Risk Management

and Financial Instruments

FINA5520

Week 3

Interest Rates
Interest Rate Futures

Andrew Caminschi

Spot Future Price Future Spot Price

Y
S0 . erT

Given:
S0 = $ 110.00 / bbl
r = 1.5% / year
T = 117 days
Y = $112.00 / bbl
X = $109.00 / bbl

Basis = S0 F0
Find:
a) F0 = ?
b) What is the basis ?

21-Jul

c) You can trade a forward maturing

at T, at price X, for 1000 barrels.
What should you do ?

117 days

15-Nov

d ) An over committed trader wants to

exit a 1000 barrel forward maturing at
T, and they bought at price Y. What
profit / loss is she facing ?

Spot & Futures Pricing

+1 GC
DEC

Basis
=
Spot Futures

Yield on cash
Yield on underlying
Storage costs
Transactions costs

Convenience Yields

Fo = So . e

(r + u - y) T

What should y be for

an investment asset ?

The Course
Week 1

Intro (H1)

Week 2

Week 3

Futures hedging
strategies (H3)

Interest rates
(H4)

Futures (H2)
Forward and
futures prices
(H5)

Interest rate
futures (H6)

Week 8

Option pricing 2:
Black-SholesMerton
(H13,14)

Options on stock
indices,
currencies and
futures
(H16,17)

Week 13

Revision

Week9

Study Break

Week 7

Greeks (H18)
Volatility smile
(H19)

Week 4

Swaps (H7)
Securitization
and the credit
crisis
(H8)

Week 10

Value at Risk
(H21)

Week 5

Mechanics of
options
(H9,10,11)

Week 11

Credit Risk
(H22)
Credit
Derivatives
(H24)

Week 6

Option pricing 1:
Binomial trees
(H12)

Week 12

Energy and
Commodity
derivatives
(H33)

Exam Weeks

Typical run rate of:

2 Chapters / week
6 Seminar questions / week

Interest Rates
Week 3

Rate Types

Treasuries
Rates on instruments issued by a government in its own currency

xBOR (LIBOR, TIBOR, SIBOR.)

Rate of interest at which a bank is prepared to deposit money with another bank.
(The second bank must typically have a AA rating)
LIBOR is compiled once a day by the British Bankers Association on all major
currencies for maturities up to 12 months
LIBID is the rate which a AA bank is prepared to pay on deposits from another
bank

Repo
Repurchase agreement is an agreement where a financial institution that owns
securities agrees to sell them today for X and buy them bank in the future for a
slightly higher price, Y
The financial institution obtains a loan.
The rate of interest is calculated from the difference between X and Y and is
known as the repo rate

The Risk-Free Rate

The short-term risk-free rate traditionally used by derivatives practitioners is

LIBOR
The Treasury rate is considered to be artificially low for a number of reasons
(See Business Snapshot 4.1)
As will be explained in later chapters:
Eurodollar futures and swaps are used to extend the LIBOR yield curve beyond
one year
The overnight indexed swap rate is increasingly being used instead of LIBOR as
the risk-free rate

http://www.ft.com/intl/indepth/libor-scandal

Measuring Interest Rates

The compounding frequency used for an interest rate is the unit of measurement
The difference between quarterly and annual compounding is analogous to the
difference between miles and kilometers
Compounding frequency

m=

Value of $100 in one year at 10%

Annual (m=1)

110.00

Semiannual (m=2)

110.25

Quarterly (m=4)

110.38

Monthly (m=12)

110.47

Weekly (m=52)

110.51

Daily (m=365)

110.52

Rm

Rc m ln1

Rm m e Rc / m 1

10

Zeros (Zero Coupons Bonds)

A zero rate (or spot rate), for maturity T is the rate of interest earned on an investment
that provides a payoff only at time T

Price

Rate

. =

Fixed
Future
Value

Term Structure of Risk-Free U.S. Interest Rates

Bonds

Time, Coupon vs Yield

= Accrued Interest

Premium

quoted
clean

Discount

Par

cash
invoice
dirty

Coupon Bonds as series of ZCB

15

Bond Pricing

To calculate the cash price of a bond we discount each cash flow at the
appropriate zero rate
In our example, the theoretical price of a two-year bond providing a 6% coupon
semiannually is

r1T1
r2T2
r3T3

As shown on yield curve, often r1 r2 r3

Data to Determine Zero Curve

(Table 4.3, page 82)

Bond Principal Time to

Maturity (yrs)

Coupon per
year ($)*

Bond price ($)

