Chapter 8: The Structure of Forwards &

Futures Markets

KEY CONCEPTS

Explanations of the Basics of Forward and

Futures Contracts

ore E!"# is ore Beautiful

Ter$s and Conditions of Futures Contracts

ar%ins& 'ail( Settle$ents& Price #i$its and

'eli)er(

Futures Traders and Tradin% St(les

*eadin% Price +uotes

Futures Contracts

Chica%o Board of Trade ,CBOT-

.rains& Treasur( /ond futures

Chica%o ercantile Exchan%e ,CE-

Forei%n currencies& Stoc0 "ndex futures& li)estoc0

futures& Eurodollar futures

New Yor0 ercantile Exchan%e ,NYE1-

Crude oil& %asoline& heatin% oil futures

'e)elop$ent of new contracts

Futures exchan%es loo0 to de)elop new contracts that

will %enerate si%nificant tradin% )olu$e
Futures
f
2
3422& f
4
3 425& f
6
3 427& f
8
3 442
f
2
3422
f
4
3 425
f
6
3 427
f
8
3 442
95
:6 9;
#on% Futures Paid :4429;:695 3 :422 3 :f
2

to .et One <nderl(in% =sset
"n ar%in
=ccount
Contract>s Ter$s? ,see p@ 6A2:6A6-
4@ SiBe ,see p@ 6A4-
6@ .rade& +uotation <nit
7@ 'eli)er( onths& 7&A&C&46
7
rd
Frida( is the #ast Tradin% da(
8@ ini$u$ Price Chan%e ,e@%@& 4D76 of 4 E& ex@ @2227465x
F422&222 3 F74@65 for T:Bond Futures-
5@ 'eli)er( Ter$s? 'eli)er( date,s-& 'eli)er( Procedure&
Expiration onths& Final Tradin% 'a(& First 'eli)er( da(
,see p@ 6A4:6A6-
A@ 'ail( Price #i$its G Tradin% Halts ,see p@ 6A6-
;@ ar%in
Futures Traders:Commission Brokers & Locals

Hed%er& Speculator& Spreader ,#on% One G Short

One-& =r/itra%eur@ I /( Tradin% Strate%(J

Tradin% St(les ,TechniKues-?

Scalper? Holds a Few inutes

'a( TraderL Hold No ore Than The Tradin%

'a(

Position Trader
Cost of Seats Fi% 4,p@6AA-& Seat can /e leased
$onthl( M4E:4@5Eof Seat price@ CBT has 4826
Full $e$/ers& G N e$/erships ,p@6AA-
Forward Market Traders: Banks & Firms
(Co. !n"estment Bankers etc.#
$rder (same as options#

Stop #oss Order

#i$it Orders

.ood:Till:Canceled

'a( Orders@
Tradin% &rocedure? ,see Fi%@ 6& p@ 6;2-
Bu'er
Bu'ers
Broker
Bu'ers Brokers(
Commission Broker
)*chan%e
(Trade#
Clearin%house
(+ecord#
ar%in
ar%in
Mar%in: (p. ,-./,-, Ta0le ,#
=?"nitial ar%in 3 $ 9 7d ,$ 3 the a)era%e of the dail(
a/solute chan%es in the dollar )alue of a futures contract&
d 3 the standard de)iation& $easured o)er so$e ti$e
period in the recent past-@

"nitial $ar%in is used to co)er all li0el( chan%es in the

)alue of a futures contract@
B? aintenance ar%in?

EKuit( position $ust /e O aintenance $ar%in or %et a

$ar%in call $ust deposit new F ,i@e@& "ariation
mar%in- up to " /efore the $ar0et opens on the next
tradin% da(@
Ex@ p@ 6;6

Open "nterest?

'eli)er( G Cash Settle$ent,p@ 6;6-

Futures Price +uotation ,see p@6;4& 6;8:6;5-

T:Bond? F422&222 ,face !alue in CBT-& F52&222 ,Face
!alue in CE-& Future Price 3,4D76- ExFace !alue& Ex@
426 7D76 is F426&2C7@;5 in CBT

T:Bill? futures price per F422 3 422 : ,422:" "ndex-x

,C2D7A2-& Face )alue 3 F4 & Ex@ 'ec@ C8@C5 /( "&
the =ctual futures price 3 I422:,422:C8@C5-,C2D7A2-J
xF4D4223 FCP;&7;5 ,will /e used Chapters 44-

Note? " Kuotes /ased on a C2:da( T:/ill wD7A2:da(

(ear@

F4 Face !alue& "nterest *ate "s 'iscount *ate

@
4@ #ast Tradin% 'ate?The Business 'a( Prior to the 'ate
of "ssue of T:/ills in the Third wee0 of the onth
6@'eli)er( 'a(? a- =n( Business 'a( =fter the #ast
Tradin% 'ate ,'urin% the Expiration onth-
@/- First Business 'a( of onth& c- Cash settle$ent
8@"f Seller elects to 'eli)er a C4 or C6 da(s T:Bill& then
*eplace C2 /( C4 or C6 in the For$ula in p@ 7;7& f 3 422
: ,422:" "ndex-,C2D7A2-
T/Bond Futures: Based on 81 Coupon & 23 4rs5
Maturit' T/Bond (Face 6alue 72.....#

+uoted in 'ollar G 4D76 of par )alue of F422@

Ex@ 444:4; is 444 4;D76 3 444@57465& or
F444&574@65
Expiration? arch& Qune& Sept& 'ec@

#ast tradin% 'a(? the Business 'a( Prior to the

#ast se)en da(s of the expiration $onth@

The First 'eli)er( 'a( 3 The First Business 'a(

of the onth

T:Notes Futures? Sa$e =s T:Bond Except the

$aturit( wD6 & 5 and 42 (ears T:Notes
$ther Futures

=%ricultural Co$$odit( Futures

Stoc0 "ndices Futures

Natural *esources Futures

iscellaneous Co$$odities Futures

Forei%n Currenc( Futures ,Euro R& S& etc@-

T:Bills G EuroFs ,the $ost acti)e in <S- Futures

T:Notes G T:Bonds Futures

"ndex Futures ,i@e@& EKuities Futures-

ana%ed Futures? Futures Funds ,Co$$odit( Funds-&

Pri)ate Pools& SpecialiBed Contract

Hed%e Funds

Option on Futures
Transaction Cost: Co$$ission& Bid:=s0 Spread& 'eli)er(
Cost
+e%ulation of Futures Markets
Chapter 8: &inciples of Forward & Futures
&ricin%

KEY CONCEPTS

'ifference Between Price and !alue of

Forward and Futures Contracts

*ationale for a 'ifference Between Forward

and Futures Prices

Cost of Carr( Futures Pricin% odel

Con)enience Yield& Bac0wardation and

Contan%o

*is0 Pre$iu$DContro)ers(

*ole of Coupon "nterestD'i)idends in Futures

Pricin%

Put:Call ForwardDFutures Parit(

Pricin% Options on Futures

Comparison of Forward and Futures Contracts

Forward Futures
Pri)ate contract /etween Traded on an exchan%e
two parties
Not standardiBed StandardiBed contract
<suall( one specified *an%e of deli)er( dates
deli)er( date
Settled at end of contract Settled dail(
'eli)er( or final cash Contract usuall( closed out
settle$ent usuall( ta0es prior to $aturit(
place
Forward &rice & Futures &rice
Price )s@ !alue
"s Price 3 !alue True for Futures or ForwardsT =ns@ No&
wh(T
Price 3 !alue ,fro$ efficient $ar0et-
F 3 forward price toda(
f 3 futures price toda(
F
t
3 forward price written at ti$e t
f
t
3 futures price written at ti$e t
!
t
3 )alue at ti$e t of a forward contract written toda(
3 S
t
: F,49r-
:,T:t-
M ti$e t
Ex@ p@6C2& F3422&r342E& T385 da(s& after 62da(s&
S3426& the )alue of Forward wD65 da(s 3 426:
422,4@42-
:65D7A5
36@A5
T
t 2
f
f
t
F F
t

