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In this chapter, we explore one of the most successful innovations in the history of futures markets; that is, interest rate futures contracts. This chapter is organized into the following sections: 1. Interest Rate Futures Contracts 2. Pricing Interest Rate Futures Contracts 3. Speculating With Interest Rate Futures Contracts 4. Hedging With Interest Rate Futures Contracts
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Deliverable Grades: Cash Settled to 3-month Dollar LIBOR Tick Size: 0.01=$25.00 Months 11 thru 40; 0.005=$12.50 Months 2 thru 10; 0.0025=$6.25 for nearest expiring month. Price Quote: Price is quoted in terms of the IMM 3-month Eurodollar index, 100 minus the yield on an annual basis for a 360-day year with each basis point worth $25. Contract Months: March, June, September, and December cycle for 10 years Expiration and final Settlement: Eurodollar futures cease trading at 5:00 a.m. Chicago Time (11:00 a.m. London Time) on the second London bank business day immediately preceding the third Wednesday of the contract month; final settlement price is based on the British Bankers=Association Interest Settlement Rate. Trading Hours: Floor: 7:20 a.m.-2:00 p.m; Globex: Mon/Thurs 5:00 p.m.-4:00 p.m.; Shutdown period from 4:00 p.m. to 5:00 p.m. nightly; Sunday & holidays 5:30 p.m.-4:00 p.m. Daily Price Limit: None
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Eurodollar Futures
1. Eurodollar futures currently dominate the U.S. market for short-term futures contracts. 2. Rates on Eurodollar deposits are usually based on LIBOR (London Interbank Offer Rate).
LIBOR is the rate at which banks are willing to lend funds to other banks in the interbank market.
3. Eurodollars are U.S. dollar denominated deposits held in a commercial bank outside the U.S. 4. The Eurodollar contracts is for $1,000,000. 5. A Eurodollar futures contract is based on a time deposit held in a commercial bank (e.g., 3-month Eurodollar) 6. Eurodollar contracts are non-transferable.
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Eurodollar Futures
7. Eurodollar futures were the first contract to use cash settlement rather than delivery of an actual good for contract fulfillment. 8. To establish the settlement rate at the close of trading, the IMM determines the three-month LIBOR rate. 9. This settlement rate is then used to compute the amount of the cash payment that must be made. 10. The yield on the Eurodollar contract is quoted on an add-on basis as follows:
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Add on Yield !
In order to calculate the add-on yield, the price and discount must be computed as follows:
DY ( Face Value)( DTM ) 360
$ Discount !
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0.0832(1,000,000)(90) 360
$Discount ! $20,800
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A one basis point change in the Add-on Yield, on a 3-month Eurodollar contract implies a $25 change in price. This amount can be compute using:
Face Value v ( Add on Yield v DTM v 360
$1,000,000 v .0001v 90 v 360 ! $25
Eurodollar futures contract prices are quoted using the IMM Index which is a function of the 3-month LIBOR rate: IMM Index = 100.00 - 3-Month LIBOR
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Euribor Futures
Euribors are Eurodollar time deposits. Swaps dealers use Euribor futures to hedge the risk resulting from their activities. Euribor futures are traded at: Euronex.liffe
Contracts are based on a 3-month time deposit with a 1,000,000 notional value. Contracts are cash settled at expiration .
Eurex
Contracts are based on a 3-month time deposit with a 3,000,000 notional value. Contracts are cash-settled at expiration.
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TIEE 28 Futures
The TIEE 28 futures contract is based on the short-term (28-day) Mexican interest rate. The contract is traded on the Mexican Derivatives Exchange (Mercado Mexicano de Derivados, or MexDer) A 28-day TIIE futures contract has a face value of 100,000 Mexican pesos. The contract is cash settled based on the 28-day Interbank Equilibrium Interest Rate (TIIE), calculated by Banco de Mxico.
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Tick Size: One basis point of the annualized percentile rate of yield Price Quote: Trading of 28-Day TIIE futures contracts use the annualized percentile rate of yield expressed in percentile terms, with two decimal places. Contract Months: MexDer lists different Series of the 28-Day TIIE Futures Contracts on a monthly basis for up to sixty months (five years). Expiration and final Settlement: The last trading day is the bank business day after Banco
de Mxico holds the primary auction of government securities in the week corresponding to the third Wednesday of the Maturity Month.
Trading Hours: Bank businessdays from 7:30 a.m. to 3:00 p.m., Mexico City time. Daily Price Limit: None
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2. The Treasury bill futures contract calls for the delivery of T-bills having a face value of $1,000,000 and a time to maturity of 90 days at the expiration of the futures contract.
