‘The theoretical Treasury bond futures price may be at a premium to the cash market price (higher than the cash market price) or at a discount from the cash market price (lower than the cash market price), depending on (r—c) where r = financing rate and c = current yield where c is the coupon rate divided by the cash market price. The term rc is called the met financing cost because it adjusts the financing rate for the coupon interest eamned. The net financing cost is more commonly called the east of carry, or simply carry. 4. If the Eurodollar CD futures contract is quoted at 91.75, what is the annualized futures three- month LIBOR? ‘The three-month Eurodollar CD is the underlying instrument for the Eurodollar CD futures contract. As with the Treasury bill futures contract, this contract is for $1 million of face value and is traded on an index price basis. The index price basis in which the contract is quoted is equal to 100 minus the annualized futures LIBOR. In our problem, a Eurodollar CD futures price of 91.75 means a futures three-month LIBOR of 100 ~ 91.75 = 8.25, which translates into a rate of retum of 8.25%. Thus, the annualized futures three-month LIBOR is 8.25%. 5. How do you think the cost of carry will affect the decision of the short as to when in the delivery month the short will elect to deliver? ‘The short will elect to deliver at that time when it is most advantageous. For example, consider a short position such that future price falls to the extent c > r. By delivering as early as possible the future price would be enhanced. 6. Explain the asymmetric effect on the variation margin and cash flow for the short and long in an interest-rate futures contract when interest rates change. If interest rates rise, the short position in futures will receive margin as the futures price decreases; the margin can then be reinvested at a higher interest rate. In contrast, if interest rates fall, there will be variation margin that must be financed by the short position; however, because interest rates have declined, financing will be possible at a lower cost. The opposite occurs for the long position. “7. What are the delivery options granted to the seller of the Treasury bond futures contract? ‘The delivery options are the quality option or swap option, the timing option, and the wild card option. The options imply that the long position can never be sure of which Treasury bond will be delivered or exactly when it will be delivered. 8. How is the theoretical futures price of a Treasury bond futures contract affected by the delivery options granted to the short? In the case of the Treasury bond futures contracts, the delivery options granted to the seller reduce the actual futures price below the theoretical futures price suggested by the standard arbitrage model. More details are given below. In selecting the issue to be delivered, the short will select from all the deliverable issues the one that is cheapest to deliver. This issue is referred to as the cheapest-to-deliver issue; it plays a key role in the pricing of this futures contract. The cheapest-to-deliver issue is determined by participants in the market as follows. For each of the acceptable Treasury issues from which the seller can select, the seller calculates the return that can be earned by buying that issue and 427delivering it at the settlement date, Note that the seller can calculate the return because she knows the price of the Treasury issue now and the futures price that she agrees to deliver the issue. The retum so calculated is called the implied repo rate. The cheapest-to-deliver issue is then the one issue among all acceptable Treasury issues with the highest implied repo rate because it is the issue that would give the seller of the futures contract the highest retum by buying and then delivering the issue. In addition to the choice of which acceptable Treasury issue to deliver—sometimes referred to as the quality option or swap option—the short position has two more options granted under CBT delivery guidelines. The short position is permitted to decide when in the delivery month delivery actually will take place. This is called the timing option. The other option is the right of the short position to give notice of intent to deliver up to 8:00 P.M. Chicago time after the closing of the exchange (3:15 P.M. Chicago time) on the date when the futures settlement price has been fixed. This option is referred to as the wild card option. The quality option, the timing option, and the wild card option (in sum referred to as the delivery options) mean that the long position can never be sure of which Treasury bond will be delivered or when it will be delivered. 9. Explain how the shape of the yield curve influences the theoretical price of a Treasury bond futures contract. The theoretical price of a futures contract is equal to the cash or spot price plus the cost of carry. ‘The cost of carry is equal to the cost of financing the position less the cash yield on the underlying security. In the case of interest-rate futures, carry (the relationship between the short- term financing rate and the current yield on the bond) depends on the shape of the yield curve. When the yield curve is upward-sloping, the short-term financing rate will generally be less than the current yield on the bond, resulting in positive carry. The futures price will then sell at a discount to the cash price for the bond. The opposite will hold true when the yield curve is inverted. 