Note? ,E3F3S,49r-
T
M ti$e 2& p@ 6C2-
!alue of Futures M T 3 )
T
3 f
T
: S
T
2
!alue of Futures M t 3 )
t
3 f
t
: f
t:4
,/efore $ar0ed:to:$0t-
G )
t
2 once $ar0ed:to:$0t
Forward "s. Futures &rices (p. ,8,/,83#
,The effect of dail( settle$ent on forward and
futures prices- ,if r is certain or uncorrelated to
f-
Exa$ple? ,= Two:Period odel-
=@ One da( prior to expiration , p@ 6C6-
Bu( a forward M F
t
and sell a future M f
t
The profit 3 ,:F
t
9f
T
- 9 ,f
t
: f
T
- 3 f
t
: F
t
2:in)est$ent G 2 ris0 M t 3O f
t
3 F
t
B@ Two da(s prior to expiration ,interest rate r is constant for
two periods& or uncorrelated to futures price- ,p@ 6C7-
Bu( a forward M F and sell ,49r-
:,T:t-
futures M f
=t ti$e t& the profit 3 ,f:f
t
-,49r-
:,T:t-
in)est in ris0:free
/onds@ This close the futures position@ Now& sell a new
futures M f
t
M T&
T
3 ,f
t
:f
T
- 9 I,f:f
t
-,49r-
:,T:t-
,49r-
,T:t-
J 9 ,f
T
:F-

3 f : F 3 2 , F2 in)est$ent G ris0:free-



f 9 (:# F if futures prices & interest rates are positi"el'
(ne%ati"el'# correlated (p. ,8;#
The )ffect of !ntermediate Cash Flows on Futures
&rice

#on% a Stoc0 S and Short a Futures at f
S S
T
9 '
T
2 f:f
T
3 f : S
T
S '
T
9f
S 3 ,'
T
9 f-,49r-
:T
Or f 3 S,49r-
T
: '
T
Ex@ S 3 F422& '
T
3 F6& r 3 AE& T 3 @65&

then f 3 422,4@2A-
@65
:6 3 FCC@8;

f 3 S,49r-
T
: '
t
,49r-
,T:t-


3 S,49r-
T
: '
T
3 Future Spot Price : F!,'- ,see p@6C5-

3 IS : P!,'-J,49r-
T
3 S 9

For Continuous 'i)idends? f 3 Se
,rc:-T
3 IS:P!,'-Je
rcT


3 S 9 ,where is the continuous di)idend (ield-& r
c
3
continuousl( co$pound ris0:free rate@
Ex4@ S 3 P5& 3 PE& r
c
3 42E& T 3 C2 da( 3
2@68A5;5(r& f 3 P5e
,2@4:@2P-2@68A5;5
Ex6@ S
.
<3. T<=.>?=3 r
c
<81 @<=1
f
.
<S
.
e
(..8/..=#=.>?=3
<;8.8, (p. ,8-#.
6
t
(.T#<S
t
/A
tT
/F(2Br#
/(T/t#
for the "alue of Forward
6
t
(.T#<S
t
e
:,T:t-

CFe
rc,T:t-

for continuous.
&6 of continuous A is S
t
,4:e
:,T:t-

#
"nterest *ate Parit(? F3S,49r-
T
D,49U-
T

S3Spot Exchan%e *ateDF

U 3*is0:Free *ate in <S

r3Forei%n *is0:Free *ate

F3Forward Exchan%e *ateDF

F,49 U-F3FS,49r-

'eposit <SF in <SVs Ban0 <s Forward *ate to #oc0 in

and then Con)ert to Forei%n Currenc( 3 Con)ert in to
Forei%n Currenc( and 'eposit in Forei%n Ban0@ Exa$ple?
S3R2@;C2PDF& U 3 5@P8E& r37@5CE& T3C2D7A5&
F< D..-8.8(2..38;#
/8.>?=3
(2..?38#
8.>?=3
< D ..-8==

=r/itra%e Opp@ Exists "f Parit( is !iolated ,chapter 42-

49 U
49r
F
S
<S
<K
Commodities w>Stora%e Cost: f<S(2Br#
T
Bs ( p. ?..#
Spot &rices +isk &remiums & Cost of Car'
4@ *is0 Neutral?
=@ Bu( Now ,F- ,Paid-
,4- Spot Price& S
2
,6- Stora%e Cost& s
,7- "nterest Fore%one& iS
2
B@ Bu( #ater?,Paid-
,4- Expected Future Spot Price E,S
T
-@
"n EKuili/riu$& = 3 B& or
S
2
9 s 9 iS
2
3 E,S
T
-& "@e@&
S
2
3E,S
T
-:s:iS
2
,see p@724-
6@ *is0 =)ersion?,in ter$s of F-

=dd *is0 Pre$iu$ E,- to =@

S
2
9 s 9 iS
2
9 E,- 3 E,S
T
-
S
2
3E,S
T
- :s : iS
2
: E,-
Cost of Carr( s 9 iS
2
3 W

<nder no $ar%in& $ar0:to:the:$ar0et etc@
"n Spot ar0et ? S
2
3 E,S
T
- : : E,- &
where& 3 Cost of Carr( 3 s,Stora%e cost- 9 iS
2
,Opp@ Cost
of one(-& E,- 3 *is0 Pre$iu$,"nsurance-
The Cost of Carr' Futures &ricin% Model
(Theoretical Fair &rice# (p.?.,#

Consider /u( a spot co$$odit( M S and sell a futures
contract M f@ =t ti$e T& Closin% /oth position and the
profit is
,S
T
:S
2
:s:iS
2
- 9 ,f : S
T
- 3 3 f:S
2
: ,ris0:free- 3 2 T

Futures Price 3 Spot Price 9 Cost of Carr(

Euasi Fr0itra%e? =sset owner sell his =sset and
Bu( a Futures if f X S9 to ta0e the =r/itra%e Opp@

=r/itra%e Opp@ Exists if f S9
'efinition? Basis Cash price S : Futures Price f

4@ "f Futures Prices f X Cash Spot Prices S 3O
Bac0wardation ,or "n)erted- ar0et

6@ "f futures Prices f O Cash Prices S3O Contan%o ar0et

7@ Con)enience Yield c? f 3 S 9 : c
*is0 Pre$iu$ Contro)ers( ,$ixed in e$pirical
studies-
4@ f 3 E,S
T
- INo *is0 Pre$iu$J

6@ f X E,f
T
- 3 E,S
T
- 3 S 9 9 E,- 3 f 9 E,-

Exa$ple@ p@ 72C
Nor$al Contan%o? E,S
T
- X f
Nor$al Bac0wardation? f X E,S
T
-
Put:Call ForwardDFutures Parit(

*elationship /etween the prices of Put& Call& and

Futures on =sset ,i@e& Options G Futures Expire on
the Sa$e Ti$e? = Special Case-

