Lecture 7. Topics  Pricing  Delivery Complications for both  Multiple assets can be delivered on the same contract…unlike commodities  The deliverable.

Slides:



Advertisements
Similar presentations
Financial Engineering
Advertisements

FINANCING IN INTERNATIONAL MARKETS 3. BOND RISK MANAGEMENT.
CHAPTER 4 BOND PRICES, BOND YIELDS, AND INTEREST RATE RISK.
Review of Time Value of Money. FUTURE VALUE Fv = P V ( 1 + r) t FUTURE VALUE OF A SUM F v INVESTED TODAY AT A RATE r FOR A PERIOD t :
Interest Rate Markets Chapter 5. Chapter Outline 5.1 Types of Rates 5.2Zero Rates 5.3 Bond Pricing 5.4 Determining zero rates 5.5 Forward rates 5.6 Forward.
©David Dubofsky and 9-1 Thomas W. Miller, Jr. Chapter 9 T-Bond and T-Note Futures Futures contracts on U.S. Treasury securities have been immensely successful.
1 Chapter 21 Removing Interest Rate Risk Portfolio Construction, Management, & Protection, 4e, Robert A. Strong Copyright ©2006 by South-Western, a division.
© 2004 South-Western Publishing 1 Chapter 11 Fundamentals of Interest Rate Futures.
Treasury bond futures: pricing and applications for hedgers, speculators, and arbitrageurs Galen Burghardt Taifex/Taiwan 7 June 2004.
1 Chapter 23 Removing Interest Rate Risk. 2 Introduction u A portfolio is interest rate sensitive if its value declines in response to interest rate increases.
Interest Rate Derivatives Part 1: Futures and Forwards.
Bond Pricing Fundamentals. Valuation What determines the price of a bond? –Contract features: coupon, face value (FV), maturity –Risk-free interest rates.
Interest Rate Futures Chapter 6, excluding Sec for 7 th edition; excluding Sec. 6.5 – 6.6 for pre 7 th editions.
Bond Price, Yield, Duration Pricing and Yield Yield Curve Duration Immunization.
Lecture 11. Topics  Pricing  Delivery Complications for both  Multiple assets can be delivered on the same contract…unlike commodities  The deliverable.
1 Chapter 4 Understanding Interest Rates. 2 Present Value  One lira paid to you one year from now is less valuable than one lira paid to you today. Even.
1 Bond Valuation Global Financial Management Campbell R. Harvey Fuqua School of Business Duke University
Understanding Interest Rates
Understanding Interest Rates
Part Two Fundamentals of Financial Markets. Chapter 3 What Do Interest Rates Mean and What is Their Role in Valuation?
Pricing Fixed-Income Securities. The Mathematics of Interest Rates Future Value & Present Value: Single Payment Terms Present Value = PV  The value today.
© 2004 South-Western Publishing 1 Chapter 11 Fundamentals of Interest Rate Futures.
Futures Hedging Examples. Hedging Examples  T-Bills to Buy with T-Bill Futures  Debt Payment to Make with Eurodollar Futures  Futures in Portfolio.
Options and Speculative Markets Interest Rate Derivatives Professor André Farber Solvay Business School Université Libre de Bruxelles.
Drake DRAKE UNIVERSITY Fin 288 Interest Rates Futures Fin 288 Futures Options and Swaps.
© K.Cuthbertson, D. Nitzsche1 Version 1/9/2001 FINANCIAL ENGINEERING: DERIVATIVES AND RISK MANAGEMENT (J. Wiley, 2001) K. Cuthbertson and D. Nitzsche LECTURE.
Options and Speculative Markets Interest Rate Derivatives Professor André Farber Solvay Business School Université Libre de Bruxelles.
Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 22.
Copyright © 2012 Pearson Prentice Hall. All rights reserved. CHAPTER 3 What Do Interest Rates Mean and What Is Their Role in Valuation?