100

0.25

97.5

100

0.50

94.9

100

1.00

90.0

100

1.50

96.0

100

2.00

12

101.6

* Half

the stated coupon is paid each year

16

17

The Bootstrap Method

18

Zero Curve Calculated from the Data

(Figure 4.1, page 84)

12

Zero
Rate (%)
11

10.681
10.469
10

10.808

10.536

10.127

Maturity (yrs)
9

0.5

1.5

2.5

19

Theories of the Term Structure

Expectations Theory: forward rates equal expected future zero rates

Market Segmentation: short, medium and long rates determined independently of

each other

Liquidity Preference Theory: forward rates higher than expected future zero rates

Short-Term Versus Long-Term U.S. Interest Rates and Recessions

21

Forward Rates

The forward rate is the future zero rate implied by todays term structure of interest
rates

Suppose that the zero rates for time periods T1 and T2 are r1 and r2 with both rates
continuously compounded.
The forward rate for the period between times T1 and T2 is

r2T2 r1T1
T2 T1

This formula is only approximately true when rates are not expressed with continuous
compounding

r1,2

r0,1
T1

T0
r0,2

T2

0,1 1 . 1,2 (21)

=
0,2 2

Example

Year (n)

Zero rate for n-year

investment
(% per annum)

3.0

4.0

5.0

4.6

5.8

5.0

6.2

5.5

6.5

3.0 x 1

5.0 x 1

. e

Forward rate for nth

year
(% per annum)

3.0 x 1 + 5.0 x 1

4.0 x 2

23

Instantaneous Forward Rate

The instantaneous forward rate for a maturity T is the forward rate
that applies for a very short time period starting at T. It is

RT

R
T

where R is the T-year rate

For an upward sloping yield curve:
Fwd Rate > Zero Rate > Par Yield
For a downward sloping yield curve
Par Yield > Zero Rate > Fwd Rate

24

Forward Rate Agreement

A forward rate agreement (FRA) is an OTC agreement that a certain rate

will apply to a certain principal during a certain future time period
An FRA is equivalent to an agreement where interest at a predetermined
rate, RK is exchanged for interest at the market rate
An FRA can be valued by assuming that the forward LIBOR interest rate, RF
, is certain to be realized
This means that the value of an FRA is the present value of the difference
between the interest that would be paid at interest at rate RF and the
interest that would be paid at rate RK

25

Valuation Formulas

If the period to which an FRA applies lasts from T1 to T2, we assume that RF and RK
are expressed with a compounding frequency corresponding to the length of the
period between T1 and T2
With an interest rate of RK, the interest cash flow is RK (T2 T1) at time T2
With an interest rate of RF, the interest cash flow is RF(T2 T1) at time T2
When the rate RK will be received on a principal of L the value of the FRA is the
present value of

( RK RF )(T2 T1 )

received at time T2
When the rate RK will be received on a principal of L the value of the FRA is the
present value of

( RF RK )(T2 T1 )

received at time T2

26

Example
An FRA entered into some time ago ensures that a company will
receive 4% (s.a.) on $100 million for six months starting in 1 year
Forward LIBOR for the period is 5% (s.a.)
The 1.5 year rate is 4.5% with continuous compounding
The value of the FRA (in $ millions) is

100 (0.04 0.05) 0.5 e 0.0451.5 0.467

27

Example continued
If the six-month interest rate in one year turns out to be 5.5% (s.a.)
there will be a payoff (in $ millions) of

100 (0.04 0.055) 0.5 0.75

in 1.5 years
The transaction might be settled at the one-year point for an
equivalent payoff of
0.75
0.730
1.0275

28

Duration
Duration of a bond that provides cash flow ci at time ti is

ci e yti
D ti

i 1
B
n

where B is its price and y is its yield (continuously compounded)

Duration is important because it leads to the following key
relationship between the change in the yield on the bond and the
change in its price

B
Dy
B

29

Duration continued
When the yield y is expressed with compounding m times per year

BDy
B
1 y m

The expression

D
1 y m

is referred to as the modified duration

30

Bond Portfolios
The duration for a bond portfolio is the weighted average
duration of the bonds in the portfolio with weights
proportional to prices
The key duration relationship for a bond portfolio
describes the effect of small parallel shifts in the yield
curve
What exposures remain if duration of a portfolio of
assets equals the duration of a portfolio of liabilities?