P3C:S9P!,E- P:C:P on Spot Option

P3C9P!,E-:P!,f- P:C:Forward Parit(

Or

P,S&E&T-3C,S&E&T-9P!,E:f-

Spot Price M T )s@ Exercise Price E for Options on

the Spot
Put:Call:Futures Parit(
T<. GT
S
T
: )
GT
S
T
9)
Sell a Futures
But a Put
2
P,S&T& E-
S
T
:f
E:S
T
S
T
:f
2
Bu( a Call
'eposit P!,E:f-
C,S&T&E-
P!,E:f-
2
E:f
S
T
:E
E:f
P3C9P!,E:f- E:f S
T
:f
$ption on the Futures

Basic Characteristics of Options on Futures

"ntrinsic !alues& #ower Bounds G Put:Call

Parit( of Options on Futures

Yh( Both Calls G Puts i%ht Be Exercised

Earl(

Blac0 G Bino$ial Option on Futures Pricin%

odels

Tradin% Strate%ies for Options on Futures

'ifference Between Options on the Spot G

Options on Futures
Options on Futures? Hnderl'in% Fsset is Futures
To %i)e the /u(er the ri%ht to /u( ,or sell- a futures
contract M a fixed price ,E- up to a specified
expiration date ,Option expiration 'ate T-@
,Co$$odit( Options or Futures Option-
Call G Put Options
"ntrinsic !alue of an =$erican Option on Futures

3 ax,2&f:E- for Call@

3 ax,2&E:f- for Put@

Ex@
$ptions $n Futures

Call Option On Futures

C,f& T&E-3"!9T!
"!
C
3ax,2& f
t
:E- for Call at ti$e t&
"!
P
3ax,2& E:f
t
- for Put at ti$e t

#ower Bound for =$erican G European Options ,see P@

744 G746-

Ex @ See p@747

Bu( ,in =pril- a Qul( call futures on .old,422 ounces- wDE3

F4222@ )*ercise 'ecision in a( 5? "f Qul( %old futures
price is F4282 and the $ost recent settle$ent price,i@e@& the
last tradin% futures price on a( 8-3F427P@ The "n)estor
recei)e a lon% .old Futures Contract 9 a Cash of F7&P22
Ii@e@& ,427P:4222-x422J@ "f "n)estor 'ecides to close out the
lon% futures for a %ain of ,4282:427P-x4223F622@ Total
Pa(off fro$ the 'ecision of )*ercise is F8&222@ ,f
t
:
E-x4223F8&222 ,So Called The Effecti)e Pa(off-
&ut/Call &arit'
C
e
,f&T&E- 3 P
e
,f&T&E- 9 ,f:E-,49r-
:T
Ex@ P
e
,f&T&E- 3 ;@85& f 3 762& E3745& r 3 5@8AE& T 3 @65&
then C
e
,f&T&E- 3 ;@85 9 5,4@258A-
:@65
3 46@56

Exa$ple See p@74;

&ut/Call &arit' of $ption on Futures:
&
e
< C
e
B ()/f#(2Br#
/T
"s. &
e
< C
e
/S B )(2Br#
/T
P!
Bu( a Put P E: f
T
2
Bu( a Futures 2 f
T
:f f
T
:f
E:f f
T
:f
Bu( a Call C 2 f
T
:E
Bu( a Bond
wD P!,E:f- P!,E:f- E:f E:f
E:f f
T
:f
f
T
E f
T
E
Current 'ate
Expiration 'ate
Put:Call Parit( of Options on Futures?
&(fT)# < C(fT)#B&6()/f#

)*ercise of the option %i)es holder a position of

Futures Contract

)arl' )*ercise of Call & &ut $ptions on

FuturesI (Te*t0ook: &ossi0le for Both Call &
&ut p.?23#
BDS Option On Futures Pricin%
odel ,p@ 74C-
C,f&T&E-3P!IfN,d
4
-:EN,d
6
-J

Yhere
d
4
3 ln,fDE-9Z
6
TD6
Z [T
d
6
3 d
4
: Z [T

Z 3 the )olatilit( of the futures price

Black $ption on Futures &ricin% Model
C,f&T&
6
&E& r- 3 e
:rcT
IfN,d
4
- : EN,d
6
-J
where& d
4
3 Iln,fDE- 9 @5
6
TJDZT
d
6
3 d
4
:Z

Ex
Chapter 2.: Futures Fr0itra%e Strate%ies

KEY CONCEPTS

Cash and Carr( =r/itra%e

"$plied *epo *ate

'eli)er( Option "$/edded in the T:Bond Futures

Contracts

*ationale for Spread Strate%ies

Stoc0 "ndex Futures =r/itra%e and Pro%ra$ Tradin%

Short/term !nterest +ate Futures
Strate%ies

T:Bill Cash G Carr(D"$plied *epo

"$plied *epo *ate r fDS : 4 3 DS &If : S 3 J

r3,fDS-
4Dt
:4 3 the return i$plied /( the cost of carr(
relationship /etween spot G futures prices
Sell a Futures Contracts f:S
T
Bu( a Spot S
T
Borrow S ,use Spot as :S,49r-
Collateral-
Net Cash 2 f:S,49r-32
r is the repo
+epo is an insured loan
*epo? Federal Funds Futures Carr( =r/itra%e
Federal Funds futures contract siBe? F5
+uote? at 422:,dail( o)erni%ht rate-
7D4
8D4
#"BO*
4
35@5E& #"BO*
6
3AE
=pril f3C7@;5@ Borrow P!3
5 M4 $onth and lend all
F M 6 $onths #"BO*
Sell one =pril futures
MC7@;5
*epa( /orrowin% F5
Bu( a futures to closed out
P!,5-3F8&C;;&4P;@PC
#oan Balance on 5D43P!,5-,49AE,A2D7A2--3F5&26A&C5C@;;
=ssu$e 4:$onth #"BO*3;@65E on 8D4& P! of #B
6
on 8D4 is
#B6D,49;@65E,72D7A2--3F8&CCA&;;2@C8@ <nder no /asis ris0 ,so
Futures price on 8D4 is 422:;@653C6@;5@ The %ain fro$ futures is
F8&4AA@A;3,C7@;5:C6@;5-x5,72D7A2-D422@ *epo is
I,F8&CC&;;2@C898&4AA@A;-DF,P!,5--:4J7A2D723 3.-?193.3.1
T:Bill and EuroF Futures Price
'eter$ination

T:Bill? f utures price per F422 3 422 : ,422:"

"ndex-x ,C2D7A2-& Face )alue 3 F4 & Ex@ 'ec@
C8@C5 /( "& the =ctual futures price 3 I422:
,422:C8@C5-,C2D7A2-J xF4D4223 FCP;&7;5

Note? " Kuotes /ased on a C2:da( T:/ill

wD7A2:da( (ear@

F4 Face !alue& "nterest *ate "s 'iscount *ate

)uro7 Futures: 72MM Face 6alue Based on L!B$+

"nterest *ate of EuroF is Called #"BO*

Note? T:/ill is a discount instru$ent& and EuroF is an

add:on instru$ent@
Ex@ 42E Kuote rate on T:/ill G EuroF ,Spot Market-
Pa( 422:42,C2D7A2-3C;@5 G %et 422 par in C2 da(s
Yield 3 ,422DC;@5-
7A5DC2
:4 3 42@P4E for T:/ill@
Pa( C;@5 %et /ac0 C;@5,@4-,C2D7A5-36@88 interest 9 C;@5
principle
Yield 3 ,496@8DC;@5-
7A5DC2
:4 342@7AE for EuroF
)uro7 Futures &rice Same as T/0ill Futures &rice
Calculation

Futures price per F422 3 422 : ,422:" "ndex-x

,C2D7A2-& Face )alue 3 F4 & Ex@ 'ec@ C8@8A /(
"& the =ctual futures price 3 I422:,422:C8@8A-
,C2D7A2-J xF4D4223 FCPA&452

