrage. Buy 167-day T-bill 2.Interest Rate Futures Rate Relationships Method 1 Jan 5 Mar 22 Jun 20 1. Buy 77-day T-bill 2. Collect from maturing T-bill Method 2 Jan 5 Mar 22 Jun 20 1. Since both investment have exactly the same risk and exactly the same investment. Collect from maturing T-bill 4.

5% Price 750 0% 53.611 ??% $??? Use the no arbitrage equation to determine the appropriate yield on the 77-day T-bill by. using the following equation: Price of utures Contract  Long Term T  Bill Price DTMF Price of utures Contract X 360 N Yield ! Where: NA Yield = the no arbitrage Yield DTMFC = days to maturity of the futures contract Chapter 7 47 .Financing Cost and Implied Repo Rate Calculate the rate that must exist on the 77-day T-bill to avoid the arbitrage as follows: Event MAR Contract (Matures on March 22 or 77 days) Cash T-bill 167-day T-bill (deliverable on MAR futures) 77-Day T-bill Discount Yield 2.

07306 So in order for there to be no arbitrage opportunities available.86 NA Yield ! 0. engage in a cash-and-carry arbitrage. If the yield on the 77 day T-bill is greater than 7. the yield on the 77 day T-bill must be 7.750  953. If the yield on the 77 day T-bill is less than 7.3063%. then engage in a reverse cash-and-carry arbitrage.204.611 77 $968.139 $207.Financing Cost and Implied Repo Rate NA Yield ! $968.750 X 360 Yield ! $15.3063%.3063%. Chapter 7 48 .

assuming this is the only financing cost. Chapter 7 49 . it is also the cost of carry.5875% The implied repo rate is the cost of holding the commodity for 77 days.611 1  C 0. t ! 1.750 ! 1 $953. t S0 ! 1 C 0.015875 0. t In our case the spot price is the price of the 167-day to maturity T-bill. between today and the time that the futures contract matures. t The implied repo rate (C) is 1. so: $968.Financing Cost and Implied Repo Rate We can also calculate the implied repo rate as follows: 0.

then exploit a reverse cash-and-carry arbitrage. then exploit a cash-and-carry arbitrage opportunity Borrow funds Buy cash bond Sell futures Realize profit Deliver against futures Hold bond 2. If the implied repo rate exceeds the financing cost. Buy futures Sell bond short Invest proceeds until futures exp.Financing Cost and Implied Repo Rate 1. If the implied repo rate is less than the financing cost. Realize profit Repay short sale obligation Take delivery Chapter 7 50 .

Cost-of-Carry Model for T-Bond Futures The cost of carry concepts for T-bill futures that we have just examined also apply to T-bond futures. the computation must be adjusted to reflect the coupon payment and accrued interests. However. Chapter 7 51 .

Recall that allowing the borrowing and lending rates to differ leads to an arbitrage band around the futures price. and the Cost-of-Carry Model is explored under the following assumption: 1. or one-fourth of a percentage point. Now assume that the borrowing rate is 25 basis points.Cost-of-Carry Model in Imperfect Markets In this section. Chapter 7 52 . Ignore the differences between forward and futures prices. The financing cost is the only carrying charge. 3. 2. The borrowing rate exceeds the lending rate. the borrowing and lending assumptions are relaxed. 4. higher than the lending rate. Continuing to use our T-bill example. Ignore the options that the seller may possess.

Cash-and-Carry Strategy Instrument 7 -d y 7a 7a -d y Lending Rate 73 3 Borrowing Rate 75 53 5 Table 7.6 CashBandBCarry Transactions with Unequal Borrowing and Lending Rates January 5 Borrow $953. Sell one TBbill futures contract with a yield of 12.5563. March 22 Deliver the originally purchased TBbill against the MAR futures contract and collect $969. Profit: -$2  0 Notice that the entire arbitrage profit disappears when these differential borrowing and lending rates are considered.275. Chapter 7 53 .277. Buy 167Bday TBbill yielding 10% for $953.611 for 77 days at the 77Bday borrowing rate of 7.29% for $969.611.275. Repay debt on 77Bday TBbill that matures today for $969.

