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CFA Institute

The Uses of Treasury Bond Futures in Fixed-Income Portfolio Management Author(s): Francis H. Trainer, Jr. Source: Financial Analysts Journal, Vol. 39, No. 1 (Jan. - Feb., 1983), pp. 27-34 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4478612 . Accessed: 17/12/2013 10:09
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however..e.. adding a long futures position to a long-termbond portfoliowill increase the portfolio's interest rate sensitivity and. given the properratiobetween the futures contractssold and the par value of the underlyingbonds.55. changes in the marketvalue of the bonds will be offset by margincallson or creditsto the futurescontract.000 Treasurybond contracts representing over$11billionmarket valueof bonds. can increaseportfoliorisk and expected return. The purchase of financialfutures. Thisreturn may be augmentedor reduced.however.1 years. reinvesting in money market instruments-when making his decision. by definition. He thanksDavidA. HE INTRODUCTION of financialfutures adds to the bond manager'stools a powerful instrument thatcanbe used to increase or decreasethe risk of a fixed-incomeportfolio.Jr. a managerwho wishes to reduce the interestrate risk of his portfolio may choose to sell futurescontracts.176.Hedging with the futures offers majoradvantagesin terms of reduced transactionscosts and enhancedliquidity.In general. In essence.declines sharplyas the level of interestrates rises. 17 Dec 2013 10:09:42 AM All use subject to JSTOR Terms and Conditions . Levine and JonathanReiss for their assistance. Bernstein& Co. Emil Filiume In Fixel-Incume Purilulim MU. on the other hand.forexample.The ChicagoBoardof Trade(CBT) trades approximately170.Butthe managershould also considerthe potentialreturnfrom his "synthetic security"-his short futures-longbond position-in comparisonwith the return available from the alternative-i. Trainer. the hedger will end up paying something in exchange for the reduction of his portfolio'srisk.96 on Tue.For instance. Inc. daily tradingvolume exceeds $3 billion.The inventoryhedging activityof the brokeragecommunity and the interest shown by portfolio managershave rapidlyswelled the bond futures T market.naiemenl Financial futurescontractsmay be used eitherto enhance or reduce the risk of a bond portfolio. This may present problemsif the investment horizon is a fairly fromstandard long one. Frank Traineris Manager of Fixed-IncomeInvestmentsat SanfordC.by changesin the relative pricingof the futures and cash markets. Futuresmay be especiallyuseful in the managementof an immunized portfolio. Immunizationrequires matching a bond portfolio's duration (a measure of its interestrate sensitivity)to the time remainingto the end of a chosen investment horizon. 27 FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1983 U This content downloaded from 86. The hUme ml Treauir.Because the purchaseof a futurescontractis equivalentto buyingbonds on leverage. its duration. since the maximumdurationavailable couponbonds is limited and. Thusinterestrateriskforthe period between the sale of the contractand the deliveryis eliminated. furthermore. at a 14 per cent interestrate.by FrancisH.the returnto the syntheticsecuritywill roughlyapproximate the interestincomefromthe bond.the duration of a 40-year bond at paris only 7. ratherthan sellingout his position.

in return.000initialmarginrequirement. Second.theirrelationship explains article to the actualbond market. June. bond futures contractsallow for the immediatereductionof interestrate risk. It is thereforereasonableto assume that expectedreturnwill also be reduced. whereas institutional money are generallymore managersand broker-dealers of the futures potential with the hedgin.hedging can be used to earna higherrate on money marketinof returnthan that available struments.the puris equivalentto chase of one bond futurescontract worth of long governments on buying $65.A sale of one bond futurescontract equivalentto shortselling$65. If.000-an amount that may be withdrawn. effectively a securitywith no marketriskpossesses the essential characteristics of a short-termsecurity. The primary is