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Interest Rate Futures

Interest Rate Futures. July 2011. Introduction. Interest rate Futures Short term interest rate futures (STIR) Long term interest rate futures (LTIR). World interest rate contracts. 2010 Break down of interest rate contract volume by product group. Source: FIA Magazine March/April 2011.

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Interest Rate Futures

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  1. Interest Rate Futures July 2011

  2. Introduction • Interest rate Futures • Short term interest rate futures (STIR) • Long term interest rate futures (LTIR)

  3. World interest rate contracts

  4. 2010 Break down of interest rate contract volume by product group

  5. Source: FIA Magazine March/April 2011

  6. Volume by geographical zone

  7. Principle value of 1 Mil with a three-month maturity • Quote : 100 - yield • yield = (discount/price)(360/day to maturity) • price = 1 mil – discount yield(%)*1 Mil*DTM • 360

  8. Short term interest rate futures • Eurodollar • Assume discount yield is 8.32 % with 90 days to maturity what is the price? • price = 1 mil – discount yield(%)*1 Mil*DTM 360 • Price = 1,000,000 - [(.0832*1,000,000*90 )/360] • = 979,200 • Quotation = 100-.0832 = 91.68

  9. Pricing futures • Cost of carry model in perfect market • market is perfect • financing cost is the only carrying charge • ignore the different between forward and futures prices • ignore the options the seller may possess

  10. Interest rate futures and arbitrage 10% Jan 5 167 days Mar 22 77 days 90 days 6% 12.5%

  11. Interest rate futures and arbitrage Jan 5 10% Mar 22 167 days 77 days 90 days 8% 12.5%

  12. Interest rate futures and arbitrage • For no arbitrage to happen: • Holding 167 days t-bill(10%) must give equal yield to hold 77 days t-bill followed by 90days t-bill (12.5%) from futures delivery • Only yield that prevent arbitrage is • 953611 = 968750-(96850*(x)*(77/360)) • 953611/968750 = 1-(.213889x) • X = .73063

  13. Financing cost and implied repo rate 1+C = 968,750/953611 = 1.015875

  14. Interest rate futures and arbitrage Unequal borrowing and lending rate

  15. Interest rate futures and arbitrage Unequal borrowing and lending rate

  16. The futures yield and forward rate of interest 1.048646 953,611 1,000,000 10% • 1.048646 = x * 1.015875 • X = 1.032259 ; forward rate =3.2559% 167 days 77 days 90 days 953,611 7.3063% 968,750 12.5% 1.015875

  17. Longer maturity interest rate futures • Treasury bond Futures • Treasury Note futures

  18. US Treasury Note & Bond Futures

  19. US Treasury Note Futures

  20. Delivery of Bond futures • Majority of position will be liquidated or rolled forward and only tiny amount resulted in delivery

  21. Deliverable grade • Deliverable grade is defined in contract specification and is varied by contract. • Several bonds could be delivered against the contract. Seller will choose the cheapest to deliver bond to deliver. • Conversion factors will adjust for the differences in coupons and maturity among the deliverable bonds. (approximate from assume face value of bond is 1$ and discounted the CF from bond at 6% using bond pricing equation) • When delivery , invoice piece will equal converted futures price + accrued interest • converted futures price = contract scale factor (1000)* settlement price *conversion factors

  22. Invoice price If accrued interest is 519.71

  23. Delivery process

  24. Conversion factor

  25. The cost of carry model for T-bond futures Cash and carry arbitrage for a T-bond • T-bond that is deliverable on a futures contract has an 8% coupon and cost 100$. • Financing rate 7.3063% on a discount basis for 77 days until futures contract is deliverable. Assume perfect market no seller options

  26. Speculating with interest rate futures • Outright position • Long trader: betting interest rate will fall and futures prices will rise • Short trader: betting interest rate will rise and futures prices will fall Example : Trader Expect short term interest rate will rise.

  27. Speculating with interest rate futures • Spread position • Intra-commodity : speculate on the term structures of interest • Example : Trader expects that the current very steep upward sloping yield curve would flatten within six month. (not sure whether rates were going to rise or fall. .

  28. Speculating with interest rate futures • Spread position • Inter-commodity : speculate on shifting risk level between instrument • Example : International debt crisis, bank involved in international lending has more risk. May expect to find a widening of yield spread between T-bill and Eurodollar deposit. .

  29. Hedging with interest rate futures Long hedge

  30. Hedging with interest rate futures Short hedge

  31. Hedging with interest rate futures Cross hedge

  32. Thank you

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