Note? " Kuotes /ased on a 7:$onth #"BO*

wD7A2:da( (ear@

Expiration $onths? arch& Qune& Sept& 'ec@

#ast Tradin% 'ate? Second #ondon Business 'a(

/efore the third Yed@ of the onth

First 'eli)er( 'a(? Cash Settled on #ast Tradin%

'a(@
)uro7 Fr0itra%e? ,Cost of Carr' relation is 6iolated
Between )uro7 Futures & Spot# (Ta0le , p. ??,#

E1? On CD4A& a #ondon /an0 needs either to issue F42

of 4P2 da( EuroF C' M P@;5 or to issue a C2:da( C' M
P@65 and sellin% a EuroF futures contract expirin% in 7
$onths of " index of C4@7;@ ,Ta/le 6& p@ 776-

"f 4P2:da( EuroFC' is issued& then paid F42&87;&522 3

F42I49@2P;5,4P2-D7A2J& or 8..-1

"f C2:da( C' is issued M P@65 and sell 42 EuroF futures M

C4@7;& then need to pa( 42 I49@2P65,C2D7A2-J on 46D4A
and %et 42\C;P&865 fro$ futures pa( 42\CP2&422 to close
the futures ,loss F4A&;52-@ The fir$ needs to issue F42
x,49 @2P65D8- 9 F4A&;52 3 F42&667&222 on 46DA and pa(s
F42&677&222 ,49@2;CAD8- 3 F42&86A&87P or 8.8;1 : 8..-1
S'nthetic 28./Aa' CA
Current 'ate? C2:
da( C' *ate P@65
!ssue C2 da( C'
for F42
" C4@7;D'ec
Sell 42 Futures
at FC;P&865 each
7 $onths return on C' ,..=,31
Owe 42,49P@65D8-
3F42&62A&652
New C2:da( C' *ate
;@CA@ "3 C6@283O
f3 CP@24@ !ssue new
C2:da( C' for
42&62A&652 9 ,C;P865:
CP2422-x42
4P2 'a(s
4P2:da( C' *ate P@;5@ $we F42,49P@;5x4P2D7A2-
or the cost of de/t 8..-1 9 8.8;1
$we
42&667&222x
,49;@CAD8-3
42&86A&87P
%et F42
the cost of
de/t 8.8;1
*eturn on futures ,.23-31
3I,422:C4@7;-D422JD8
Fnnual +eturn from 8./da' CA & Furures < 8.8;1
#on%:ter$ "nterest *ate ,T:Bond Futures-
=r/itra%e
Yhich 'ate G Yhich Bond to 'eli)er( in 'eli)er(
onthT aturit( ,of the /ond ti$e re$ainin% fro$
the 4st da( of deli)er( $onth to /ond $aturit( - G
Coupon *ate
Con)ersion Factor is F4 /ond wDcoupon G $aturit( 3
'eli)era/le /ond on Bond Futures Contract with AE
Coupon *ate
"n)oice Price 3 futures price x CF9="
Con"ersion Factor (see p. ?3?# :

Ex@ Find CF for deli)er( of the 5 2>, of =u%ust 45& 626P&

on the arch 622A T:/ond future contract ,for Short
arch futures contract-@ 'ecided to deli)er on 8D;D622A

On the arch ;& 622A the /ond>s re$ainin% life is 66 (rs& 5

$onths@ *oundin% down to 2 ,2&7&A&C-@
CF
2
3 ,@255D6-I4:4@27
:6\66
JD@27 9 4@27
:6\66
3 2@C7C7A8
CF
7
3CF
2
92@255D6-,4@27-
:2@5
:2@255D832@C7PC6C;4P

The "n)oice price 3 Settle$ent Price on position da( \ CF

9 =ccrued interest

"f the settle$ent price on arch ; is F446 and the =ccrued

interest 3 F727@P;& then "n)oice price 3 F446&222\2@C7PC
9 F727@P; 3 F425&8A2@A;

,For$ula for CF see p@757-

The cheapest:to:deli)er /ond& a$on% all deli)era/le /onds&

is the /ond that is $ost profita/le to deli"er. Note? profit is
$easured /(? IThe F! of net cash flow /( Sellin% a
futures G Bu'in% a Spot M ti$e t J ,see Ta/le 8& p@ 778:A-
f,CF- 9 ="
T
: I,B9="
t
-,49r-
T:t
: F! of Coupon at TJ&
where& ="
T
is the accrued interest on the /ond at T& the
deli)er( date& ="
t
is the accrued interest on the /ond at
ti$e t ,i@e@& toda(-& r 3 ris0:free rate& B 3 /ond price
)*ample:Ji"en Current date 2,>23 Aeli"er' Aate =>22
+epo +ate ,.=,1 Future &rice 22,.=3=,3
F: 2,.31 Coupon Mature on 8>23>.8 CF < 2.;.,,
6D45
PD45
47974972974972974945 34P4 da(s
6D45
8D45
AD44
4797494535C 4597494435;
="
t
3A@65x5CD4P436@28 on 8D45& ="
T
3A@65x,5C95;-D4P43 8@24
fro$ 6D45 to AD44@
Bond price is +uoted 4A2@465,as0 price-@ The "n)oice Price
3f,CF- 9 ="
T
3446@A5A65,4@8466-98@2432=2.88 on AD44
,B9="
t
-,49r-
T:t
3 ,4A2@46596@28-,4@26A6-
5;D7A5
32=,.8,
f,CF- 9 ="
T
: I,B9="
t
-,49r-
T:t
J32=2.88/2=,.8,< /.8;
)*ample: Continue
B: 8.2,31 Coupon Mature on 3>23>,2 CF < 2..2?-
B < 22=.,28-3 r < ,.=,1
44D45 5D45 AD44 8D45
72
da(s
6;da(s
4P8 'a(s
="
t
3 8@2A65,4P4:72-D4P43 7@7C on 8D45 fro$ 44D45 to 8D45
="
T
3 8@2A65,6;D4P8- 3 2@A2 on AD44 fro$ 5D45 to AD44
F!,8@2A65-38@2A65,4@26A6-
6;D7A5
38@2; on AD44 fro$ 5D45:AD44
f,CF- 9 ="
T
: I,B9="
t
-,49r-
T:t
: F! of Coupon at TJ 3
446@A5A65,4@247;-92@A : I,44A@64P;597@7C- ,4@26A6-
5;D7A5
:8@2;
3:4@66& 2,.31 Coupon is Cheapter/t/A Bond than 8.2,31
+ules (Aeterminin% the Euoted Futures &rice#

4@ Find the Cash Spot Price ,Cheapest:to:deli)er Bond-

fro$ +uoted Price

6@ Find Futures Price /ased on on f 3 IS:P!,'-Je

r,T:t-

7@ Find +uoted Futures Price fro$ the Cash Futures Price

8@ 'i)ide the +uoted Futures Price /( Con)ersion Factor to

=llow the difference Between the C:t:' Bond G 45Yrs PE
Coupon
Pa($ent
Current
Ti$e
Coupon
Pa($ent
aturit(
Of Futures
Coupon
Pa($en
t
A2
'a(s
466
'a(s
48P
'a(s
7A
'a(s
Suppose C:t:' T:Bond is 46E& Con)ersion Factor 4@8 G
Futures is 6;2 da(s to $ature& Coupon Pa( Se$iannual&
"nterest rate is 42E G Current +uoted Bond Price is F462
)*ample: Continue

