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Interest Rate Futures

Interest Rate Futures. Professor Brooks BA 444 02/14/08. Rate. Price. The Underlying Asset. Bonds or Interest Bearing Accounts These can be real or fictitious bonds They are interest rate sensitive As interest rates change the value of the underlying changes

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Interest Rate Futures

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  1. Interest Rate Futures Professor Brooks BA 444 02/14/08

  2. Rate Price The Underlying Asset • Bonds or Interest Bearing Accounts • These can be real or fictitious bonds • They are interest rate sensitive • As interest rates change the value of the underlying changes • Therefore can be used to hedge interest rates

  3. Interest Rate Futures • Domestic Set of Underlyings • U.S. Treasury Bills, Notes, and Bonds • For Delivery • T-Bill, 91-Day • Notes, 2 and 5 years • Bonds, 10 and 30 years • Around the World • Eurodollars (most popular) – U.S. dollars in a foreign bank • Euroyen, Euroswiss, Euibor, etc.

  4. T-Bill as the Underlying Asset • T-Bills -- sold with maturities of 4 weeks, 13 weeks and 26 weeks • Pure Discount Bill • Pay “market price” today and it grows to maturity or face value with no interest payments • Quoted on a Bank Discount Basis

  5. Auctions for T-Bills • All buyers get the same price • Bids are in yields… • Use yield to find price, • Example, discount yield is 1.5% on • 13 week T-bill, Price of T-bill: $9,962.08

  6. True Yield on the T-Bill • Correcting for 360 days a year (should be 365) • Correcting for using maturity as investment price (should be the purchase price) • Bond Equivalent Yield • BEY = (Par – Price)/(Price) x 365/(Days to Maturity) • Example: BEY = ($10,000 - $9962.08) / $9,962.08 x 365/91 • BEY = 0.0152662 or 1.5266% • This is simple interest • Correcting for compound interest • True Yield = (Par Value / Price) (365 / Days to Maturity) - 1 • True Yield = ($10,000 / $9662.08)(365 /91) -1 = 0.0153539 • True Yield = 1.5354%

  7. T-Bill as Underlying Asset • At Delivery, you will deliver (take delivery) • T-Bill with 91 days to maturity (13-weeks) • Par Value of the T-Bill is $1,000,000 • Futures Price is the Bank Discount Yield • The anticipated 13-week T-Bill rate • Remember when you enter the Futures contract it has a delivery date for the T-Bill with 13 weeks t maturity • See Figure 11-1 on page 234

  8. T-Bill Futures Prices • On CME • Look at February ‘08 – Settle at (9)96920 • My best guess on CME prices is that the first nine is not displayed… • http://www.cme.com • What is the implied discount for the T-Bill for delivery? • 0.01218 or 1.218% discount • This annualized as BEY is 1.239%

  9. Eurodollars as Underlying • The interest rate on U.S. dollars deposited in a foreign bank (main activity in London) • Not a security • Nontransferable bank deposit • You are buying or selling a “savings account” • Three month savings account with $1,000,000 maturity (or other maturities) • Savings rate is LIBOR…an average of a survey of banks • Add-On yield – but again simple interest

  10. Futures Price of ED Underlying • Let’s assume quote for Futures is 2.00% or that at the maturity of the Futures contract you will get savings account that in three months will mature at $1,000,000 with a current price that implies a 2% interest rate.

  11. Eurodollar Underlying • To find the Value of the savings account at deposit… • Price is present value of the Par Value • At the periodic discount rate • Convert the annual yield to periodic rate and find price of underlying “savings account”

  12. Eurodollar Underlying • Add-on Yield is quoted as 0.0124 or 1.24% • Convert to periodic yield • 0.0124 x 91/360 (three month savings) • 0.00313444444 • Find price with periodic rate • Price = $1,000,000 / 1.003134444 • Price = $996,875.35 • On a calculator • N=1, I/Y = 0.313444, FV = 1,000,000, PMT = 0 • Compute PV = $996,875.35

  13. Speculating in T-Bills or Eurodollar • Belief – Interest Rates will rise… • You are betting that the T-Bill or ED will fall in price • You sell the T-Bill or ED futures contract • Proof with ED… • Sell Futures ED – June ’08 with current discount at 3% (implied price of delivery $992,473.75) • Wait five months… • Discount rate rises to 3.5% • Cost to deliver at 3.5% is $991,230.35 • Profit $1,243.38