the complexityof the instrument.000loss-the same resultthat would occurif $65.This and discouraged managers how futureswork.so transactions be easilyhandledin one day withoutaffectingthe to liqmarket.000 roughly 97 per cent margin.55. the shortfuturesposition acts to reduce risk. it represents $65. At today's market costs totala very low transaction prices. Becausefuturesaccountsare markedto marketon loss wouldresult a dailybasis. Uses of the Contract eitherto speculateon Futuresareused primarily of interestratesor to hedge portfolios the direction againstinterestratechange.000of long governfallsone mentson 97 percentmargin.Despite the growth of the marketfor financial futures and their potential usefulness to bond portfoliossuch as pension managers. Assumor calldate (if callable) ing a $2. the extentof this reduction To determine we have to calculatethe returnon the portionof security. or 11/2per cent.Having hedged the position with futures. reductionor enhancementon portfolioreturns.He caninsteaduse futuresto eliminate the risk of his portfolio.If the nearbybond futureis tradingat $65. Assuming a futurespriceof $65.176. fall in the market.. Futuresaffordthe investor a very efficientvehicle for accomplishing these objectivesbecausethe bid-askedspreadper contractplus the round-tripcommissionsare approximately2/32 of a point.Thefuturesposition offsetsthe marketriskof the long bond. on the synthetic Evaluatingthe Synthetic Security To calculatethe yield on a syntheticsecurity.it is necessaryto understandthe deliverymechanism of the futures exchange.institutional plans and endowment funds have been reluctant reasonfor this neglect to acceptthem.Of course. A manager who wishes to liquidatehis bond portfoliobut expects to reestablishthe position within a short transperiodof timecan expectto incursubstantial actioncosts.round-trip 1/10 of 1 per cent.The combinationof a long-termbond and a shortfuturespositionrepresentsa synthetic short-term securitywhen the bond that is held is deliverable againstthe future. Since the par value representedby one contractis 100 bonds. from$65to $64. the transactioncosts would be substantial.000.the accountis creditedwith $1. hedging with futures allows for temporaryreductionof interestrate risk. Therearethreecircumstances manager might hedge his portfolio with bond futures ratherthan liquidate. temporarily Third.the above-mentioned in a margincall of $1.000 of at least 15 years.g concerned A portfolio canvirtually eliminate manager contract.000marketvalue in long-term govemment bonds fell in price by 11/2 per cent. One thousand contractsrepresent only slightlymore than 2 per cent of the daily trading of this size can volumeon the CBT. one attempted uidate a $65 millionportfolioin a single day.A full underand theirrelationship standingof futurescontracts to the cash market has simply eluded portfolio the use of futures. in the speculative Individuals areofteninterested uses of futures.resultsin a $1. First. a one point.If the market point. Septemberand December.000bond conthe interestrateriskof a porttractswill neutralize valueof $65 folioof long-term bonds with a market million. 17 Dec 2013 10:09:42 AM All use subject to JSTOR Terms and Conditions .000in marketvalue of 8 per cent government and a maturity bonds with a parvalue of $100. The Basic Contract Buying a bond futureis the economicequivalent of buying a long maturitybond on margin.96 on Tue. the portfolio managermay liquidatehis portfolioin an orderly fashion while reducing his futures position accordingly.Deliverable bonds includeall Treasury 28 FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1983 O This content downloaded from 86. Selling a financialfuture is the mirrorimage of is a purchase. There are four delivery months each year-March. the portfolio hedged-i. on the otherhand. one might reasonably wonder why a managerwho wishes to eliminate interestrate risksdoesn't simply sell out his posiunderwhich a tion. the sale of 1. the interestrateriskof a bond portfolioby selling with an equivalentmarketvalue futurescontracts and maturity.from$65 to $64.theirusefulnessin alterand the effectof risk ing the risklevel of a portfolio.e. In each of these cases.