4@ The Cash Price 3 +uoted Bond Price 9 =ccured "nterest

2,. B =*K=.>28.L < 2,2.8-8&
The P! ,FA- in 466 da(s ,2@7786 (r- 3 F5@P27
6@ The Futures Price for 6;2 da(s ,2@;7C; (r- is
(2,2.8-8 / 3.8.?#e
..-?8-*..2
< 2,3..8;
=t 'eli)er(& There are 48P 'a(s of =ccured "nterest& The
+uoted Futures Price <nder 46E Coupon is
7@ 2,3..8;/=*2;8>28? < 2,..,;,
The +uoted Futures Price under PE should /e
8@ 2,..,;,>2.; < 83.88-

$
Aeli"er' $ptions:
4@ Yild Card Option? if B
5
X f
7
\CF Inote? issue notice of
intention to deli)er at Cp$ to clearin%houseJ

6@+ualit( ,or Switchin%- Option?,switchin% to fa)ora/le B-

7@ The:end:of:the:$onth Option? ,sa$e as Yild Card

Option& there are ; Business 'a(s in the expiration $onth-

8@ Ti$in% Option,in one $onthL financin% cost )s coupon-

!mplied +epo>Cost of Carr' (T/B Futures#
f,CF- 9 ="
T
3 F recei)ed for 'eli)er(
3 F paid for Bond 9 Cost of Carr( 3 ,B9="-,49r-
T
r 3 I,f,CF- 9 ="
T
-D,B9="-J
4DT
: 4
!mplied +epo>Cost of Carr'

*epo
Bu( a Bond :,B9="- B
T
9="
T
Borrow B9=" :,B9="-,49r-
T
Sell a T:Bond Futures f,CF-9="
T
: ,B
T
9="
T
-
Net Cash Flow 2 f,CF-9="
T
:,B9="-,49r-
T

. !n"estment . risk r < K(f(CF#BF!
T
#>(BBF!#L
2>T

/2
Current 'ate Expiration 'ate
On 2,>,>.3& p@7CP@ .i)en B347A@46AC5&P@465E coupon
of $ature on 5D45D6264& 'eli)er on 7D;&=" 3@7P & CF34@62P7&
f3446& ="
T
36@54 3P@465,C5D7A5-& r 3 7@PCE& T3C5D7A5&
r3I,446,4@62P7-96@54-D,47A@46AC592@7P-J],7A5DC5-37@PE
44D45
46D6D25
C5 'a(s
7D;D2A 6D45
F
F
T/Bond Futures Spread: Lon% & Short a T/B Futures
w> Aifferent )*piration Aates

Ex@ to speculate r & if r will in short period then Sell a

shorter $aturit( futures G Bu' a lon%er $aturit( futures
T/Bond Futures Spread & the !mplied +epo +ate
t T
Bu(
Sell
M Ti$e t& .et T:Bond G Pa( f
t
,CF
t
-9="
t
&Finance B( *epo
*ate r@ M Ti$e T& 'eli)er T:Bond G .et f
T
,CF
T
-9="
T
@ 2
Net Cash Flow M Ti$e 2 G t G 2 ris0 at Ti$e T ,f
t

,CF
t
-
9="
t
-,49r-
T:t
3 f
T
,CF
T
-9="
T
& or
r3I,f
T
,CF
T
-9="
T
-D,f
t
,CF
t
-9="
t
-J
4D,T:t-
:4@ "f r forward rate&
then =r/itra%e Opportunit( Ii@e@ O)er,under-priced futuresJ
2
)*. (T/Bond Futures Spread> !mplied +epo +ate#
On 22>2?>.8& = ?>;s T:Bond aturin% on PD45D6A is the C:T:
' Bond& arch:Qune Spread G .i)en =" 3@82& CF

34@2;CP&
CF
Q
34@2;C6& f

344A& f
Q
3445& ="

3@75& ="
Q
36@4A
3O,i$plied repo rate fro$ 7D47:AD44-
r 3 I,445,4@2;C6-96@4A-D,44A,4@2;CP-9@82 -J
7A5DC2
:4 3 4@CC
E ,ex@ P@ 787-
44D47 7D47 AD44
'eli)er( 'ate
For arch futures
'eli)er( 'ate
for Qune
f

344A
f
Q
3445
Turtle Trade? "$plied *epo *ate on T/Bond Spread
)s@ "$plied *ate on Fed Funds Futures
Stock !nde* Futures Strate%ies

Stoc0 "ndex =r/itra%e?

when f 3 Se
,rc:-T
is !iolated

Then Bu' Low Sell Mi%h&

See Ex? p@ 788& G Ta/le 5

Pro%ra$ Tradin%

=t least F4 $0t

!alue G =t least 45

Stoc0s transaction
)*chan%e +ate Fr0itra%e: !nterest +ate &arit' is
6iolated
=ssu$e Forward price3futures price
"nterest *ate Parit(? f,49r
R
-3S,49r
F
-& or in Continuous:
ti$e f3Se
,rF:rR-T
Ex? S3R2@;C2PDF& r
F
35@P8E& r
R37@5C
E& T3C2D7A532@68AA
B( "nterest *ate Parit(&
f,4@25P8-32@;C2P,4@275C-& f3 R2@;PAADF
"f F^R2@;PAADF& the =r/itra%e Exists
Bu( #ow Sell Hi%h
This Fr0itra%e is called
Co"ered !nterest
Fr0itra%e
Chapter 22: Forward and Futures Med%in%
Spread and Tar%et Strate%ies

KEY CONCEPTS
Yh( Hed%e

Hed%in% concepts

Factors in)ol)ed when constructin% a

hed%e 'ifference Between a Short Hed%e
and a #on% Hed%e and Yhen to <se Each
=ppropriate Hed%in% Contract
to <se in a .i)en Situation
Opti$al Hed%e *atios
=nal(sis of Specific Hed%e
4ou will
Jet
+ich Euick
Yh( Hed%eT

The )alue of the fir$ $a( not /e independent of

financial decisions /ecause

Shareholders $i%ht /e unaware of the fir$Vs ris0s@

Shareholders $i%ht not /e a/le to identif( the correct nu$/er

of futures contracts necessar( to hed%e@

Shareholders $i%ht ha)e hi%her transaction costs of hed%in%

than the fir$@

There $a( /e tax ad)anta%es to a fir$ hed%in%@

Hed%in% reduces /an0ruptc( costs@

ana%ers $a( /e reducin% their own ris0@

Hed%in% $a( send a positi)e si%nal to creditors@

'ealers hed%e so as to $a0e a $ar0et in deri)ati)es@

Yh( Hed%eT ,continued-

*easons not to hed%e

Hed%in% can %i)e a $isleadin% i$pression of the

a$ount of ris0 reduced

Hed%in% eli$inates the opportunit( to ta0e

ad)anta%e of fa)ora/le $ar0et conditions

There is no such thin% as a hed%e@ =n( hed%e is an

act of ta0in% a position that an ad)erse $ar0et
$o)e$ent will occur@ This& itself& is a for$ of
speculation@
Hed%in% Concepts

Short Hed%e and #on% Hed%e

Short ,lon%- hed%e $eans to hed%e /( a short

,lon%- position in futures

Short hed%es can occur /ecause

The hed%er owns an asset and plans to sell it later@

The hed%er plans to issue a lia/ilit( later

#on% hed%es can occur /ecause

The hed%er plans to purchase an asset later@

The hed%er $a( /e short an asset@

=n anticipator( hed%e is a hed%e of a transaction

that is expected to occur in the future@

See Ta0le 22.2 p. ?38 for hed%in% situations@

The Basis
Basis 3 spot price : futures price@
Hed%in% and the Basis
,short hed%e- 3 S
T
: S
2
,fro$ spot $ar0et- : ,f
T
: f
2
-
,fro$ futures $ar0et-
,lon% hed%e- 3 :S
T
9 S
2
,fro$ spot $ar0et- 9 ,f
T
: f
2
-
,fro$ futures $ar0et-

"f hed%e is closed prior to expiration&

,short hed%e- 3 S
t
: S
2
: ,f
t
: f
2
-

,lon% hed%e- 3 :,S

t
: S
2
-9 f
t
: f
2
"f hed%e is held to expiration& 3S
2
f
2
@
Basis:
/
2
S : f ,initial /asis-
/
t
S
t
: f
t
,/asis M t-
/
T
S
T
: f
T
,/asis M expiration-

t
=(Short hed%e-3 /
t
: /
2
& "f Position closed out M
ti$e t@
&rofit from Med%e Strate%' ?