91-day and 92 day T-bills may also be delivered with a price adjustment. The contracts have delivery dates in March, June, September, and December. The delivery dates are chosen to make newly issued 13 week T-bills immediately deliverable against the futures contract.
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Position Day
Short declares his/her intentions to make delivery. This may occur on the first position day or some other later day. Delivery Day Clearinghouse matches the short and long traders and requires them to fulfill their responsibilities.
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Treasury Bond Futures Price Quotation for Major Interest Rate Futures Contracts
Insert Figure 7.1 Here
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CF =
Conversion Factor
(the conversion factor as provided by the CBOT)
AI = Accrued Interest
(Interest that has accrued since the last coupon payment on the bond)
This system is effective as long as the term structure of interest rates is flat and the bond yield is 6%. However, if the term structure of interest rates is not flat, or if bond yields are not 6%, some bonds will still be less expensive to deliver against the futures contract than others.
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The Delivery Sequence for T-Bond & T-Note Futures Expiring in 1997 First First First Last Last Position Notice Delivery Trading Delivery FEB 27 FEB 28 MAR 3 MAR 21 MAR 31 MAY 29 MAY 30 JUN 2 JUN 20 JUN 30 AUG 28 AUG 29 SEPT 2 SEP 19 SEP 30 NOV 26 NOV 28 DEC 1 DEC 19 DEC 31
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Coupon 5 1/4 5 1/4 5 1/2 6 6 1/8 6 1/8 6 1/4 6 1/4 6 3/8 6 1/2 6 5/8 6 3/4 6 7/8 7 1/8 7 1/4 7 1/2 7 5/8 7 5/8 7 7/8 8 8 1/8 8 1/8 8 1/2 8 3/4 8 3/4
Maturity Date 11/15/28 02/15/29 08/15/28 02/15/26 11/15/27 08/15/29 08/15/23 05/15/30 08/15/27 11/15/26 02/15/27 08/15/26 08/15/25 02/15/23 08/15/22 11/15/24 11/15/22 02/15/25 02/15/21 11/15/21 05/15/21 08/15/21 02/15/20 05/15/20 08/15/20
Sep-04 0.9052 0.9047 0.9370 0.9999 1.0155 1.0159 1.0278 1.0324 1.0461 1.0606 1.0761 1.0903 1.1029 1.1236 1.1352 1.1734 1.1774 1.1889 1.1928 1.2113 1.2206 1.2224 1.2474 1.2750 1.2775
Dec-04 0.9056 0.9052 0.9374 1.0000 1.0153 1.0159 1.0277 1.0322 1.0460 1.0602 1.0758 1.0899 1.1024 1.1228 1.1343 1.1721 1.1759 1.1878 1.1911 1.2094 1.2185 1.2206 1.2450 1.2721 1.2750
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5-year & 10 year contract $100,000 Deliverable Maturities 2-year contract 5-year contract 10-year contract 21 -24 month 4 yrs 3 mos. to 5 yrs 3 mos. 6 yrs 6 mos. to 10 years
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Contract Months: March, June, September, and December Expiration and final Settlement: The last trading day is the seventh business day preceding the last business day of the delivery month. The contract is settled with physical delivery. The last delivery day is the last business day of the delivery month. Trading Hours: Open Auction: 7:20 am - 2:00 pm, Central Time, Monday - FridayElectronic: 7:00 pm - 4:00 pm, Central Time, Sunday - FridayTrading in expiring contracts closes at noon, Chicago time, on the last trading day. Daily Price Limit: None.
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Contract Months: The three successive months within the March, June, September, and December delivery cycle. Expiration and final Settlement: The last trading day is two trading days prior to the delivery day of the contract month. The delivery day is the 10th calendar day of the contract month, if this day is an exchange trading day; otherwise, the immediately following exchange trading day. Trading Hours: Eurex operates in three trading phases. In the pre-trading period users may make inquiries or enter, change or delete orders and quotes in preparation for trading. This period is between 7:30 and 8:00 a.m. The main trading period is between 8:00 a.m. and 7:00 p.m. Trading ends with the post-trading period between 7:00 p.m. and 8:00 p.m. Daily Price Limit: None
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Cost-of-Carry Rule 3
Recall: the cost-of-carry rule #3 says:
F 0, t ! S 0(1 C 0, t )
Where: S0 = F0,t = C0,t= The current spot price The current futures price for delivery of the product at time t The percentage cost required to store (or carry) the commodity from today until time t
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Cost-of-Carry Rule 6
Recall: the cost-of-carry rule #6 says:
F 0, d ! F 0, n (1 Cn , d )
F0,d = Fo,n= Cn,d= the futures price at t=0 for the the distant delivery contract maturing at t=d the futures price at t=0 for the nearby delivery contract maturing at t=n the percentage cost of carrying the good from t=n to t=d
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Repo Rate
Recall from Chapter 3 that if we assume that the only carrying cost is the financing cost, we can compute the implied repo rate as:
F 0, t 1 ! C 0, t S0
or
F 0, t ! 1 C 0, t S0
Interest rate futures conform almost perfectly to the Costof-Carry Model. However, we must take into account some of the peculiar aspects of debt instruments.