Thefactor value of each eligiblesecurity. may be withdrawn).55. creditsto the account(which.' (Footnotesappear at end of article. the marketpricesof the bond and the futurescontract riseto $66. The Factor System assumedthatour portfolio The aboveillustration Treasury bondswith consistedof 8 percent.5 L $65 00 J (2) 1x)2 = 12. If deliveryis made duringthe firstthreeweeks of the deliverymonth. which have a market valueof $65.If we sell one Junecontract at $65. Assume furthermore thatour entireportfolio consistsof 100of these 8 per cent Treasuries.such as the opportunity costs (benefits) of additional margin deposited the impactof these factorsis minor.thisreturn to a semiannual return.000. If the closing price on June 1 is $72. Sincethe purchasepriceand sale priceareequal in our example. the managershould compare it with alternative money marketyields. the increasedproceeds of $7.50 Sincethis returnis nearlycerper cent is assured.the correct was one future per $100. ty of one bond thatmaybe substituted Thisfactorrepresentsthe relativemarketvaluesof all deliverable bonds when they are priced to an 29 FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1983 O This content downloaded from 86. the bonds will be lower in value by $1.In practice. the market thereis no achedgingis not such a simplematter.) (Ls es Price Purchase 2.000on our futurescontract.000we receivewhen we deliverthe bonds will equal the $7. a rateof returnwithin a smallband around12. it provides an exchangeratethatdeterminesthe quantiforanother. it is necessaryto utilizethe factor system developed by the CBT.The sellerof a contract(the short)is entitled to deliver $100.but we will have $1. locked in.96 on Tue.000par value of 8 per cent Treasury bonds. 17 Dec 2013 10:09:42 AM All use subject to JSTOR Terms and Conditions . The remainderof the this resultingwealthratioinexpressiontranslates Forourexample. or theirequivalent.00x92 $65.alldeliveries over the remainder of the month aresettledat the price that prevailedat the close of tradingon this day.if the rateis return by using lower.3 tain.000on the bonds.If the priceis lower at settlement. 20-year Treasuries with 15 years to call and an 8 per cent coupon aresellingat $65.in satisfaction of his short contracton any business day during the deliverymonth.the rateof returnearnedover the life of the hedge will equalthe currentyield on the on a semiannual bond. (withdrawn). If the rate is higher than 90-day money marketyields. then he would be sacrificing futuresand he should thereforesell the portfolio rather securities and investin actualmoney market than syntheticones. The short may use to satisfy his contractany or issue with at least 15 yearsto maturity Treasury the exactdelivery systemestablishes call.we willreceivea margin call of $1.in essence. If. the marketvalue of the overallpositiondoes not vary in any material way. The expressioninside the bracketsrepresentsthe proceedsat sale plus the incomereceivedover the period divided by the cost.Becauseof futurescontract hedge ratioin our example this match. and thatthe nearbyJune futurescontract is also selling at $65. bonds thatmatchthe coupon of the Treasurybond and maturityspecifications thattradeson the CBT.Thismaybe expressed compound equivalentbasis as: 2 thereare some addiAlthoughin actualpractice tionalfactorsto consider. Assume that on March 1 of any year. equals: FN.e.000par value of bonds. the balancingprocesswill continueright into deliverymonth. alternatively.If the hedge is establishedcorrectly.20-year 15yearsto call-i.. one day afterwe establish the hedge. tual8 percentTreasury bond with 15yearsor more to call. in effect. we have done the equivalent of sellingthe Treasury bond forwardat $65 for deliveryin June (assuming thatwe eventuallycompletethe transaction by deliveringour bonds in satisfaction of the futures Note that the sale priceof the bonds is. valueof the Thismeansthatchangesin the market bond are offset by equal and opposite changes in value of the futurescontract.000. the buyer of a contract (thelong) is obligatedto pay the short the closingfuturespricethatprevailed two business days prior to delivery of the bonds.000 of additionalmargin deposited over the life of the contract. the manager should use futuresto reducehis risk. If the marketpricefalls to $64. contract).o+($8.as mentionedearlier.176. Betweenthe day the syntheticsecurityis created in the priceof the and the deliveryday. (1) where N equals the actualnumberof days held.50%.000of excess margincreditedto our account.the reverse will be true. However.but we will have a paper gain of $1.00365J192 ( 182.Despitethese cash flows.bonds with at least 15 years to maturityor call (if callable). variations future will triggermargin calls or. Tradingof futures contractsceases on the eighth business day beforethe end of the month.