T
Profit of lon% spot and short future,i@e@&Short
Hed%e-
3 ,S
T
: S- 9 ,f : f
T
- 3 f : S 3 : /
2
,Bu( M S and
Sell M f-

T
,#on% Hed%e- 3 /
2

t T
Spot
futures
Spread
Exa$ple@
S 3 C5& f 3 C;& S
T
3 x&
T
,Short Hed%e- 3 F6 ,wh(T-

t
3 ,S
t
: S- 9 ,f : f
t
- 3 ,S
t
:f
t
- : ,S:f- 3 S:f 3 /
t
: /
2
@
0
t
: /
2
"s Stochastic
S O f Stren%thenin% Basis for Short Hed%er
S X f Yea0enin% /asis for Short Hed%er
"f closed out /efore expiration date at ti$e t
Mt& S
t
3 C6& f
t
3 C2& .i)en S 3 C5& f 3 C;&
then
t
,Short Hed%e- 3 ,C6:C2-:,C5:C;-
3 6:,:6-38

The Basis ,continued-

This is the chan%e in the /asis and illustrates the

principle of /asis ris0@

Hed%in% atte$pts to loc0 in the future price of an

asset toda(& which will /e f
2
9 ,S
t
: f
t
-:S
2
@

= perfect hed%e is practicall( non:existent@

Short hed%es /enefit fro$ a stren%thenin% /asis@

E)er(thin% we ha)e said here re)erses for a lon%

hed%e@

See Ta0le 22., p. ?=2 for hed%in% profita/ilit( and

the /asis@

The Basis ,continued- ,p@7A4-

Exa$ple? arch 72@ Spot %old F42P;@45@ Qune

futures F42PP@A2@ Bu( spot& sell futures@ Note?
/
2
3 42P;@45 : 42PP@A2 3 :4@85@ "f held to
expiration& profit should /e chan%e in /asis or
4@85@
=t expiration& let S
T
3 F442P@52@ Sell %old in
spot for F442P@52& a profit of 64@75@ Bu( /ac0
futures at F442P@52& a profit of :4C@C2@ Net
%ain 34@85 or F485 on 422 oB@ of %old@
Exa$ple? ,continued-
"nstead& close out prior to expiration when S
t

3 F42;;@56 and f
t
3 F42;P@A7@ Profit on spot
3 :C@A7@ Profit on futures 3 C@C;@ Net %ain
3 @78 or F78 on 422 oB@ Note that chan%e in
/asis was /
t
: /
2
or :4@44 : ,:4@85- 3 @78@
Beha)ior of the Basis@ See Fi%ure 2..2 p.
?=,@
Two risks e*ist in Med%e?

4@ Cross Hed%e ,co$$odit( is not the sa$e as the

underl(in% co$$odit( of futures-

6@ +uantit( *is0? SiBe

Contract Choice
*ule _4? Yhich futures co$$odit(T

One that is $ost hi%hl( correlated with spot

= contract that is fa)ora/l( priced

*ule _6? Yhich expirationT

The futures whose $aturit( is closest to /ut after the

hed%e ter$ination date su/`ect to the su%%estion not
to /e in the contract in its expiration $onth ,i@e@&
Expiration 'ate of Contract is O)er and Close to the
Hed%e Ter$ination 'ate-

See Ta0le 2..? p. ?=; for exa$ple of reco$$ended

contracts for T:/ond hed%e

Concept of rollin% the hed%e forward

Contract Choice ,continued-

*ule _7? #on% or shortT

= critical decisiona No roo$ for $ista0es@

"f Positi)e Correlated 3O One #on% and One

Short & "f Ne%ati)e Correlated 3O Both are
#on% or Short

Three $ethods to answer the Kuestion@

,See Ta0le 2..; p. ?=?#
a- worst case scenario $ethod
/- current spot position $ethod
c- anticipated future spot transaction $ethod
ar%in *eKuire$ents and ar0in% to ar0et
low $ar%in reKuire$ents on futures& /ut cash will
/e reKuired for $ar%in calls
'eter$ination of the Hed%e *atio

Hed%e ratio? The nu$/er of futures contracts to

hed%e a particular exposure

Nab)e hed%e ratio ,Spot asset )alueDfutures price-

=ppropriate Nab)e hed%e ratio N
f
should /e
such that so$e %oal can achie)e
Portfolio consists of a lon% S and N
f
of Futures
,H3S9 N
f
f & )s@ H3hS:C in Option--
3 S 9 N
f
f 3 2 3O N
f
3 :SDf
Note that this ratio N
f
3 : SDf $ust /e
esti$ated@
Med%e +atios

F. Minimum 6ariance Med%e +atio

B. &rice Sensiti"it' Med%e +atio

C. Stock !nde* Futures Med%e


F. Minimum 6ariance Med%e +atio
(p.?=8#
N&rofit from short hed%e N 3 S 9 fN
f
!ariance of Profit
6

<
6
S
B N
6
f

6
f
9 6N
f

Sf

ini$iBin%
6

3O N
f
3 :
Sf
D
6
f
3 : in the
re%ression of S on f

Effecti)eness of Hed%e
e\ 3 ,
6
S
:
6

-D
6
S
3 N
6
f

6
f
D
6
S
Consider? S 3 9 f 9 & Then
The Effecti)eness of the ini$u$ !ariance
Hed%e
e\ 3 ,
6
S
:
6

-D
6
S
3 *
6
3 The Coefficient of
'eter$ination in The *e%ression =nal(sis@
F. Minimum 6ariance Med%e +atio (continued#

Hed%in% effecti)eness is
e
\
3 ,ris0 of unhed%ed position : ris0 of hed%ed
position-Dris0 of unhed%ed position
This is coefficient of deter$ination fro$ re%ression@
B. &rice Sensiti"it' Med%e +atio
H/r 3 S/r +
f
f/r& Portfolio H 3 S 9
f
f
3 ,S/(
s
)((
s
/r) + f(f/(
f
)((
f
/r) 3 2
3O N
f
3 : ,S/(
s
)D,f/(
f
- if (
s
/r = (
f
/r
or
N
f
3 : ,SD(
s
-D,fD(
f
-
"n Ter$s of 'uration
'
s
3 :I,SDS-,49(
s
-JD(
s
N
f
3 : I'
s
SD,49(
s
-JDI'
f
fD,49(
f
-J
&rice Sensiti"it' Med%e +atio

This applies to hed%es of interest sensiti)e

securities ,e@%@&T:Bond& T:Notes-@

First we introduce the concept of duration@

Ye start with a /ond priced at B?
where CP
t
is the cash pa($ent at ti$e t and
( is the (ield ,"**-& or discount rate@