10, Suppose that the conversion factor for a particular Treasury bond that is acceptable for delivery in a Treasury bond futures contract is 0.85 and thatthe futures price settles at 105. ‘Assume also that the accrued interest for this Treasury bond is 4, What is the invoice price if the seller delivers this Treasury bond at the settlement date? ‘The price that the buyer must pay the seller when a Treasury bond is delivered is called the involce price. The invoice price is the settlement futures price plus accrued interest on the bonds delivered. The seller can deliver one of several acceptable Treasury issues. To make delivery fair to both parties, the invoice price must be adjusted based on the actual Treasury issue delivered. It is a conversion factor that is used to adjust the invoice price. The invoice price is invoice price = (contract size)(C futures contract settlement price) Clconversion factor)] + accrued interest In our problem, the Treasury bond futures contract settles at 105 (the futures contract settlement price of 105 means 105% of par value); the short elects to deliver a Treasury bond issue with a conversion factor of 0.85; the contract size is $100,000; and, the accrued interest is 4 (or $4 per $100 which is $4,000 per $100,000). Inserting these values into our invoice price formula, we get: ($100,000)(511.05\(20.85) + 4 = $89,250 + $4,000 = $93,250, 428The underlying for the currently traded municipal note contract is up to 250 municipal bond issues each of which is large and liquid. (b) Why is the contract cash settled? Futures based upon hypothetical issues are not deliverable and must be cash settled or there must be found an acceptable substitute, The determination of whether or not a municipal note contract is cash settled depends upon CBOT, buyer and seller preferences, and the capacity to deliver acceptable securities. In this case, the notes are already highly liquid and thus similar to cash. More details are on the traded municipal note contract is given below. In October 2002, the CBOT began trading its 10-year municipal note index futures contract. (At ‘one time the CBOT traded on The Bond Buyer 40 Index, which included only 40 municipal bond issues.) The underlying for the contract is now up to 250 municipal bonds that are large and liquid sus. ‘Candidates for inclusion in this broad-based index of the municipal bond market must satisfy the following conditions: (i) rated AAA by both S&P and Moody's; (ii) a principal size of at least $50 million and is a component of an issue that has a deal size of at least $200 million; (iii) has a remaining maturity between 10 years and 40 years; (iv) has an issue price of at least 90; and, (v) the coupon rate must be at least 3% and no greater than 9%. ‘An issue can be callable or noncallable. If an issue is callable, the first call date must be at least seven years from inclusion in the index. Insured bonds can be included in the index. The index is priced once a day by a well-known pricing service, FT Interactive. The contract is a cash settlement contract, That is, no securities are delivered. 16. A manager wishes to hedge a bond with a par value of $20 million by selling Treasury bond futures. Suppose that (1) the conversion factor for the cheapest-to-deliver issue is 0.91, (2) the price value of a basis point of the cheapest-to-deliver issue at the settlement date is 0.06895, and (3) the price value of a basis point of the bond to be hedged is 0.05954. Answer the below questions, (@) What is the hedge ratio? Assuming a fixed yield spread between the bond to be hedged and the cheapest-to-deliver issue, the hedge ratio can be written as: hedge ratio = (PVBP of bond to be hedged / PVBP of CTD\conversion factor for CTD). Inserting in our given numbers, we have: hedge ratio = (0.05954/0.06895)(0.9 = (0,8635242\0.91) = 0.7858071 or about 0.79. (b) How many Treasury bond futures contracts should be sold to hedge the bond? Given the hedge ratio in part (a) of 0.7858071, the number of contracts that must be short is determined as follows: number of contracts = (hedge ratio)(par value to be hedged / par value of contact). 431Because the amount to be hedged is $20 million and each Treasury bond futures contract is for $100,000, this means that the number of futures contracts that must be sold is: number of contracts = (hedge ratio)($20,000,000 / $100,000) = 0.785807 1(200) = 157.16142 or about 157 contracts. 17, Suppose that a manager wants to reduce the duration of a portfolio. Explain how this can be done using Treasury bond futures contracts. Interest-rate futures can be used to alter the interest-rate sensitivity of a portfolio. Money ‘managers with strong expectations about the direction of the future course of interest rates will adjust the durations of their portfolios so as to capitalize on their expectations. Specifically, if a ‘manager expects rates to increase, the duration will be shortened (s0 as to avoid locking in relatively lower rates for the longer haul); if interest rates are expected to decrease, the duration will be lengthened (so as to lock in relative higher rates for the longer haul). Although money managers can alter the durations of their portfolios with cash market instruments, a quick and inexpensive means for doing so (on either a temporary or permanent basis) is to use furures contracts. In addition to