To demonstrate the effectof the basison ratesof return.55.the basis one must understandhow the changein the basis collapses. The yield on the syntheticshort when the basis is zero can be calculatedas follows: ($106.then.64.Thus ratioof prices(thehedge ratio) 164 contractswould have the same marketvalue as a $10 million par value portfolio of 14 per cents-$10.37% relationship of the futuresmarketto the long bond $65 1.10times 1.00 1.5 the long bond marketperfectly. the basis would be negativeone point. 17 Dec 2013 10:09:42 AM All use subject to JSTOR Terms and Conditions . Withan upwardslopingyieldcurve.4Whileit does not hold exactlyat higher yields. the basis is negative.the basiswould be positiveone bonds is 13. (3) The currentyield on this bond and the returnon the syntheticsecurityareidentical-13. we would not expect any capitalgains pricetimesfactor) justedfuturesprice(AFP)is greaterthan the cash or losses over the life of the hedge. futurespriceto converge. the would be 1.6377 $106.40percentand the current yieldon long tradingat $105.00 13. What determinesthe -1. Future Factor AFP(1 x 2) Cash Basis(3-4) Yield This raises two questions.makethe totalreturnon the cash-futures combinaty.and we could lock in a capital the June 1982bond contract). if three-monthTreasurybills are $106. As the basis changes from zero to negative one point.45. Now.6377 $106. and that futures are then priced to reflect the cashprices-i.660.37per cent.6377 $106. As I The Relationship Between the Cash and Table illustrates.the AFP would be gain over the life of the hedge.45.zero-i.45. if the priceof the 14percentsfellby 10points. futuresprice(futures term Treasuries. when the AFP is less exceed the currentyield on long bonds-i.8 per cent yield. This is rarelythe case. In orderto use futuresproperly.we basiswas example would the cash bond and the adjusted expect zero.6377(the actualfactorfor than the cash price.the market value of the portfoliowould fall by one million dollars.As this occurs.it should ofUnderstandingthe Basis The "basis"is a measureof the relativepricing fer the same return. we would expect the futurescontractto fall in price by 6.3 per cent.we have computed the yield on the synthetic short-terminvestment under three basis values.176. FuturesMarkets a positivebasis.45 $105. the basis on a three-month "shouldbe" one point.the AFPwould be higher for the 14 per cents is 1. given the $65 marketvalue of our hypothetical8 per cents.e.45 9. Forexample.the yieldon combinationof two components-the interestincome fromthe cash securityand the changein the money market instrumentsis below the current FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1983 O 30 This content downloaded from 86..45 + $ 365 ] -1)x2 = 13. As the that Ouroriginal assumed the deliverymonth approaches.Then. to Table I. The returnon a syntheticsecurityis actuallya tion equalto the returnon the short-term security.e. the basis is positive.the effect of a negativebasis is to reducethe totalreturnon the syntheticsecurity.96 on Tue. we would expect the basis to be less the cashprice.Whenthe ad.37%.45 + 1. however. augmentingthe currentreturnso as to affectsthe yield of the syntheticshort-term securi. the than the cash price. At the same time..45 marketbetween deliverymonths?And to which $65 1.60. For example.000). both initiallyand in the deliverymonth. Thus if yieldcurveis downwardsloping-we would expect the futurescontract is tradingat $65and the factor the basis to be positive. on the other hand. if they are yielding17.45 $107.000(164times $65.000). basis.Letus assumefurther that the prices of actual cash securitiesare Table I Effectof Basis on Synthetic Short-TermYield determined. If short rates price.40% long bond is the futurescontractactuallypriced? If the syntheticsecurityhas the same risk as a bill of comparable Treasury maturity. augmentsthe We have so farassumedthatthe futurespricetracks return. the factorcan still be consideredan approximationof the ratio of futures to bonds necessaryto hedge a portfolio.if the market priceof the 14percent Treasuries of 2011is $106. if the currentreturnon of the cash (the price of the bond) and futures long Treasuries exactlyequals the yield on shortIt equalsthe adjusted markets..45% $65 0. offsettingthe loss on the portfolio.according synthetic security point.If the 14 per cents are tradingat $107.e. the yield on the three-month synthetic securityfalls by nearly400 basis points.00 17.45 $106. the direction of causality (1) (3) (4) (5) (6) (2) flows fromthe bond marketto the futuresmarket.10 points for a gain of one milliondollars(164times $6.

