Interest Rate Forwards and Futures

Bond basics
Forward rate agreements, eurodollars,
and hedging
1 / 25
Bond Basics
U.S. Treasury
Bills (<1 year), no coupons, sell at discount
Notes (110 years), Bonds (1030 years), coupons,
sell at par
STRIPS: claim to a single coupon or principal,
zero-coupon
2 / 25
Bond Basics (contd)
Notation
r
t
(t
1
, t
2
): interest rate from time t
1
to t
2
prevailing at
time t
r
0
(0, 1)
r
0
(0, 2)
r
0
(1, 2)
t = 0 t = 1 t = 2
-
-
-
P
t
0
(t
1
, t
2
): price of a bond quoted at t = t
0
to be
purchased at t = t
1
maturing at t = t
2
Note: If t
0
= t
1
we will drop the subscript for
convenience
Yield to maturity: percentage increase in dollars
earned from the bond
3 / 25
Bond Basics (contd) Table 7.1
Zero-coupon bonds make a single payment at maturity
Five ways to present equivalent information about default
free interest rates. All rates but those in the last column
are eective annual rates.
Zero- Zero- One-year Continuously
Years Coupon Coupon implied Par Compounded
to Bond Bond Forward Coupon Zero
Maturity Yield Price Rate Yield
1 6% 0.943396 6% 6% 5.82689%
2 6.5 0.881659 7.00236 6.48423 6.29748
3 7.0 0.816298 8.00705 6.95485 6.76586
4 / 25
Bond Basics (contd)
One year zero-coupon bond: P(0, 1) = 0.943396
Pay $0.943396 today to receive $1 at t = 1
Yield to maturity (YTM) =
1/0.943396 1 = 0.06 = 6% = r(0, 1)
Two year zero-coupon bond: P(0, 2) = 0.881659
YTM=1/0.881659 1 = 0.134225 =
(1 + r(0, 2))
2
1 r(0, 2) = 0.065 = 6.5%
5 / 25
Bond Basics (contd)
Zero-coupon bond price that pays C
t
at t:
P(0, t) =
C
t
[1 + r(0, t)]
t
Yield curve: graph of annualized bond yields against time
Implied forward rates
Suppose current one-year rate r
0
(0, 1) and two-year
rate r
0
(0, 2)
Current forward rate from year 1 to year 2, r
0
(1, 2),
must satisfy
[1 + r
0
(0, 1)][1 + r
0
(1, 2)] = [1 + r
0
(0, 2)]
2
6 / 25
An investor investing for 2 years has a choice of buying a 2-year
zero-coupon bond paying [1 + r
0
(0, 2)]
2
or buying a 1-year bond paying
1 + r
0
(0, 1) for 1 year, and reinvesting the proceeds at the implied
forward rate, r
0
(1, 2) between years 1 and 2. The implied forward rate
makes the investor indierent between these alternatives.
[1 + r
0
(0, 1)] [1 + r
0
(1, 2)]
Earn r
0
(0, 1) Earn implied forward rate r
0
(1, 2)
Earn r
0
(0, 2) per year
[1 + r
0
(0, 2)]
2
0 1 2 Time
7 / 25
Bond Basics (contd)
In general
[1 + r
0
(t
1
, t
2
)]
t
2
t
1
=
[1 + r
0
(0, t
2
)]
t
2
[1 + r
0
(0, t
1
)]
t
1
=
P(0, t
1
)
P(0, t
2
)
Example using the Table 7.1
What are the implied forward rate r
0
(2, 3) and
forward zero-coupon bond price P
0
(2, 3) from year 2
to year 3?
r
0
(2, 3) =?
P
0
(2, 3) =?
8 / 25
Solving for Forward rates
Suppose r
0
(0, 4) = .085 and r
0
(0, 5) = .0825, what is the
implied one-year forward rate from year 4 to 5, r
0
(4, 5)?
Can you use prices instead to nd this out?
9 / 25
Solving for Forward rates
Suppose r
0
(0, 4) = .085 and r
0
(0, 7) = .0825, what is the
implied annual three-year forward rate from year 4 to 7,
r
0
(4, 7)?
Can you use prices instead to nd this out?
10 / 25
Par Coupon Rates (Column 4)
Coupon bonds
Given the zero coupon bond prices, what coupon rate
would price the bond at par?
The price at time of issue of t of a bond maturing at
time T that pays n coupons of size c and maturity
payment of $1
B
t
(t, T, c, n) =
n

i=1
cP
t
(t, t
i
) + P
t
(t, T)
where t
i
= t + i(T t)/n. For example, a 10-year
bond paying coupon semi-annually, then
T = t + 10, n = 20, i = 1, 2, ...20, t
i
=
t + 0.5, t + 1, t + 1.5, ...
For the bond to sell at par the coupon size must be
c =
1 P
t
(t, T)

