1. Ch23 Interest rate Futures and Swaps Interest-rate futures contracts Currently traded interest-rate futures contracts Pricing Interest-rate futures Bond portfolio management applications Interest rate Swap

2. Ch23 Basics of Futures Definition Opening position Liquidating a position –Liquidation before settlement –delivery –Cash settlement

3. Ch23 Basics of Futures Role of Clearinghouse –When an investor takes a position in the futures market, the clearinghouse takes the opposite position and agrees to satisfy the terms set forth in the contract. –Give instruction of delivery in the day of settlement Margin requirement –Initial margin –Maintenance margin –Variation margin –Leverage is involved when taking position in futures Marking to market –As futures price changes, the proceeds accrue to the trader’s margin account immediately. Difference from Forwards –More standardized and low default risk

4. Ch23 Treasury Bill Futures Based on 13-week treasury bill with a face value of $1 million –Seller needs to deliver to the buyer at the settlement date a Treasury with 13 weeks remaining to maturity –Index price = 100 – (y d *100) Where y d = D/F*(360/t) –A change of one basis point will change the dollar discount, and the invoice price, by

5. Ch23 Example The index price for a Treasury bill futures contract is 92.52. Then –Y d –D –Invoice price

6. Ch23 Eurodollar CD Futures Traded on –International Monetary Market of Chicago Mercantile Exchange –London International Financial Futures Exchanges Underlying asset: 3-month Eurodollar CD Face value is &1 million, price quoted as: 100 – annualized futures LIBOR

7. Ch23 Treasury Bond Futures Underlying asset is $100,000 par value of a hypothetical 20-year 6% coupon bond CBOT allows the seller to deliver one of several Treasury bonds that the CBOT declares is acceptable for delivery. Conversion factor: Invoice price (example see page 523) –Invoice price = contract size*futures contract settlement price*conversion factor + accrued Interest

8. Ch23 Pricing Interest Rate Futures A 20-year 100-par-value bond with a coupon rate of 12% is selling at par. The bond is the deliverable for a futures contract that settles in three months. Current 3-month interest rate is 8% per year What should be the price of the futures contract?

9. Ch23 What will you get from the futures contract? If you take long position in the futures –After 3 months, pay futures price –Get the bond –Pay accrued interest (page 31) If you take short position in the futures –Deliver the bond after 3 month –Get futures price and accrued interest

10. Ch23 Cash-and-carry trade You decide to hold the hold the bond and take a short position in futures –Sell futures at P –Get accrued interest –Purchase bond by borrowing money

11. Ch23 Reverse cash-and-carry trade Buy the futures contract at P Sell the bond for ? Invest the proceed for 3 months at 8% per year

12. Ch23 Theoretical Futures Price F=P[1+t(r-c)] –Where r is financing rate, c is current yield, P is cash market price, and F is futures price and t is time, in years to the futures delivery date –R-c is the net financing cost

13. Ch23 Bond Portfolio Management Applications Speculating on the movement of interest rate Controlling the interest rate risk of a portfolio Creating synthetic securities for yield enhancement Hedging

14. Ch23 Creating Synthetic Securities for Yield Enhancement Consider an investor who owns a 20-year treasury bond and sells treasury futures that call for the delivery of that particular bond 3 months from now. Synthetic 3-month T bill. Yield on the synthetic 3-month t-bill and yield on the cash market treasury bill.

15. Ch23 Hedging Hedging: taking a futures position as a temporary substitute for transactions to be made in the cash market at a later date. The outcome of a hedge will depend on the relationship between the cash price and the futures price The difference between cash price and futures price is basis The risk that the basis will change in an unpredictable way is basis risk

16. Ch23 Hedging Cross hedging Short hedge Long hedge Hedge ratio

17. Ch23 Allocating Funds between Stocks and Bonds An alternative way to reallocate assets is to buy and sell interest rate futures and stock index futures Benefits –Transaction costs are lower –Market impact costs are avoided –Activities of the money managers employed by the pension sponsor are not disrupted

18. Ch23 Interest rate Swap Basics Two parties agree to exchange periodical interest payments. The dollar amount fo the interest payments exchanged is based on a predetermined dollar principal, notional principal amount. (example: page 590) Fixed-rate payer Floating-rate payer Viewed as a package of forward contracts

19. Ch23 Exercise Chapter 543, Problem 4, 11.