2008.29 83.9633 98. be zero in the deliverymonth.83 82. If the basison any bond were substantially positive in any deliverymonth. arbitrage would be possible. the basisbetween deliverymonthswill dependupon the shapeof the yield curve.8 when dealersuse Treasury bond futures Moreover. '81 March '82 June '82 123/4% 137/8% 137/8% 14% 14% 14% 11/15/10 05/15/11 05/15/11 11/15/11 11/15/11 11/15/11 (19.13 73.63 98.In this case. / JANUARY-FEBRUARY 1983 D 31 ANALYSTS JOURNAL FINANCIAL This content downloaded from 86.especiallyamong underwriters and market-makers seekingto protectthemselvesfrom inventorylosses.becausethe long cannotrequire deliveryof a specificbond.57 61.3885 66.55 63.06 (31) (96) (111) (105) (101) 153/1 141/4 75/8 77/8 2/15/02 2115102(07) 1. The most obis cost: Whichof the eligiblebonds vious criterion is the cheapest to deliver? TableII lists for each eligible bond the market pricetimes futuresprice(futures priceand adjusted factor) as of June18.69 80.55. If a short chooses to deliver. deliveringthe 83/8 per cents due August 15. short is not a perfectsubstitute forhedgingwith conventionalfutures.6 Note fromTableII that some bonds have an extremelynegativebasis.2) (38.67 83.6201 1.22 $ 60.79 90.7544 $ 61.showing the bases for the most actively traded long-term governments and also for the cheapest bond to deliver during recent delivery periods indicates that the basis-even on the cheapestbond-has typicallybeen negativein the deliverymonth.5205 1.61 95.81 (55) 7 6 5/15/04(09) 11/14/04(09) 2/15/05(10) 1.9) (22. these bonds are the cheapest to deliver.13 71.03 93. but it should convergeto zero in the deliverymonth. The greatestprofitwill come from Table II Calculating Which Bond is Cheapest to Deliver Market Basis Price Call(andMaCoupon turity)Date Factor 6/18/82 AFP* in 32nds 81/4% 113/4 13'/8 133/8 5/15/00(05) 2/15/01 5/15/01 8/15/01 11/15101 1. An arbitrageur would buy the bond with a positive basis.Bernsteinestimates. the. that qualify for delivery.3125.6) (48.96 on Tue.2) ( 0.short-run value of the insuranceit offers is so greatthat the relative cheapness of the futures to cash seems to be of secondary importance to those involved.36 1 (15) (30) 10 123/4 5/15/05(10) 11/15/05(10) 1.Bernsteinestimates.2) (12.0378 1. the adjusted futurespriceformsa floorfor alldeliverable issues.64 58. so the basis should be negative.4) ( 8.18 104.6377 97.10 74. But TableIII. However.and trading a synthetic securisimultaneous or nearlysimultaneous ty requires executionin two differentmarketsas well as the addetailof transferring ministrative and maintaining the synthetic margin.64 88. sell the futures contractand immediatelyannouncehis intentionto deliver.60 92. as a generalized interestratehedge againstnonde- Table III The Basis in the Delivery Month Delivery Month MostActively Traded Issue Coupon Maturity Basison MostActively Traded Issuein 32nds to Basison Cheapest DeliverIssuein 32nds March '81 June '81 Sept.4) (16.he must selectfromthis list.) So far we have assumed that the basis expands or contractsso as to equate the currentreturnon long bonds with the yield on short-term securities. '81 Dec.3) ( 1.yield on long bonds.6120 0.47 107.1149 1. In fact.81 96.61 57. whereas none has a basis that is substantially positive.3589 1.83 (5) (42) 137/8 14 5/15/06(11) 11/15/06(11) 1.29 61.6) ( 7.32 63.4931 1. Source: WallStreetJournal. Thefuturesinstrument is complex. we have assumedthat the basiswill Furthermore.(The reverseis not possible. 1982(thelastfulldayof trading and the difference beweenthe on the Junecontract) two-the basis.2078 1. Telerate. since the event of delivery should force convergence between the futureand the cheapestto delivercashsecurity. Choosing the Bond to Deliver 17issues therearecurrently As TableIIindicates.4976 71.9874 1.then.3) Telerate.6) (22.0758 60.Becauseof thesefactors.8) (31.In general.176.0233 1.84 58.2448 1.29 66. 17 Dec 2013 10:09:42 AM All use subject to JSTOR Terms and Conditions .14 (49) (54) *Junefutures contractselling at 59.60 88. the built-incapitalloss in the hedge would reducethe rateof returnon the synin the to the shortrateprevailing theticinstrument money market. Source: WallStreet Journal.09 97.56 90.7 Thereareseveralreasonsforthis.14 (103) (47) 83/8 83/4 91/8 103/8 113/4 11/15/02(07) 8/15/03(08) 11/14/03(08) 0.