4E 3 422 /ase points

=
+
=
T
4 t
t
t
(- ,4
CP
B

'uration 3 ' 3 Yei%hted =)era%e aturit( of
Bond

' 3 :,BDB-DI(D,49(-J

BDB :'I(D,49(Dn-J& n 3 _ of "nterest
Pa($entD(r
)*ample: Ji"en
B 3 P!,c
i
- 9 P!,P-
' 3 iIP!,c
i
-JDB& 7 (ears 42E Coupon Bond wDface
!alue F422& (3 46E& paid se$iannual?
Ti$e Pa($ent P!,c
i
- Yei%ht Ti$e x Yei%ht
2@5 5 8@;4; 2@28CA 2@268P
4@2 5 8@852 2@28AP 2@28AP
4@5 5 8@4CP 2@2886 2@2AA7
6@2 5 7@CA2 2@284A 2@2P76
6@5 5 7@;7A 2@27C7 2@2CP7
7@2 425 ;8@264 2@;;P5 6@7755
Total 472 83..8, 2..... ,.=3;8< A
&rice Sensiti"it' Med%e +atio (continued#
=n approxi$ation to the chan%e in price for a (ield
chan%e is
with '<*
B
/ein% the /ondVs duration& which is a
wei%hted:a)era%e of the ti$es to each cash pa($ent
date on the /ond& and represents the chan%e in the
/ond price or (ield@
'uration has $an( wea0nesses /ut is widel( used as a
$easure of the sensiti)it( of a /ondVs price to its (ield@
Modified Auration MA:
'3 '<*D,49(-
( 4
(- , '<*
B B
B
+

=
&rice Sensiti"it' Med%e +atio (continued#

The hed%e ratio is as follows

Technicall(& the hed%e ratio will chan%e

continuousl( li0e an optionVs delta and& li0e delta&
it will not capture the ris0 of lar%e $o)es@

+
+

=
f
B
'
'
( 4
( 4
f
B
'<*
'<*
N
f
B
B
f
f
B
f
&rice Sensiti"it' Med%e +atio (continued#
=lternati)el(&
O
f
< /(4ield 0eta#&6B&
B
>&6B&
f
where Yield /eta c
(
is the /eta fro$ a
re%ression of spot (ields (
/
on futures i$plied
(ields and
P!BP
B
& P!BP
f
is the present )alue of a /asis
point chan%e in the spot and futures prices@
That is& P!BP
B
3 NBDN(
/
3'
B
B
yieldbeta

=
f
B
'
'
N
f
B
f
C. Stock !nde* Futures Med%in% (&rice sensiti"it'
is not applica0le to Stock !nde*#
Fro$ the ini$u$ !ariance Hed%e& %i)en S 3 r
s
S& f 3
r
f
f & an appropriate hed%e ratio is
N
f
3 :
s
,SDf-& where
s
is o/tained /( re%ression of
r
s
3 9
s
r
f
9 ,0t odel-

Med%in% Strate%ies: Fpplications

2. Currenc' Med%es

,. !ntermediate & Lon%/term !nterest +ate

Futures Med%es

?. Stock Market Med%es

7 ost =cti)el( Traded Currenc( Futures

4@ Euro with siBe of R465&222

6 British Pound with siBe of dA6&522

7 Qapanese Yen with siBe of e46&522&222

"n <S& Futures Prices =re Stated in F@

E1@ F@P742 for e is e46&522&222xF@22P742D e

3F427&P;5DFutures

On ;D4& Car 'ealer in <S /u(s 62 British Car of

d75&222Dcar& =DP on 44D4@
Lon% Currenc' Med%e: F>& in P
'ate Spot 0t Futures 0t
;D4
F4@74CDd& F3F4@72AD d
Forward Cost
362,75222-x4@72A
<782;,.. Forward M
f
'
3F4@6;PDd&
_of Contract3 Nab)e hed%e
62,75&222-DA6&522344@6
Bu' 22 Currenc' Futures
44D4
S3F4@886Dd& Total Cost in F
F;22&222,4@886#<72...8;..
f
'
3F4@87;5Dd&
Sell 22 Contracts
Cost F4&22C&822:FC48&6223FC5&622 for No hed%e than Forward
F4&22C&622:44I,4@87;5:4@6;P2-xA6&522J3F4&22C&622:42C&A5A@65
3 7888-;?.-3 0' Futures Med%e

On AD6C& CFO in <K will Transfer d42 to NY

on CD6P ,Forward Med%e-
Short Hed%e? Con)ert d to F in the Future
'ate Spot 0t Forward 0t
AD6C
S3F4@7A6Dd&F3F4@75;Dd

Sell d2.MM Forward
Currenc' G72.?3->d
CD6P S3F4@67;5Dd Exercise Forward
Paid d42 G
.et 72?.3-MM
&aid P2.MM & Jet 72,.?-3MM for Oo Med%e
&aid P2.MM & Jet 72?.3-MM 0' Forwards Med%e
Strip Med%e & +ollin% Strip Med%e
On 4D6& =BC to Borrow F at
7D4 F45
AD4 85
CD4 62
46D4 42
Strip?
On 4D6 ?Sell 45 arch & 85
Qune& 62 Sep and 42 'ec
contracts@
On 7D4 Bu( 45 Futures
On AD4 Bu( 85 Futures
On CD4 Bu( 62 Futures
On 46D4 Bu( 42 Futures
*ollin% Hed%e Strip? On 4D6 Sell C2 arch Futures
On 7D4 Bu( C2 arch Futures and Sell ;5 Qune Futures
On AD4 Bu( ;5 Qune Futures and Sell 72 Sep Futures
On CD4 Bu( 72 Sep Futures and Sell 42 'ec Futures
On 46D4 Bu( 42 'ec Futures
,. !ntermediate & Lon%/term !nterest +ate
Futures Med%e

"nter$ediate and #on%:Ter$ "nterest *ate Futures Hed%es

First let us loo0 at the T:note and /ond contracts

T:/onds? $ust /e a T:/ond with at least 45 (ears to

$aturit( or first call date

T:note? three contracts ,6:& 5:& and 42:(ear-

= /ond of an( coupon can /e deli)ered /ut the

standard is a AE coupon@ =d`ust$ents& explained in
Chapter 42& are $ade to reflect other coupons@