000.97% for $967. June 20 Collect $1.454.575 from the maturing 77-day T-bill.454 at the 167-day borrowing rate of 10. Pay $1.575 and take delivery of a 90-day T-bill on the futures contract.7 Reverse ashBandB arry Transactions with Unequal Borrowing and Lending Rates January 5 Borrow $952. Buy 1 MAR futures contract with a futures yield of 12.575. Buy a 77-day T-bill yielding 7.000 from the maturing 90-day T-bill that was delivered on the futures contract.003 debt on the maturing 167-day T-bill.000.Reserve Cash-and-Carry Transaction Table 7.3063% for $952. Profit: -$3  0 Again notice that the entire arbitrage profit disappears when these different borrowing and lending rates are considered. Pay $967.25%. March 22 Collect $967. Chapter 7 54 .

A Practical Survey of Interest Rate Futures Pricing Recall from Chapter 3 that transaction costs lead to a noarbitrage band of possible futures prices. ± Treasury securities are so widely held. Chapter 7 55 . From a practical perspective. many traders can simulate short selling by selling T-bills. Therefore. In essence. or Tbonds from inventory. Impediments to short selling as a market imperfection would frustrate the reverse cash-and-carry arbitrage strategy. restrictions on short selling are unlikely to have any pricing effect. T-notes. transaction costs increase the no-arbitrage band just as unequal borrowing and lending rates do. restrictions on short selling are unimportant in interest rate futures pricing because: ± Supplies of deliverable Treasury securities are plentiful and government securities have little (or zero) convenience yield.

Speculating with Interest Rate Futures There are several ways that you can speculate with interest rate futures: 1. Intra-Commodity T-Bill Spread 3. Outright Position. Notes over Bonds (NOB) Chapter 7 56 . 2. A T-bill/Eurodollar (TED) Spread 4.

Purchase an interest rate futures contract: a bet that interest rates will go down. The transactions necessary to bet on your hunch are outlined in Table 7.8 Speculating with Eurodollar Futures Date September 20 September 25 Futures arket Sell 1 DEC 90 Eurodollar futures at 90. Suppose you think that interest rates will go up.Speculating with Outright Position Two ways to speculate with outright positions are: 1. Sell an interest rate futures contract: a bet that interest rates will go up.30.30 B90. 2. Profit: 90. Buy 1 DEC 90 Eurodollar futures at 90.80. Table 7.18 Total Gain: 18 basis points * $25 = $450 Chapter 7 57 .12 = .12.

12) = 0.30 ± 90.18 0. each of which implies a $25 change in contract value so: Profit = (Basis Points)( alue per Basis Point) Profit = (18)($25) = $450 Chapter 7 58 . Your profit (based on $25 per basis point contract) is: Profit = (Sell Rate ± Buy Rate)($25) Profit = (90.Speculating with Outright Position Interest rates have gone up as you predicted.18 is 18 basis points.

Chapter 7 59 .Intra-Commodity T-Bill Spread If you don¶t know if rates will rise or fall. you would buy the shorter term contract and sell the longer term contract. (that is the relationship between short term interest rates and long term interest rates will change) you might engage in an Intra-commodity T-bill spread. If you think that the spread will narrow (the yield curve will become flatter) you would buy the longer term contract and sell the shorter term contract. but do think that the shape of the yield curve will change. If you think that the spread will widen (the yield curve will become steeper).

Table 7.50 88.50 Chapter 7 60 .50 86.00 87.00% 10.85 11.50 13.17 11.9 Spot and Futures Eurodollar Rates for March 20 Time to Maturity or Futures Expiration 3 months 6 9 12 Add-on Yield 10. and the right 3 columns are futures contracts.00% 12. You think that the yield curve will flatten and wish to trade to make a profit.47 Futures Contract JUN SEP DEC Futures IMM InYield dex 12.Intra-Commodity T-Bill Spread Suppose you have the following information (Table 7.9) regarding T-bills and T-bill futures contracts for March 20. The left 2 columns are T-bills.

as it is demonstrated in Table 7.Intra-Commodity T-Bill Spread Notice that the T-bills exhibit an upward sloping yield curve. If the yield curve flattens. Notice that the futures contract yields also exhibit and upward sloping yield curve. Since you think that the spread will narrow (the yield curve will become flatter) you would buy the longer term contract and sell the shorter term contract. Chapter 7 61 . That is.10. the difference between the yield on the December contract and on the September contract must narrow. the yield spread between subsequent maturing futures contracts must narrow.