000 a durationof five years. irrespectiveof the coupon.176.undercurrent conditions.Butwhile tracts it is true. for $16.He can avoidthis problemby purchasingTreasurybond futures. 32 FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1983 O This content downloaded from 86.4millionof the 14per cents.the greateris the mismatchupon delivery.The shorthas untilthe lastday of the monthto deliver bondsagainst his contract.10 awarenessand appreciation Using a standardoption model. Alterwe canswap $10millionof the 14percents natively. Shorting 164 contractscalls for delivery of $16. If interestrates on long bonds are at 13 per cent. 17 Dec 2013 10:09:42 AM All use subject to JSTOR Terms and Conditions .the valueof this option is approximately16/32 of a point. These alternatives representa put optionfor the seller. Thus. they do not explainthe recentwideningof the basison the mostactively traded issues. of one bond futureis the equivalent Thepurchase of buying $65. we should be short164futuresconif we wish to negatethe market risk. if the shortsellerof the futuresowns $10millionof the 14per centsat the closeof futures trading.Thepriceat the closeon that day is the pricethat will be used (with the factor) to determinethe invoiceamount-the amountthat the short seller of the futurescontractwill bill the long when bonds aredelivered. and avoid deliverthese bonds againstthe contract loss.A straightforward measure of the risk of a bond portfoliois its duration.It would appear.12 Assume that a portfolio manager receives and wishes to establisha portfolio with $10. the duration of the 83/8 per centbond maturing on August15."1Thus.such as corporatebonds.The largerthe factor. Why have they become so expensive relativeto futures? The Role of the Put Option Earlier. the manageris under pressure to become fully invested immediately.we arenothedged for delivery.55. Althoughthe futurespriceand the invoice amount for each deliverable bond are fixed over the interveningseven days. the shortcan swap the 14 per cents for 8 per cents.96 on Tue. we canpurchase an additional $6. Using Futuresto IncreaseMarket Risk We have concentrated on the hedging applications of futures-how they may be used to reduce or a bondportfolio's risk. if the marketrises.the shortcan purchaseat a relatively low pricethe additional$6.If we assumethatthe basishas a negative of 4/32 beforetakinginto accountthe value of the put (because the synthetic short is not a perfect short-term substitute forconventional investments).000. and the higherthe valueof the put option.4millionof 8 per cents (becausethey have the same market value) and exactly match the The option chosen will dedeliveryrequirement. 2008is 7. that we are hedged againstmarket risk.8 years. or to increase Very often. then the basis should approximate 20/32. If prices fall. the meaningfulnessof the basis is furtherdiluted.To makeup the shortfall. As we mentioned. In orderto determinethe proper number of futures to purchase.Juneand Septemmorenegaberof 1981. pend upon the behaviorof bond pricesduringthe delivery month-particularly towardsthe end of the month. when a managerreceivesa new account. the short will buy additional bonds at the lower prices and put these bonds to the long at the higherinvoiceprice.4 millionparvalue required and deliver the bonds at the (alreadydetermined)higher invoice price.4 million par value of bonds.the highest has the largestput option.causinga profitable outcomeforpurchasers of the put option (those who were long the 14 per cents and short the futures). Thus.and if the marketpriceof these bondsfalls overthe lastseven businessdays of the month. the bond market is not.liverablesecurities.Because aredirectly couponsand factors related.Futures eliminate market can a targetlevel of marketrisk also be used to establish the risk of an existing portfolio.000marketvalue of the cheapestto deliverTreasury bond.that the most recent delivery month basis of 48/32 is approximately 28/32 too high. if we own $10 million of the 14 per cents of 2011and the factoron these bonds is 1.tradingof the futurescontract ends on the eighth business day priorto the end of the deliverymonth.On the otherhand. Table coupon Treasury III merely reflects market participants'growing of this put option.we pointed out that the deliveryfactor representsthe correcthedging ratiofor protecting againstmarketloss. it is first risk level necessaryto determinethe appropriate of the targetportfolio. althoughit appearsfromTableIIIthatthe basison the mostactively tradedsecurity was approximately equalto the put value in March. we calculated that.the basiswas considerably tive in Decemberof 1981and Marchand June of bias 1982.9 Althoughthesefactors may explainwhy the basis tends to be negative. therefore.64. Particularly in the lattercase. A plausibleexplanation of this apparent misvaluationis that in four of the past five delivery months the markethas sold off sharply. the portfoliorepresentsa combinationof securitiesand cash.so that his returnwill not be adverselyaffectedby short-term marketmovements. or just plaincash. in this example.