31

Convexity
The convexity, C, of a bond is defined as
n

1 2B
C

B y 2

c t

2 yti
i i e

i 1

This leads to a more accurate relationship

B
1
Dy Cy 2
B
2

2nd order Taylor

approximation

When used for bond portfolios it allows larger shifts in the yield
curve to be considered, but the shifts still have to be parallel

Interest Rate Futures

Week 3

Day Count
Interest = rate x time = r . T

T=

French
English

Good Summary at:

https://en.wikipedia.org/wiki/Day_count_convention
http://www.opengamma.com/sites/default/files/interest-rate-instruments-and-market-conventions.pdf

Does Day Count Matter ?

X=1
Y = 365

US Govt Bond
Act/Act

FEB-27

FEB-28

MAR-1

T =1/365=0.00274

US Corp. Bond
30/360

FEB-27

FEB-28

FEB-29

FEB-30

MAR-1

X=3!
Y = 360

T =3/360=0.00833
> 3x

T-Bills
Bills : < 1yr, no coupon. ACT/360

360
P
(100 Y )
n
Y is cash price per $100
P is quoted price
Interest = rate x time = r . T
Interest / time = rate

Good references:
http://newyorkfed.org/aboutthefed/fedpoint/fed07.html
http://www.wsj.com/mdc/public/page/2_3020-treasury.html

T- Notes & Bonds

Notes : 1yr-10yrs, s.a. coupon, ACT/ACT

Bonds : 10+yrs, s.a. coupon, ACT/ACT
Cash Price = Quote + Acc Int.
Quotes in USD 1/32ths

Good references:
http://newyorkfed.org/aboutthefed/fedpoint/fed07.html
http://www.wsj.com/mdc/public/page/2_3020-treasury.html

Interest Rate Futures

Treasure Futures

Eurodollar Futures

CBOT

CME

Bond Delivery for cash

Cash settled

Cash price =

3 Month LIBOR on $1M

Settlement price
Conversion factor
+ Accrued interest

$25/bps/contract

Quality Option
Delivery Option
Wild Card Play

Quarterly out to 10 yrs

+ front 4 months
3rd Wednesday of
Delivery Month

Tour of IR Markets
http://www.cmegroup.com/trading/interest-rates/

Eurodollar futures vs FRA

____ settles at T1
with daily settlement,
i.e. cash flows

T0

R1,2
T1

T2

____ Settles at T2
with no daily settlement

___________ Adjustment
_________ Rate = _________ Rate

Ho-Lee, JF 1986

T1 T2

Application Building a yield curve

1.
2.
3.
4.

Get Eurodollar Quotes

Convert to Futures rates
Convert to Forward rates (convexity adjustment)
Convert to Zero rates

Application Portfolio Immunization

N* =

PD P
VF DF

VF

Contract price for interest rate futures

DF

Duration of asset underlying futures

at maturity of futures contract

Value of portfolio being hedged

DP

Duration of portfolio
at hedge maturity

Example
It is August. A fund manager has $10 million invested
in a portfolio of government bonds with a duration of
6.80 years (in Dec) and wants to hedge against
interest rate moves between August and December.
The manager decides to use December T-bond
futures. The futures price is 93-02 or 93.0625 and the
duration of the cheapest to deliver bond is 9.2 years
(in Dec).
The number of contracts that should be _______ is:

Example
It is August. A fund manager has $10 million invested
in a portfolio of government bonds with a duration of
6.80 years (in Dec) and wants to hedge against
interest rate moves between August and December.
The manager decides to use December T-bond
futures. The futures price is 93-02 or 93.0625 and the
duration of the cheapest to deliver bond is 9.2 years
(in Dec), with face value of $100,000.
The number of contracts that should be sold is: 79
10,000,000 6.80

79
93,062.50 9.20

Issues / Limitations

_____

_____

The Course
Week 1

Intro (H1)

Week 2

Week 3

Futures hedging
strategies (H3)

Interest rates
(H4)

Futures (H2)
Forward and
futures prices
(H5)

Interest rate
futures (H6)

Week 8

Option pricing 2:
Black-SholesMerton
(H13,14)

Options on stock
indices,
currencies and
futures
(H16,17)

Week 13

Revision

Week9

Study Break

Week 7

Greeks (H18)
Volatility smile
(H19)

Week 4

Swaps (H7)
Securitization
and the credit
crisis
(H8)

Week 10

Value at Risk
(H21)

Week 5

Mechanics of
options
(H9,10,11)

Week 11

Credit Risk
(H22)
Credit
Derivatives
(H24)

Week 6

Option pricing 1:
Binomial trees
(H12)

Week 12

Energy and
Commodity
derivatives
(H33)

Exam Weeks

Typical run rate of:

2 Chapters / week
6 Seminar questions / week