Buy the SEP Eurodollar futures at 89.50.50 B89.64 Total Gain: 12 basis points * $25 $300 SEP 87.02 B 1.02.50. Sell the DE Eurodollar futures at 88.52 Futures Market Buy the DE Eurodollar futures at 86.14.10 Speculation on Eurodollar Futures Date March 20 April 30 Profits: DE 88. Gain in Basis Points Change in December Contract Change in September Contract Net Change in Positions Each Basis Point is worth $25 Profit Net Change in Positions Basis Point alue Profit Chapter 7 1.Intra-Commodity T-Bill Spread Table 7.50 1.52 12 basis points 12 $25 $300 62 .64 -1. Sell the SEP Eurodollar futures at 87.14 B86.

Table 7. To the extent that the world situation is considered safe. should pay a lower interest rate. the difference should be high. the difference should be low. Chapter 7 63 . government. In theory. To the extent that the world situation is unsafe. Eurodollars are riskier and should pay a higher rate of interest.S.T-Bill/Eurodollar (TED) Spread The TED spread is the spread between Treasury bill contracts and Eurodollar contracts. Eurodollar deposits are generally not backed by the respective governments.11 shows the transactions necessary to engage in a TED spread when you wish to bet that the spread will widen. How much lower/higher? The amount of the difference depends upon world events. Treasury bills should always have a lower yield than Eurodollar deposits. T-bills are a safer investment and as such. T-bills are backed by the full taxing authority of the U. Thus.

91 . uy one DEC T bill futures contract yielding 8. Eurodollar 90.18. Chapter 7 64 . allowing him/her to earn a $675 profit. Sell one DEC T bill futures contract yielding 8.91.11 October 14 Profits: Notice that the spread widened as the trader expected.07.T-Bill/Eurodollar (TED) Spread Table 7.38 Total Profit: 27 basis points * $25 = $675 T bill 91.07 91.29.18 .82% with an IMM Index value of 91.11 InterBCommodity Spread in ShortBTerm Rates Date February 17 Futures Market Sell one DEC Eurodollar futures contract with an IMM Index value of 90. uy one DEC Eurodollar futures contract with an IMM Index value of 89.93% with an IMM Index value of 91.29 89.

NOB spreads exploit the fact that T-bonds underlying the T-bond futures contract have a longer duration than the Tnotes underlying the T-note futures contract. the NOB spread is an attempt to take advantage of either changing levels of yields or a changing yield curve by using an inter-market spread. Thus. Chapter 7 65 .Notes over Bonds (NOB) The NOB is a speculative strategy for trading T-note futures against T-bond futures. A given change in yields will cause a greater price reaction for the T-bond futures contract.

Long Hedges 2.Hedging with Interest Rate Futures There are several ways that you can hedge with interest rate futures. Cross-Hedges Chapter 7 66 . Short Hedges 3. including: 1.

Chapter 7 67 . not to generate profits. This also implies that a hedger takes a futures position that will generate a loss to offset a potential gain in the cash market. Using interest rate futures to hedge involves taking a futures position that will generate a gain to offset a potential loss in the cash market.Hedging with Interest Rate Futures Recall that the goal of a hedger is to reduce risk.

on June 15. so forward rates are all 12% as well. exactly when the funds come available for investment as Table 7.000. Market Yield: 12% Expected face value of bills to purchase $1.000 A portfolio manager learns he will receive $970. a portfolio manager learns that he will have $970.12 shows: Table 7. Market yield: 10% $1.12 A Long Hedge with TBBill Futures Date December 15 Cash Market Futures Market The manager buys one TBbill futures contract to mature in six months. Loss = -$5.000 to invest in 90-day T-bills six months from now.000 in six months to invest in TBbills. Futures price: $970. The manager finds the 12% rate attractive and decides to lock it in by going long in a T-bill futures contract maturing on June 15.000 to invest.Long Hedges On December 15.000.000.000 Chapter 7 68 .000 Profit = $5.000 Net wealth change = 0 The manager sells one TBbill futures contract maturing immediately. June 15 Manager receives $970. Current yields on T-bills stand at 12% and the yield curve is flat.000.000 face value of TBbills now costs $975. Futures yield: 10% Futures price: $975.