Price is Kuoted in units and 76nds& relati)e to F422

par& e@%@& C7 48D76 is C7@87;5@

Contract siBe is F422&222 face )alue so price is

FC7&87;@52
Ex@ Hed%in% a #on% Position in a .o)>t Bond ,Ta0le - p.?-8-
Hold F4 of .o)>t Bond Toda(@ "f /ond prices ,interest
rate -& then futures on T:Bond will @ So& (ou should sell
T:/ond future toda( to Hed%e the *is0@
B3424&'
s
3;@P7&
'
f
3;@6& f3;2@5
3ON
f
3:45@A& Sell
2= T:Bond Futures
Toda( M F;2&522
N
f
34&242'
s
D
;2@5'
f
345@A
T:Bond f3FAA&;4P@;53FAA 67D76
&B3C5@AP;5
Sold F4 .o)>t Bond %et
FC5A&P;5&,Loss 73?2,3 w>o Med%e-
w>Med%e?Closed out Futures Position at
FAA&;4P@;5& f3;2@5:AA@;4P;537@;P465
per F422
f
&
f
34Axfx4222 3F=.3..
IT:/ond futures F422&222DContractJ
Net 3 FC5A&P;5 9A2&5223F2.2-?-3
6D65
7D6P
Med%in% a Future &urchase of a T/Ootes (p. ?-8#
7D6C& $ana%er will ha)e F4 =D* on ;D45 and decides to
/u( 44 5DP T:notes ,C (rs- wD5@A $odified duration G (ield
46@26E@ .i)en Forward price of notes is C; 6PD76@ Bu( T:
note futures to hed%e ,wh(T-@
7D6C
F3C; 6PD76& '
s
35@A&
f3;P 64D76& '
f
3A@6&
3ON
f
3:44@68& Bu'
22 T:Notes Futures
Toda( M F;P 64D76
,i@e@&F;P&A5A@65-
#oc0:in 78-8-3.
8-8-3.MAs>-8=3
=.,3MAf<22.,;
;D45& S342; 4CD76
f3PA AD76 or FPA&4P;@5
YDO hed%e& F4 face )alue T:note is
72.-38?-.3& #oss FC;P&;52:
F4&2;5&C7;3 (78-28-.3#
YDHed%e?44,FPA&4P;@5:;P&A5A@65- 3
FP6&P87@;5 fro$ futures& Net 3
F4&2;5&C7;@5:FP6&P87@;5 3 788?.8?.-3
paid for F4 T:Note for 44@;5E
)*. Med%in% a Corporate Bond !ssue (,2 'ears
maturit'#

Sell T:/ond futures ,wh(T-@

N
f
3 :'
s
SD'
f
f@

,Ta0le 8 p. ?8.-
On 6D68& a Co$pan( decides to issue F5 face )alue of
/ond on 5D68 expected (
S
347@;AE couponG price at par wD62
(rs $aturit( and '
S
3;@@66 duration@ T:/ond futures are at AP
44D76 ,3FAP&787@;5-& '
f
3;@PP
N
f
3 :'
s
SD'
f
f3:;@66,5-D;@PP,AP&787@;5-3:
A;@2@ Sell =- T/Bond Futures.

On 5D68 (345@65E& wD47@;AE coupon is priced at

FC2;@8A7PDF4222& or F;3?-?28 for F5 Bond

f3A2 65D76 ,3FA2&;P4@65-@

YDO hed%e& loss F;3?-?28:F53F8A6&AP4

YDHed%e& A;,AP&787@;5:A2&;P4@65-3F52A&AP;@5
.ain fro$ futures& Total F recei)e3F8&57;&74C9
F52A&AP;@5 3F3.;;..=.3 or Yield of 47@A7E
?. Stock !nde* Futures Med%e (f< CM) inde*Q7,3.#

Note? SGP 522 "ndex CE 3 ;85@85 on 44D66D2x&

f 3 ;85@85\652 3 F4PA&7A6@5D'ec@ index futures Contract

Expiration? arch& Qune& Sept& 'ec@

#ast Tradin% 'a(? The Thursda( /efore the 7rd Frida( of

Expiration onth

Ex@ Stoc0 Portfolio Hed%e ,Ta0le 2. p ?8,-

Hold a portfolio@ Sell the SGP 522 futures to hed%e his
portfolio@ N
f
3 :
s
SDf@
0t !alue wei%hted /etas to %et
s
& Portfolio $0t )alue 3
S& "ndex futures ti$es 652 3 f@
)*. Med%in% a Takeo"er ( Ta0le 22 p. ?83
hed%in% a future purchase of stocks#.
Bu( N
f
SGP 522 futures Contracts& N
f
3 :SDf&
= /eta in C=P
)*. Med%in% a Takeo"er ( Ta0le 22 p. ?83
hed%in% a future purchase of stocks#.

On ;D45& a fir$ decide to /u( 422&222 shares of stoc0 to

ta0e o)er another co$pan( on PD45& S<7,=.3 wD/eta34@P&
N
f
3 SDf& SGP futures34&6A2@5& or x6523F745&465Dcontract
N
f
34@P,6&A52&222D745&465-345@48@ Bu' 45 futures

On PD45 Stoc0 price36P@;5& Cost of shares36P@;5x422&222

F6&P;5&222 ,YDO Hed%e-& additional F665&222 cost $ore
than that fro$ S3F6A@5

YDHed%e& f34&76;@6 or x6523F774&P22& 45,774&P22:

745&465-3 F652&465 %ain fro$ futures& Total cost for ta0in%
o)er 3 F6&P;5&222:652&465-3F,=,3...& or ,=.,3>share
Chapter 2,: Swaps

Ke( Concepts

"nterest *ate Swaps ,pricin%& =pplications& Ter$ination-

Forward *ate =%ree$ents G Si$ilarit( to Swaps

"nterest *ate Options <se G Pricin%

Caps& Floors& Collars <se G Pricin%

The 'eri)ati)e "nter$ediar(

The Nature of Credit *is0 G How "t "s ana%ed

.eneral =wareness of =ccountin%& *e%ulator( G Tax

"ssues
Basic Concepts

Swaps 3 Pri)ated =%ree$ents Between 6 Parties to

Exchan%e Cash Flows "n the Future =ccordin% to a
Prearran%ed For$ula 3 Portfolio of Forwards
Contracts

Co$parati)e =d)anta%e ? Borrowin% Fixed Yhen

it Yants Floatin% or !ice !ersa

Pri$e *ate ,*eference *ate of "nterest for

'o$estic Financial 0t-

#"BO* ,*eference *ate for "nternational Financial

0ts-
Exa$ple
Borrowin% *ate? Fixed Floatin%
Co$pan( = 42E A:$onth #"BO* 92@7E
Co$pan( B 44@6E A:$onth #"BO* 94E
B pa(s 4@6E $ore than = in Fixed G Onl( @;E in Floatin%
B has Co$parati)e =d)anta%e in Floatin% *ate 0t& = has
Co$parati)e =d)anta%e in Fixed *ate 0t
= Swap is Created?
=
B
C@C5E
#"BO*
= pa(s 42ED(ear to Outside
#ender& *ecei)e C@C5ED(ear
fro$ B& Pa(s #"BO* to B
B Borrows M #"BO*94E
= Borrows M Fixed 42E G
Then Enter a Swap to Ensure
that = Ends <p Floatin% *ate
#"BO*94E
42E
Exa$ple?

Co$pan( B Cash Flow?

4@ Pa( #"BO*94E to Outside #ender

6@ *ecei)e #"BO* fro$ =

7@ Pa(s C@C5E to =
Co$pan( = Net Cash Flow with Swap

:42E9C@C5E:,#"BO*- 3 :,#"BO*92@25E-
Yithout Swap& Co$pan( = Pa(s #"BO*92@7E& Sa"e ..,31
Co$pan( B Net Cash Flow with Swap

:,#"BO*94E-:C@C5E9I#"BO*J 3 :42@C5E
Yithout Swap& Co$pan( = Pa(s 44@6E& Sa"e ..,31
The Total .ain 3 I44@6E:42EJ : I,#"BO*94E- : ,#"BO*9
2@7E -J 3 2@5E@
+ole of Financial !ntermediar' (Oet ..21#

=? Cash Flow? ,Net 3 #"BO*92@4E& Sa"e ..,1 -

Pa( 42E to outside #enders
*ecei)e C@CEDannu$ fro$ Financial "nter$ediar(
Pa( #"BO* to Financial "nter$ediar(
F
B
Financial
!nstitutio
n
C@CE
#"BO*
#"BO*
9 4E
42@2E
42E
#"BO*
B? Cash Flow? ,Net 3 44E& Sa"e ..,1-
Pa( #"BO* 9 4E to Outside #enders
*ecei)e #"BO* fro$ Financial "nter$ediar(
Pa( 42EDannu$ to Financial "nter$ediar(