change long-term the basis is taken into account.with a duraTo establisha positionof $10. Thus.As attractive portunities develop in the cash market.Forinstance. the yield on the futures-augmentedportfolio is greater than the then portfolio. he can reduce his futures position accordingly. we could sell Department. a point is eventually effectbecomesso reachedwhere the reinvestment large that even the longest bond cannot generate sufficient priceactionto offsetit.13This is accomplishedby setting and the durationof the portfolioequal to maintaining the time remainingto the end of the horizon. 15. 17 Dec 2013 10:09:42 AM All use subject to JSTOR Terms and Conditions . among other things. Notes and Bond Futures.In effect. tion of 15 yearsto effectan immunization program.0-year durationof the zero coupon-cashbond portfolio. We assumed above that this basis will be .1 yearswill raisethe duration will add 7.so that it will matchthe 15.9 2.in to the timehorizon essence. For example. Chicago. classicalimmunizationoccurs.As interest rates rise and pricesfall. Long-term Trade's "Understanding the Delivery Process in If we neededa duraduration of an entireportfolio.Thiswould increase pressed in a variety of ways (discount.futuresmay be purchasedin orderto lengthen the durationof an immunizedportfolio.a durationof have chosen semiannual compounding in order to be consistent with bond yields as generally expressed.176.S. maturity.1.000 --x $65.the change in marketvalue would have been $71. matchingthe duration resultsin a balancebetween pricemovementand coupon reinvestment. the of zerocouponbonds duration-extending capability can be duplicatedin the futuresmarket. by definition. of a 40-year bondatparwas 13. Had the zero couponbonds not been added to the portfolio.1 bond at par years. see the Chicago Board of zeros can thus be used to raise the ty.000 (becausethe durationwas 7.20/32 in the deliverymonth." These may be Treasury but the durationof our portfolioof $10 million14 the Chicago Board of Trade Marketing from ordered per cent bonds at par was 7.the additionof the zeros levers the bond portfolio. The yield on the zero coupon Theyieldon the comis simplyits yieldto maturity. half the portfolioand invest the proceedsin zero 312-435-3558.0yearsimpliesa 1.1 years. minimal.Adding a futurespositionto a long-termbond long financial to as a Texashedge) portfolio(sometimesreferred increasesits interestratesensitivityand.M E 33 This content downloaded from 86.14 Purchasing to the duration. coupon bonds with an average maturityof 22.when bond yields were at 7 per cent. in the 1970s.000. interest at folio to 15 years. of zero coupon bonds has exThe introduction tended the availablemaximumduration. Thus the expectedchange in the basis is the differencebetween the basis at the time the futures position is establishedand .000. a change in yield of 10 basis points would resultin a $150.000change in marketvalue.When these effectsoffseteach other. LaSalle at Jackson. Although a change in the basis will securidominate the yieldon a syntheticshort-term a or effect of one-half the point one-quarter ty. For a more complete description of the delivery prothe duration cess and specifications. it is important to express the yields Durationis. Inasmuchas the purchaseof a futures contract is equivalent to buying bonds on leverage.5 per centchangein pricefor FINANCIAL ANALYSTS JOURNAL I JANUARY-FEBRUARY 1983 a 10 basis point change in yield. the duration is 7. the reinvestmentrateon all subsequent incomerises.the additionof one futures contractto a $10 million portfoliowith a by 0. yieldon the zerocoupon-augmented the formeris more attractive. is the yieldon the cash binedcash-futures portfolio bond adjustedforthe expectedchangein the basis.55. Financial Futures" and "Delivery Manual-U. for a $10 million portfoliowith a durationof 15.96 on Tue.4years.000 tion of five years.1 years). as the level of interestrates rises."5 The riskof these two portfoliosis identical-the investmentdecisionshould thereforebe based on theirrelativeyields. Immunization. the duration of a 40-year when ratesare14percent.). Immunization is a bond managementtechnique that locks in a rate of return over a given time horizon.because Footnotes of a zero couponis equalto its maturi.9 years 184contracts years. the managershould purchase99 contracts: 5 5. The declinein the maximumdurationavailableas interestrates rise is a reflectionof this phenomenon.000 7. a measureof on various investments on comparable bases. IL 60604.Forexample. We interestratesensitivity. Zero Coupons and FuturesContracts Futurescan also be used to increasethe risk of an existingportfolio. However. its duration.043 duration of 7.0 years. when on a bond is If.0 = 99 contracts $10. Since the yields on short-term instruments are exof the portthe duration years. etc.20/32.Forexample.8 (4) Thiswill insulatethe manager'sreturnfromshortopterm fluctuationsin the market.