n
i=1
P
t
(t, t
i
)
11 / 25
Par Coupon Rates (Contd)
What is the par coupon rate for the 3 year bond in Table
7.1?
c =
?
?
12 / 25
Engineering zero coupon bonds
Suppose we buy the 3-year bond with face value of $1,
with c = .069548, for $1.
Suppose we also re-invest all coupon payments (using
todays forward rates).
This strategy constructs an eective 3-year zero out of a
3-year coupon bond
However, to preclude arbitrage, such a strategy had
better yield same return as the 3-year zero coupon
bond (7%)!
13 / 25
So lets reinvest the coupons at rates we can lock-in
today (forward rates).
year 1, we get 0.069548
FV
3
= 0.069548(1 + r(1, 3))
2
FV
3
= 0.069548(1.075035)
2
= 0.080377
year 2, we get 0.069548
FV
3
= 0.069548(1 + r(2, 3))
FV
3
= 0.069548(1.0800705) = 0.075117
year 3, we get 1.069548
So, at year 3 we have $1.220542
(1.069548 + .075117 + .080377 = 1.225042)
Our yield-to-maturity = (1.225042/1)
1/3
1 = 7%
14 / 25
Note the indierence
We are indierent between the zero bond market and
coupon bond market (combined with forward market).
Both markets lock-in yields of 7%.
If not indierent then arbitrage would exist across the
two markets
15 / 25
Another indierence
Note that we are also indierent between investing $1 in
the coupon bond and rolling an initial $1 investment
through the forward market.
(1 + .06)(1 + .0700236)(1 + .0800705) = 1.225042
The coupon rate is a constant rate that leaves us
indierent to the rates earned in the forward market.
16 / 25
Continuous Yields (column 5)
Recall, PV = FVe
rt
For a zero coupon bond paying $1 at time t, the price can
be written in terms of an annualized continuously
compounded yield, r
cc
(0, t)
this equates to P
0,t
= 1e
r
cc
t
Therefore, r
cc
=
1
T
ln
1
P(0,T)
Example:
For a 2 year zero , P(0, 2) = 0.881659
Therefore r
cc
=
1
2
ln
1
0.881659
= .0629748
17 / 25
Forward Rate Agreements
Problem: A borrower wishes to hedge against increases in
borrowing costs
To borrow $100m for 91 days at forward rate (r
FRA
),
beginning 120 days from today (Jan. 1)
Suppose we are given the eective quarterly interest
rate (r
qrtly
)
Initiation Maturity
120 days 91 days
-
? ?
Jan May Aug
18 / 25
Forward Rate Agreements Contd
FRAs are over-the-counter contracts that guarantee a
borrowing or lending rate on a given notional principal
amount
FRAs tend to be short-term: 3 months to 1 year
Can be settled at maturity (in arrears) or the initiation of
the borrowing or lending transaction
FRA settlement in arrears: (r
qrtly
r
FRA
) notional
principal
At the time of borrowing: notional principal

r
qrtly
r
FRA
1+r
qrtly
FRAs can be synthetically replicated using zero-coupon
bonds
19 / 25
Forward Rate Agreements Settle at Maturity
Example: settle date is day 211, the loan repayment date,
and r
FRA
= 1.8%, the borrower should receive on date
211 Notional principal (r
qrtly
r
FRA
)
If the borrowing rate in May is 1.5%, the borrower shall
receive 100m(1.5%1.8%) = $300, 000 from the
contracts counterparty, (i.e., he shall pay the
counterparty $300, 000)
If the borrowing rate in May is 2.0%, the borrower will
receive 100m(2%1.8%) = $200, 000
20 / 25
Forward Rate Agreements Settle at Initiation
If the borrowing rate in May is 1.5%, the payment in May
is $300, 000/(1 + 1.5%) = $295, 566.50
If the borrowing rate in May is 2.0%, the payment is
$200, 000/(1 + 2%) = $196, 078.43
21 / 25
Forward Rate Agreements (contd)
Investment strategy undertaken at time 0, resulting in net cash
ows of $1 on day t, and receiving the implied forward rate,
1 + r
0
(t, t + s) at t + s. This synthetically creates the cash
ows from entering into a forward rate agreement on day 0 to
lend at day t.
Cash Flows
Transaction 0 t t+s
Buy 1+r
0
(t, t+s)
zeros maturing P(0, t+s)
at t+s (1+r
0
(t, t+s)) 1+r
0
(t, t+s)
Short 1 zero +P(0, t) 1
maturing at t
Total 0 1 1+r
0
(t, t+s)
22 / 25
Forward Rate Agreements (contd)
Example of synthetic FRA. The transactions in this table are
exactly those in previous table, except that all bonds are sold
at time t.
Cash Flows
Transaction 0 t
Buy 1+r
0
(t, t+s)
zeros maturing P(0, t+s)
1+r
0
(t,t+s)
1+r
t
(t,t+s)
at t+s (1+r
0
(t, t+s))
Short 1 zero +P(0, t) 1
maturing at t
Total 0
r
0
(t,t+s)r
t
(t,t+s)
1+r
t
(t,t+s)
23 / 25
Conclusion about the forward rate from t
1
to t
2
Implied forward rate
r
t
0
(t
1
, t
2
) =
P
t
0
(t
0
, t
1
)
P
t
0
(t
0
, t
2
)
1
We can synthetically create the payo to an FRA,
r
t
0
(t
1
,t
2
)r
t
1
(t
1
,t
2
)
1+r
t
1
(t
1
,t
2
)
, by borrowing to buy the prepaid forward,
by
1 Buying 1 + r
t
0
(t
1
, t
2
) of the zero-coupon bond
maturing at day t
2
, and
2 Shorting 1 zero-coupon bond maturing at day t
1
24 / 25
Eurodollar futures versus FRAs
Eurodollar futures contracts are similar to FRAs
guarantee a borrowing rate
There are some subtle dierences between them
25 / 25