adjusting a portfolio based on anticipated interest-rate movements, futures contracts ‘can be used in constructing a portfolio with a longer duration than is available with cash market securities. As an example of the latter, suppose that in a certain interest-rate environment a pension fund manager must structure a portfolio to have a duration of 20 years to accomplish a particular investment objective. Bonds with such a long duration may not be available. By buying the appropriate number and kind of interest-rate futures contracts, a pension fund manager can increase the portfolio’s duration to the target level of 20. ‘A formula to approximate the number of futures contracts necessary to adjust the portfolio duration to a new level is: approximate number of contracts Pr PDP here Dy= target D;Pe effective duration for the portfolio; P; = initial effective duration for the futures contact; and, Pp = market Notice that if the money manager wishes to increase the duration, D; will be greater than D;, and the equation will have a positive sign. This means that futures contracts will be purchased. The opposite is true if the objective is to shorten the portfolio duration. To determine the approximate number of interest-rate futures contracts needed to change the market value of the portfolio allocated to bonds, assuming that the duration of the portfolio is to remain constant, we can use the formula (Pe -P)D, approximate number of contracts = DP, where Pris the target market value allocated to bonds and the other terms are the same as in the formula given eatlier to approximate the number of contracts to adjust a portfolio’s duration. ‘Notice that if the market value of the portfolio allocated to bonds is to be increased, the numerator 432|hedge is to use gains or losses from a futures position to offset any difference between the target sale price and the actual sale price of the asset. Accordingly, the hedge ratio is chosen with the intention of matching the volatility (ie., the dollar change) of the futures contract to the volatility of the asset. Consequently, the hedge ratio is given by hedge ratio = volatility of bond to be hedged / volatility of hedging instrument. ‘This equation shows that if the bond to be hedged is more volatile than the hedging instrument, more of the hedging instrument will be needed. Although it might be fairly clear why volatility isthe key variable in determining the hedge ratio, volatility has many definitions. For hedging purposes we are concerned with volatility in absolute dollar terms. To calculate the dollar volatility of a bond, one must know the precise point in time that volatility is to be calculated (because volatility generally declines as a bond seasons) as well {as the price or yield at which to calculate volatility (because higher yields generally reduce dollar volatility for a given yield change). The relevant point in the life of the bond for calculating volatility isthe point at which the hedge will be lifted. Volatility at any other point is essentially irrelevant because the goal is to lock in a price or rate only on that particular day. Similarly, the relevant yield at which to calculate volatility initially isthe target yield. Consequently, the “volatility of the bond to be hedged” referred to in above equation is the price value of a basis point for the bond on the date the hedge is expected to be delivered. 22. You work for a conservative investment management firm. You recently asked one of the senior partners for permission to open up a futures account so that you could trade interest-rate futures as well as cash instruments. He replied, “Are you crazy? I might as well write you a ccheck, wish you good luck, and put you on a bus to Las Vegas. The futures markets are nothing ‘more than a respectable game of craps. Don't you think you're taking enough risk trading bonds?" How would you try to persuade the senior partner to allow you to use futures? A primary purpose of using futures is to reduce price risk and not necessarily create more risk. Also, as a form of insurance, itis relatively cheap. More details are given below. When a position is taken in a futures contract to hedge an asset, the hedger is attempting to offset any loss in the asset through changing interest rates. This is a risk reducing strategy. Furthermore the cost for most parties is relatively cheap compared to other alternatives, For example, the party need not put up the entire amount of the investment. Instead, only initial margin must be put up. If Bob has $100 and wants to invest in bond XZ because he believes its price will appreciate as a result of a decline in interest rates, he can buy one bond if bond XYZ is selling for $100. If the exchange where the futures contract for bond XYZ is traded requires an initial margin of $5, ‘however, Bob can purchase 20 contracts with his $100 investment. (This example ignores the fact that Bob may need funds for variation margin.) His payoff will then depend on the price action of 20 XYZ bonds, and not on the one bond he could buy with $100. Thus he can leverage the use of his funds. Although the degree of leverage available in the futures market varies from contract to contract, the leverage attainable is considerably greater than in the cash market. Without the leverage possible in futures transactions, the cost of reducing price risk using futures would be too high for many market participants. 435