  14. Hedging with T-Bill Or Eurodollar • You need an inventory position that is interest rate sensitive for the period you would have a futures position… • Assume you just won the lottery and will get $1,000,000 in six months • Afraid interest rates will fall before you can invest $ • Falling interest rates hurt you (rising T-Bill prices are more expensive) • You will buy a futures contract to hedge “short” lottery position

  15. Longer Term Interest Rates • The underlying asset for longer interest rates are Treasury Notes (2 to 10 years) and Treasury Bonds (up to 20 years now) • Pricing of the underlying asset

  16. What is Yield to Maturity (YTM) • YTM is the weighted average discount rate over the life of the note or bond… • Based on the concept of stripping a bond • Each future cash flow is discounted back to the present at the discount rate for that “period” • Present Value of all future cash flow is added up to find price • Known price is used to find the YTM

  17. Problems with T-Notes and T-Bonds • The coupon rate impacts the reaction of the price of the bond to changes in interest rates • The fictitious T-Notes or T-Bonds in the futures contracts have an implied coupon rate of 6%. • Example: • T-Note, 4% coupon rate 5 years to maturity • T-Note, 9% coupon rate 5 years to maturity • What happens when rates change?

  18. T-Notes Price Changes • Five-Year T-Note YTM is 6% • Coupon rate at 4% • N=10, I/Y = 6.0, FV = 1,000,000, PMT = 20,000 • Compute Price = $914,698 • Coupon rate at 9% • N=10, I/Y = 6.0, FV = 1,000,000, PMT = 45,000 • Compute Price = $1,127,953 • YTM goes down during to 4% • 4% Coupon price $1,000,000, change of $85,302 • 9% Coupon price $1,224,566, change of $96,613

  19. The Asymmetric Reaction Implies • The T-Notes and T-Bonds have different values when delivered • There is a conversion table to account for the difference in the coupon rates… • Same is true for different maturities… • The conversion table accounts for the difference in maturities… • See pages 241, 6% conversion factors

  20. Problem #2 with T-Notes and T-Bonds • Accrued interest… • Because coupon payments are paid every six months • Holders of the bond believe they are earning the coupon over the six month period • Selling before the coupon payment date means they lose their “accrued” interest • Price includes accrued interest • What does this mean at delivery?

  21. The Price at Delivery • Function of • The futures settlement price • Contract size • Correction Factor (from table or equation) • Accrued Interest • Price is • Settlement Price x Contract Size x Correction Factor + Accrued Interest • See page 244…example

  22. Delivery Procedures • First Position Day (2 business days before first businesses day of delivery month) • Long position reports by trade date • To Clearinghouse • Short position notifies “Intention” to deliver • Settlement in 3 business days • Clearinghouse matches oldest long position • Notice Day …both parties are revealed • Delivery day…transaction completed

  23. Delivery • Short Position will deliver Treasury Note or Bond…based on the original futures contract • Now, short position will deliver the cheapest bond • Invoice will be prepared (with correction factor and accrued interest) • Invoice will indicate the price the long position will pay… • Short delivers the bonds, Long pays $

  24. Flexibility in Delivery to Short • Because the short position “elects” to deliver the position has an options value • Quality Option • Can deliver any T-Bond that satisfies futures delivery conditions (picks cheapest to deliver • Timing Option • Can deliver anytime during the month • Wild Card Option • Prices are determined at 3 p.m. but decision to deliver can be made up to 9 p.m.

  25. Arbitrage and Spreads • Arbitrage with interest rate futures happens when repo rates and financing rates have too large a spread… • Repo is a repurchase agreement where you sell an asset one day with a contract to buy it back at a later date at a pre-set price • Difference in price is repo rate • Spreads • TED (T-Bill and Eurodollar) • NOB (Notes over Bonds • LED (LIBOR and Eurodollar)

  26. Interest Rate Futures • Reverse Logic for Short and Long Position if you are thinking in terms of interest rates • If you believe interest rates will rise – short • If you believe interest rates will fall – long • Portion of Interest Rate Futures are actually delivered • Adjustment to the underlying for bonds and notes based on conversion factor and accrued interest • Delivery during the month…not at expiration

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