Long Hedges With current and forward yields on T-bills at 12 percent. if the manager were to purchase the T-bill in the market.000 face -value of T-bills for $970.000. Thus.000.000.12($1.000 short.000. the 90-day T-bill yield has fallen to 10%.000)(90) 360 Bill Price ! $975. the price of a 90 day T-bill is: DY ( Face Value )( DTM ) 360 Bill Price ! Face Value  Bill Price ! $1.000.000)(90) 360 On June 15.10($1. Chapter 7 69 .000 0.000  Bill Price ! $970.000  0. the portfolio manager expects to be able to buy $1.000 Thus.000 because: Bill Price ! Face Value  DY ( Face Value )( DTM ) 360 ill rice ! $1. he would be $5.

Insert Figure 7. plus the $5.000 futures profit.Long Hedges The futures profit exactly offsets the cash market loss for a zero change in wealth.000 face value in 90-day T-bills. With the receipt of the $970. and the portfolio manager purchases $1.7 here The idealized yield Curve Shit for the long Hedge.000 that was to be invested. Chapter 7 70 .000. the original plan may be executed.

Offset one SEP Eurodollar futures contract at 95.13 demonstrates how a bank that makes a one million dollar fixed rate loan for 9 months. Three-month LIBOR is now at 4.500. Table 7.500 = 100 basis points x $25 per basis point x 1 contract. This produces a profit of $2.5 reflecting a 3. The bank= cost of funds are one percent above s its expected cost of funds of 3. Total Additional Cost of Funds: $2. Futures Profit: $2..5 percent.e. 90/360 x .500 September Net Interest Expense After Hedge: 0 Because the bank hedged.5 percent futures yield.Short Hedge Banks may wish to hedge their interest rate positions to lock in profits. and can only finance the loan with 6-month CDs.500 Futures Market Establish a short position in SEP Eurodollar futures at 96. The additional cost equals $2.5 percent.13 Hedging a Bank= Cost of Funds Using Interest Rate Futures s Date March Cash Market Bank makes nine-month fixed rate loan financed by a six-month CD at 3. can hedged its position. its profits were not affected by a change in interest rates.0 percent and rolled over for three months at an expected rate of 3.5 percent. Table 7. Chapter 7 71 .5 reflecting a 4.01 x $1 million.5 percent futures yield. i..

Coupon 3. Chapter 7 72 . Or the time span covered by the instrument being hedged and the instrument deliverable against the futures contract.14 illustrate the cross-hedge. assume that a large furniture manufacturer has decided to issue one billion 90-day commercial paper in 3 months. Risk level 2.Cross-Hedge Recall that a cross-hedge occurs when the hedged and hedging instruments differ with respect to: 1. Table 7. Maturity 4. To illustrate how a cross-hedge is conducted.

The futures price is still $960. Chapter 7 73 .000. which should net the firm $957. plans to sell 90Bday commercial paper in 3 months in the amount of $1 billion. the sale of the $1 billion of commercial paper nets $955.000 TBbill futures contracts to mature in 3 months with a futures yield of 16%.000. so the TBbill futures rate spot rate 16%. Consequently. The TBbill futures contract is about to mature. the usual 2% above the spot TBbill rate.500. at an expected yield of 17%. The spot commercial paper rate is now 18%.000 per contract. Gain/loss 0 Time 3 mos. sells 1. and a total futures price of $960.500.000. a futures price per contract of $960.14 A CrossBHedge Between T-bill Futures and Commercial Paper Date Time 0 Cash Market The Financial V. so there is no gain or loss.P.Cross-Hedge Table 7.000.P. not the expected $957.000.000. Opportunity loss ? Net wealth change ? Futures Market The V.000.

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