Investments: Analysis and Behavior Chapter 15- Bond Valuation ©2008 McGraw-Hill/Irwin.
Corporate Financial Theory
Interest Rates and Returns: Some Definitions and Formulas
Hedging Using Futures Contracts Finance (Derivative Securities) 312 Tuesday, 22 August 2006 Readings: Chapters 3 & 6.
Lecture The Duration Model 2 - Naive Hedging Model 3 - Conversion Factor Model 4 - Basis Point Model 5 - Regression Model 6 - Yield Forecast Model.
Hedging & Futures Today Business has risk Business Risk - variable costs Financial Risk - Interest rate changes Goal - Eliminate risk HOW? Hedging & Futures.
Financial Risk Management for Insurers
Hedging & Futures Today We will return to Capital Budgeting & Financing. We will discuss how to reduce risk. Topics How to eliminate risk in capital budgeting.
The Application of the Present Value Concept
Interest Rate Futures July Introduction  Interest rate Futures  Short term interest rate futures (STIR)  Long term interest rate futures (LTIR)
Chapter 6 Interest Rate Futures Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull
CHAPTER 5 Bonds, Bond Valuation, and Interest Rates Omar Al Nasser, Ph.D. FIN
Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown Chapter 21.
10 Bond Prices and Yields.
PRICING SECURITIES Chapter 6
Copyright © 2001 by Harcourt, Inc. All rights reserved.1 Chapter 11: Advanced Futures Strategies Fund managers who aren’t using futures and options are.
Fundamentals of Futures and Options Markets, 7th Ed, Ch 6, Copyright © John C. Hull 2010 Interest Rate Futures Chapter 6 1.
© 2004 South-Western Publishing 1 Chapter 11 Fundamentals of Interest Rate Futures.
Interest Rate Futures Professor Brooks BA /14/08.
Interest Rate Futures Chapter 6 1 Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008.
Principles of Futures Cost of carry includes:
Chance/BrooksAn Introduction to Derivatives and Risk Management, 8th ed.Ch. 10: 1 Chapter 10: Futures Arbitrage Strategies We use a number of tools to.
Part 2 Fundamentals of Financial Markets. Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation?
Interest Rate Futures Chapter 6 1 Options, Futures, and Other Derivatives, 7th Edition, Copyright © John C. Hull 2008.
CHAPTER 5 BOND PRICES AND INTEREST RATE RISK. Copyright© 2006 John Wiley & Sons, Inc.2 The Time Value of Money: Investing—in financial assets or in real.
Interest Rate Futures Chapter 6 Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull
Chapter 4. Present and Future Value Future Value Present Value Applications  IRR  Coupon bonds Real vs. nominal interest rates Future Value Present Value.
Lecture 3 Understanding Interest Rate  Future Value & Present Value  Credit market instruments Simple Loan Fixed Payment Loan Coupon Bond Discount Bond.
Chapter 6 Interest Rate Futures 1. Day Count Convention Defines: –the period of time to which the interest rate applies –The period of time used to calculate.
Chapter 6: Pricing Fixed-Income Securities 1. Future Value and Present Value: Single Payment Cash today is worth more than cash in the future. A security.
Chapter 3 Understanding Interest Rates. Present Value : Discounting the Future A dollar paid to you one year from now is less valuable than a dollar paid.
Interest Rate Markets Chapter 5. Types of Rates Treasury rates LIBOR rates Repo rates.
Lec 6 Interest Rate Futures
Interest Rate Futures Chapter 6
Interest Rate Futures Chapter 6
Lec 6 Interest Rate Futures
Futures Contracts Interest Rate Futures “Cheapest to Deliver” Bonds.
Presentation transcript:

Lecture 7

Topics  Pricing  Delivery Complications for both  Multiple assets can be delivered on the same contract…unlike commodities  The deliverable assets all have different prices

Copyright: CME Group 2011 Product “Eligible” Maturity Face Amount Min. Tick Values

Cheapest to Deliver  Delivery = Treasury futures allow the short position to select which bond to deliver (or sell) to the long futures position.  The short will deliver the bond which is the least costly for the short position to purchase.  This occurs since only 4 contracts are used to hedge all interest rate instruments. Thus, a real underlying asset does not exist.  Certain bonds are “eligible” for delivery

Copyright: Bloomberg Financial Services 2015

Conversion Factor  Bond prices vary for many reasons ◦ Higher coupons have higher prices ◦ Lower coupons have lower prices ◦ Longer maturities have higher prices ◦ Shorter maturities have lower prices  If you deliver a more expensive bond, the amount you receive at delivery goes up  If you deliver cheap bond, the amount you receive at delivery goes down

 Quoted price = Price of the bond as quoted in the paper  Accrued interest = amount of coupon earned on a bond since the last coupon payment  Bond Cash Price = (Quoted price of bond X notational amount) + accrued interest  Invoice Amount = Amount of money that is exchanged when a futures contract bond is delivered

Example  What is the cash price of a bond that pays a 4% semiannual coupon and matures in 12 years and three months, if the YTM is 6.5%? Price FV = 1000 Pmt = 20 int = 3.25 n = Solve for PV = $ Quoted Price = 78.12

Example (continued)  What is the cash price of a bond that pays a 4% semiannual coupon and matures in 12 years and three months, if the YTM is 6.5%? Accrued InterestBond Cash Price

Conversion Factor  Since the bond we deliver is not specified in the futures contract, the price of the bond must be standardized.  The conversion factor converts the futures price into a settlement or invoice price.  The conversion factor is the present value of $1 at YTM=6%, assuming coupons are paid semiannual. Repo Rate  Difference between the conversion factor yield of 6% and the coupon on the bond.

 Used to convert futures prices to bond prices  What is the cash price of a bond that pays a 4% semiannual coupon and matures in 12 years and three months, if the YTM is 6.5%? Using exact dates on a HP12c provides

 Also called the Adjusted Futures price  Cash Price = Futures Price x Conversion Factor Futures Price = Cash Price / Conversion Factor

Invoice Amount = Futures Price x Conversion factor x Contract Size + accrued Interest Total amount of money exchanged at delivery

Futures Price Calculation  The price of a treasury futures contract.  The price is merely the future value of the spot price of the treasury, less PV of the coupons.  This assumes a flat yield curve.  I = present value of coupons

Example  Compute the conversion factor of a bond with exactly 9 years to maturity a 5% coupon, paid semiannually, and a YTM of 4.8%.

Example (continued)  Compute the quoted price of the bond with exactly 9 years to maturity a 5% coupon, paid semiannually, and a YTM of 4.8%. Price FV = 1000 Pmt = 25 int = 2.4 n = 18 Solve for PV = $ Quoted Price =

Example (continued)  Compute the price of the 9 month futures contract. Remember the next coupon payment will be made in 6 months.

How To Calculate Delivery Cost (steps) 1 - Look up the price (FP) 2 - Compute “Conversion Factor” (CF) 3 - CF x FP x (contract size) + (accrued interest) = Delivery cost

The CTD can be found three ways 1. Quoted Bond Price – (Futures Price x CF) Also called the “Gross basis” Select the lowest 2. Invoice Amount (lowest) Also called the “Delivery Cost” 3. Highest Repo Rate The interest rate earned by short selling a security and buying it back later.

Theoretical Futures Price (FP)? 3 Ways to Derive CTD 1 – Highest Repo Rate ( The interest rate earned by short selling a security and buying it back later. ) 2 - Calculate Futures Delivery Spot Price 3 - Cost of Delivery (“Gross Basis”) Accrued interest and others items

Example Two bonds are eligible for delivery on the June 2012 T Bond Futures K Nov38 deliveries on 15th of maturity month May39 On June 12, you announce to deliver a bond

Q: If YTM = 5%, which will you deliver and what is its price? A: CFBond PriceFC Spot Price 9.875Nov May Deliver Nov38

Q: If YTM = 9%, which will you deliver & what is its price? A: CFBond PriceFC Spot Price 9.875Nov May Deliver 7 1/4 May39

Q: If YTM = 7% and the listed futures price is , which bond is CTD? A: 9 7/8Nov38CTD = (110.5 x 1.51) = /4May39CTD = (110.5 x 1.17) = Implied Repo Rate Cost of Carry