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77
167
1. Sell futures Contract. 2. Buy T-bill Futures contract w/ 167 days to maturity.
3. Deliver T-bill (that has now 90 days to maturity) against futures contract.
4. T-bill matures
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How was the bill price of $987,167 from Table 7.2 calculated?
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0.125(1,000,000)(90) 360
0.10(1,000,000)(167) 360
0.06(1,000,000)(77) 360
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Face Value !
Face Value !
343,299,960 355.38
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Time Mar 22
Mar 22 Profit/contract
Transaction Cash Flow Deliver 167-day T-bill $968,750 (that now has 90 days to maturity) against the futures contract Repay debt on 77-day $966,008 T-Bill that matures today $2,742
4. Deliver the T-bill against the futures contract 5. Pay off the loan
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Jan 5
Mar 22
Jun 20
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Method 2:
Buy a 77 day T-bill. Buy a futures contract for delivery of a 90 day T-bill in 77 days. Use the futures contract to buy a 90-day T-bill.
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Method 2
Jan 5 Mar 22 Jun 20
1. Buy 77-day T-bill 2. Buy a future contract for 90-day T-bill w/ 77 days to maturity
3. Collect from maturing T-bill 4. Buy a 90-day T-bill using the futures contract
Either of these two methods of investing in T-bills has exactly the same investment and exactly the same risk. Since both investment have exactly the same risk and exactly the same investment, they must have exactly the same yield to avoid arbitrage.
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Use the no arbitrage equation to determine the appropriate yield on the 77-day T-bill by, using the following equation:
Price of Futures Contract Long Term T Bill Price DTMFC Price of Futures Contract X 360
NA Yield !
Where: NA Yield = the no arbitrage Yield DTMFC = days to maturity of the futures contract
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NA Yield !
NA Yield !
$15,139 $207,204.86
NA Yield ! 0.07306
So in order for there to be no arbitrage opportunities available, the yield on the 77 day T-bill must be 7.3063%. If the yield on the 77 day T-bill is greater than 7.3063%, then engage in a reverse cash-and-carry arbitrage. If the yield on the 77 day T-bill is less than 7.3063%, engage in a cash-and-carry arbitrage.
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F 0, t ! 1 C 0, t S0
In our case the spot price is the price of the 167-day to maturity T-bill, so:
$968,750 ! 1 C 0, t $953,611
1 C 0, t ! 1.015875
The implied repo rate (C) is 1.5875% The implied repo rate is the cost of holding the commodity for 77 days, between today and the time that the futures contract matures, assuming this is the only financing cost, it is also the cost of carry.
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Borrow funds
Sell futures
Realize profit
Hold bond
2. If the implied repo rate is less than the financing cost, then exploit a reverse cash-and-carry arbitrage.
Buy futures Sell bond short Invest proceeds until futures exp.
Realize profit
Take delivery
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Cash-and-Carry Strategy
Table 7.6 CashBandBCarry Transactions with Unequal Borrowing and Lending Rates
January 5 Borrow $953,611 for 77 days at the 77Bday borrowing rate of 7.5563. Buy 167Bday TBbill yielding 10% for $953,611. Sell one TBbill futures contract with a yield of 12.29% for $969,275. March 22 Deliver the originally purchased TBbill against the MAR futures contract and collect $969,275. Repay debt on 77Bday TBbill that matures today for $969,277. Profit: -$2 0
Notice that the entire arbitrage profit disappears when these differential borrowing and lending rates are considered.
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Again notice that the entire arbitrage profit disappears when these different borrowing and lending rates are considered.
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Table 7.8 Speculating with Eurodollar Futures Date September 20 September 25 Futures Market Sell 1 DEC 90 Eurodollar futures at 90.30. Buy 1 DEC 90 Eurodollar futures at 90.12.