64) in the futures price.43pointchangeon a futures point times the relative factor. In this articlewe have only discussed the uses of bond the riskof a U. and.each day to announcehis intentionto deliver.6377for the June 1982contract. ($0. atthe dose of thefutures market). Interest RateFutures: Concepts and Issues"(Richmond.this option closes is of littleor no valuebecausethe cashmarket at 5:00E..the adjustment would be $0. Let us assume that the change in the futuresprice relativeto a change in the cash priceis the ratioof theirfactors. However. pp. 5." Journal ofPortfolio Management Management. and the WSJ quotedthem at $1051/4. it can be both cumbersome sell an actualbond short. contracts futures rarelyacknowledgedin the financialand academic and costly to literature. by definition. "RiskReductionPotentialof Financial Futures.25 x 1.The shortsellerwill often not be permittedto use the proceedsof the sale or interestrateon may have to accepta below-market the cash generatedfrom the sale.if the 14 per cents WallStreet Journal. govemment bonds varies accordingto the precise numberof days in each semiannualperiod.043 portfolio.M.9 years = 184. 8. whereas the calculationof interest on U.. E.T. 0. The bond with the most 15.176.Since the risk that is being hedged is interest rate risk. 13.pp.Forthe technically orientedreader.6377). it should be noted Black-Scholes of thisput option. in thistableassumethatthe synthetic Thecalculations at a securityis held for 92 days and then liquidated basisof zero.the number of tradingdays in the deliverymonth rangesfrom 14 to 18. Inthe delivery contract trades until month. the priceson the remaining deliverable issues were adjusted downwardby $0. The factoris determinedby pricingthe deliverable bond to an 8 per centyield and dividingby 100. Thus. 4. 10..we have assumed a 365-day year. Somepreliminary plicable to corporate aregiven in resultson the efficacyof cross-hedging Hill and Schneeweis. To calculate the value of the basisover this period. the cheapestto deliverbond will issue with the longest duration.The settlementdateis the firstday of the deliverymonth and the maturity or calldate (if date is the maturity roundeddown to the firstdayof the delivery callable) month immediatelyprecedingthe maturityor call 14percentsof 2011.M.M. Moreover. Dependingon the length of the monthand the numberof holidays. 7.A $0. eds. adds Margin withdrawn maybe investedandthereby to the actual return.eachday (i.see McEnalTool for Bond Managely. of 2011weretrading at $105at 3:00P. A complete introductionto the concepts and inis containedin Bierwag.A complete listing of the Junefactorsis providedin TableII." lournalof Financial December1981. 6. Forexample. E. Ingersoll and Ross. cents of 2008.S. 27-36. 9. Dame.a daily put option exists while the future is stilltradingin deliverymonth. 321-346.the nearby 1:00P. Actually. 7.043 positive basis has.Thus a $0. the techniques discussed are apbondsas well. of the actual Thisequationis only an approximation would reflectacreturn. sincethe shorthas until9:00P. the mostpositivebasis(orleastnegative) on average.71point changein the bond will resultin a $0.the modified thatin the evaluation different model does not yield values significantly fromthe standard model. Thevalueof the put was estimated model.As a practical matter. whereas additional margin depositedhas the oppositeeffect.16point increase duration this would the by 0.the lowest price FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1983 E 34 This content downloaded from 86.S. using a modified 11. ment.96 on Tue. "Duration as a Practical Management. on the 8/4 per contract worth On a $10.VA: RobertF.55. Foran excellentdiscussionof duration. Treasury futuresin modifying portfolio. Summer1977. 1982). The price of this issue less the AFP is the basis. therefore.T.43 point change ($0. 53-57.on the eighthbusinessday priorto the end of the month.this issue is coveredin Cox.3. 14. 12. be the deliverable in the yieldcurvemayprovideexceptions Distortions to this norm. tricaciesof immunization and Toevs. in BondPortfolios. The estimatedput values variedslightlyfromone deliverymonth to the next as interest rates and our estimates of volatility changed. date. Inc.S.In the case of the Treasury it is 1.M.A moreaccurate calculation intereston interim crued interestand accumulated coupons.T.and therefore is the cheapestto deliver. In order to calculatethe basis on the remaining deliverable issues for which the Teleratepricesare we adjusted the pricesquotedin the not as accurate.e."Joumnal ofPortfolio pp."in Gay and Kolb.000 is $430per contract. Thefactor is applicable to the June1982 contract.S.the necessarysell-off must take place within two hours.71 x 1/1. "TheArtof Risk Schweitzer Kaufmann. The alternativeto hedging a position with short While is to sellshortactual securities. "The Relationbetween Forward Economics.we took the value of the most activelytraded Treasury bond from the Telerateserviceat 3:00 P.0758/1.000. As a generalrule. in the delivery month. and Future Prices.25 relativeto the adjustedfuturesprice. Spring 1981. 17 Dec 2013 10:09:42 AM All use subject to JSTOR Terms and Conditions .S.The 8/4 per cents of 2008 had years.