1 - The Duration Model 2 - Naive Hedging Model 3 - Conversion Factor Model 4 - Basis Point Model 5 - Regression Model 6 - Yield Forecast Model

 Duration Model

Duration Model  Your cash position is $1,000,000 10% coupon, 26year bonds, with YTM=12.64% and duration of 8.24 years.  The 6%, 20year, TBill has a duration of years, YTM=8.5%  The FC on this bond is priced at HR = 79.98x8.24 = = x (1,000,000 / 100,000) x.671 = 6.71 or 7 contracts

Duration Example  In 3 months, you will receive $3.3 mil in cash and must invest it for 6 months. The current 6 month rate is 11.20%. You like that rate, and wish to lock it in.  6 month tbills have a.50 duration, while 3 month bills have a.25 duration.  If the 3 month futures price is 97.36, what number of Ks are required to lock in the rate? HR = 100 x.5 = 2.05 x (3.3 /.1) = 67.8 contarcts x.25

Naive Model HR = 1.0 (all previous examples were naive hedges) Conversion Factor Model HR = conversion factor CF = Price of deliverable 6% YTM 100

Conversion Factor Model Example  You own a $1mil portfolio you wish to hedge. Your are considering a 3 month futures K. The bond that could be delivered against the contract is a 9.5%(semiannual) bond with a 30year maturity. The bond is callable in 15 years. How many Ks should you use to hedge the position? CF = /100 = 1.34 x (1mil/.1) = 13 contracts

Example - Conversion Factor Model  You have a $1mil portfolio, containing 21.5 year 10 3/8 bonds. Price = (YTM = 10 5/16)  CTD 20year, 8% bond has YTM =  Create the hedge.  Assume that in 6 months YTM on your portfolio rises to 12 % and YTM on CTD rises to %  Create a table showing your position/profit/loss

Example - Conversion Factor Model CF = PV of 3% for 43 periods / 100 = x (1mil/100,000) = 15 CashFutures TodayOwn $1mil Short (given) ($1,005,363)+ $1,195, buy (given) + $876,301($1,066,050) (129,062)+129,720

Basis Point Model BVC cash = $ change in value per basis point of cash position B = Relative yield volatility of cash to CTD = (V cash / V ctd ) BVC ctd = $ change in value per basis point of CTD CF ctd =conversion factor of CTD

Example  YTM = 9% on semi-annual bonds  Your cash portfolio consists $1mil of 26 year 9 7/8 bonds, that have a yield volatility of.60  Futures CTD is a 7.25% 26.5 year note with a yield volatility of.50  Use the basis point model to create a hedge and show the position table for a 3month time period and a change in YTM to 10%.

Basis Point Model Use Calculator bond functions for calculations

example - continued Cash 9% = BVC cash = $107 9% ) BVC ctd = $86 B =.6 /.5 = 1.20 CF =.1.16 (PV of 6% / 100) HR* = ( 107 ) x1.20 = 1.73 ( 86 / 1.16) 1 mil / 100,000 x 1.73 = 17 contracts

example - continued (10%) CashFutures Today (given) -$1,087,370+1,401,480 3 months (YTM = 10%) $ (given) +$ 988,212- $1,299,650 Net Position$99,158 loss$101,830 gain net gain of $2,672

example - continued Assume YTM = 8% CashFutures Today (given) -$1,087,370+ 1,401,480 3 months (YTM = 8%) $ (given) +$ 1,203,034- $1,522,520 Net Position$115,664 gain$121,040 loss net loss of $5,376

Regression Model HR = Covariance of Cash & Futures Variance of futures best model if HR =.90, then we know that a $1 change in futures prices correlates to a $0.90 change in cash value. requires constant monitoring because HR changes with duration

Yield Forecast Model Given various yield forecasts, the HR changes Term Structure can forecast yields HR = CVdiff / FCV diff Example Cash Value = & Futures = Forecasted YTM YTM CVYTM FCCVFCCVdiffFCdiffHR