Interest rate futures

Susan Thomas
http://www.igidr.ac.in/˜susant

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The futures market
A financial contract where settlement of a transaction
happens at a future date while all other financial aspects
of the transaction is fixed today.
Anonymous trading, exchange, price-time priority,
Standardised contracts,
Novation at clearing corporation.

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A gold futures market
We agree on a price of Rs.5000 today, expiration =
31 Dec 2003.
On 31 Dec 2003, I must come to you with Rs.5000.
You must deliver me 1 tola of gold.
Here F = 5000, “the futures price”.

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Cash settlement versus physical set-
tlement
On expiration date, suppose the price of gold is
Rs.6000.
So when you have to give me a tola at Rs.5000 (the
futures price contracted long ago), you lose Rs.1000.
Why not just have you give me Rs.1000 and we call
it quits?
“Cash settlement”.

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Basics of interest rate futures

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Interest rate futures
1. The maturity: one to three month contracts.
2. The underlying: Two underlyings – the 10 year
notional ZC bond, the 90-day notional Tbill.
3. The mode of settlement: cash settlement w.r.t. the
price of the notional bonds prevailing on expiration
date.

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Market lot
The 10-year ZC bond tends to be roughly Rs.50
So to get to Rs.200,000 of notional value, we need a
market lot of roughly 4000 bonds.

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Price time-series of the notional 10
year bond

45

40
Bond price (Rs.)

35

30

25

Jul 2001 Jan 2002 Jul 2002 Jan 2003

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Year
Speculation

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Make forecasts about the 10 year rate
Do you have views about what will happen to the
long rate?
Note: The 10-year futures market is a pure play on
the 10-year rate alone (no intervening coupons, no
other noise).

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Example 1: January 2003
On 1/1/2003, the notional 10-year bond (from
ZCYC) was Rs.45.43.
You believe the long rate will go up, so you short
three futures contracts (12,000 bonds) @ Rs.49.
On 31/1/2003, the notional 10-year bond is at Rs.39.
You have a profit of Rs.10/bond or Rs.120,000
overall.

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Example 2: January 1998
On 9 January 1998, the notional 10-year bond was at
Rs.32.
The 31/1/1998 futures were trading at Rs.33.
You thought interest rates would go down, so you
purchased two futures contracts (8000 bonds) @
Rs.33.
Interest rates went up!
On expiration, the notional bond was at Rs.21.4.
A loss of Rs.92,800.

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Arbitrage

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A locked-in position
The futures contract expires in 30 days.
30 days from now, the seller is obligated to deliver a
90-day tbill.
So:
1. Buy a ZC bond with 120 days to expiry
2. Short the 90 day futures with 30 days to
expiration
This is a locked in position!
This is cash and carry arbitrage.

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Returns on lending money into the
market
To implement the cash and carry arbitrage, I spend
100
S=
(1 + r120/365 )120/365
On expiration date, I deliver the bond and get the
futures price F .
In this transaction, I get a return of F/S over 30
days.
Therefore, I would do this cash and carry arbitrage
only if F > S(1 + r30/365 )30/365 .

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Reverse cash and carry
1. Get S by selling 120 day bond
2. Invest it into a 30-day tbill, gives S(1 + r30/365 )30/365
on futures expiration.
3. Buy 90-day futures @ F .
4. On expiration date, I’m left with
S(1 + r30/365 )30/365 − F in hand.

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When is reverse cash and carry
worth doing?
On futures expiration date, I end up holding a
90-day bond, which is exactly where I’d have been if
I had not done the transactions at all.
This is worth doing if I’m left holding cash in hand.
That is, if S(1 + r30/365 )30/365 > F
Lack of securities lending; limited only to people
who have a 120 day bond.

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As with all arbitrage,
These strategies are completely riskless.
Our approach is: To present strategies and their rates
of return.
Different economic agents in India find different
rates of return attractive.

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Pricing futures through arbitrage
We said that the cash and carry arbitrage would be
worth doing when F > S(1 + r30/365 )30/365 .
Reverse cash and carry arbitrage would be worth
doing if F < S(1 + r30/365 )30/365 .
We get the “fair price” of the futures contract when
there is no arbitrage, ie,

F = S(1 + r30/365 )30/365

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The fair price of interest rate futures

S = 100/(1 + r120/365 )120/365

F = 100(1 + r30/365 )30/365 /(1 + r120,365 )90/365
= 100/(1 + r120,365 )120/365 /(1 + r30/365 )30/365
= 100/(1 + f30,120 )90/365
The “fair price” of the futures contract is the forward rate
from the ZCYC!

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Hedging

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Duration
Make a weighted average of all the ti ,
Where the weight for cashflow i is proportional to
it’s importance in the NPV of the bond.
Weightage of cashflow i:
1 ci
wi =
NPV (1 + z(ti ))ti
Duration: X
D= wi ti

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Proof of why duration works
The sensitivity of a bond’s PV to a parallel shift λ of
ZCYC:
X
N
P (λ) = ci e−(ri +λ)ti
i=0

∂P (λ) X
N
= − ti ci e−ri ti
∂λ i=0
1 ∂P (λ)
= −DFW
P (0) ∂λ
P
where DFW = ( ti ci e−ri ti )/PV.
This is Fisher-Weil duration. Interest rate futures – p. 23/31
Duration is a first order taylor ap-
proximation
For small shocks λ it gives a reasonable prediction
of what will happen to PV.

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Hedging your portfolio
If you had a 10-year ZC bond and wanted to protect
yourself, it would be easy: short the 10-year futures.
In general, your portfolio has duration D, which is
not 10.

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More general approach
Your portfolio has duration D.
Calculate how many rupees will you lose for a 1bps
rise in the yield curve?
Find the futures position that closely offsets that
loss.

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Example
I have Rs.100 crore with duration 11 years.
A 1 bps rise in the yield curve hits me by Rs.11 lakh.
What is the futures position which gains Rs.11 lakh
if the yield curve moves up by 1 bps?
Short Rs.110 crore of the futures.

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Warning
Warning 1: We have only captured the parallel shift
of the yield curve.
Warning 2: As the yield curve keeps fluctuating, you
need to recompute whether you are still on the
correct hedge.

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Metadata

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Also see
Web page on Indian fixed income:
http://www.mayin.org/~ajayshah/FIXEDINCOME/index.html

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The end.

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