Profit: 90.30 B90.12 = .18 Total Gain: 18 basis points * $25 = $450
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Gain in Basis Points Change in December Contract Change in September Contract Net Change in Positions Each Basis Point is worth $25 Profit Net Change in Positions Basis Point Value Profit
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Thus, T-bills are a safer investment and as such, should pay a lower interest rate. Eurodollars are riskier and should pay a higher rate of interest. How much lower/higher? The amount of the difference depends upon world events. To the extent that the world situation is considered safe, the difference should be low. To the extent that the world situation is unsafe, the difference should be high. Table 7.11 shows the transactions necessary to engage in a TED spread when you wish to bet that the spread will widen.
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October 14
Profits:
Notice that the spread widened as the trader expected, allowing him/her to earn a $675 profit.
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Long Hedges
On December 15, a portfolio manager learns that he will have $970,000 to invest in 90-day T-bills six months from now, on June 15. Current yields on T-bills stand at 12% and the yield curve is flat, so forward rates are all 12% as well. The manager finds the 12% rate attractive and decides to lock it in by going long in a T-bill futures contract maturing on June 15, exactly when the funds come available for investment as Table 7.12 shows:
The manager sells one TBbill futures contract maturing immediately. Futures yield: 10% Futures price: $975,000 Profit = $5,000
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Long Hedges
With current and forward yields on T-bills at 12 percent, the portfolio manager expects to be able to buy $1,000,000 face -value of T-bills for $970,000 because:
Bill Price ! Face Value DY ( Face Value )( DTM ) 360
0.12($1,000,000)(90) 360
On June 15, the 90-day T-bill yield has fallen to 10%. Thus, the price of a 90 day T-bill is:
DY ( Face Value )( DTM ) 360
0.10($1,000,000)(90) 360
Thus, if the manager were to purchase the T-bill in the market, he would be $5,000 short.
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Long Hedges
The futures profit exactly offsets the cash market loss for a zero change in wealth. With the receipt of the $970,000 that was to be invested, plus the $5,000 futures profit, the original plan may be executed, and the portfolio manager purchases $1,000,000 face value in 90-day T-bills.
Insert Figure 7.7 here The idealized yield Curve Shit for the long Hedge.
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Short Hedge
Banks may wish to hedge their interest rate positions to lock in profits. Table 7.13 demonstrates how a bank that makes a one million dollar fixed rate loan for 9 months, and can only finance the loan with 6-month CDs, can hedged its position.
Table 7.13 Hedging a Bank= Cost of Funds Using Interest Rate Futures s
Date March Cash Market Bank makes nine-month fixed rate loan financed by a six-month CD at 3.0 percent and rolled over for three months at an expected rate of 3.5 percent. Three-month LIBOR is now at 4.5 percent. The bank= cost of funds are one percent above s its expected cost of funds of 3.5 percent. The additional cost equals $2,500, i.e., 90/360 x .01 x $1 million.. Total Additional Cost of Funds: $2,500 Futures Market Establish a short position in SEP Eurodollar futures at 96.5 reflecting a 3.5 percent futures yield. Offset one SEP Eurodollar futures contract at 95.5 reflecting a 4.5 percent futures yield. This produces a profit of $2,500 = 100 basis points x $25 per basis point x 1 contract. Futures Profit: $2,500
September
Because the bank hedged, its profits were not affected by a change in interest rates.
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Cross-Hedge
Recall that a cross-hedge occurs when the hedged and hedging instruments differ with respect to: 1. Risk level 2. Coupon 3. Maturity 4. Or the time span covered by the instrument being hedged and the instrument deliverable against the futures contract. To illustrate how a cross-hedge is conducted, assume that a large furniture manufacturer has decided to issue one billion 90-day commercial paper in 3 months. Table 7.14 illustrate the cross-hedge.
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Cross-Hedge
Table 7.14 A CrossBHedge Between T-bill Futures and Commercial Paper
Date Time = 0 Cash Market The Financial V.P. plans to sell 90Bday commercial paper in 3 months in the amount of $1 billion, at an expected yield of 17%, which should net the firm $957,500,000. The spot commercial paper rate is now 18%, the usual 2% above the spot TBbill rate. Consequently, the sale of the $1 billion of commercial paper nets $955,000,000, not the expected $957,500,000. Opportunity loss = ? Net wealth change = ? Futures Market The V.P. sells 1,000 TBbill futures contracts to mature in 3 months with a futures yield of 16%, a futures price per contract of $960,000, and a total futures price of $960,000,000. The TBbill futures contract is about to mature, so the TBbill futures rate = spot rate = 16%. The futures price is still $960,000 per contract, so there is no gain or loss. Gain/loss = 0
Time = 3 mos.
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