INTEREST RATE FUTURES

DERIVATIVES AND RISK MANAGEMENT

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Thursday, 02 May 2024 1

TOPICS

Day count and Quotation Conventions

Treasury Bond Futures
EURODOLLAR and SOFR Futures
Duration Based Hedging Strategies
Hedging Portfolios of Assets and Liabilities

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 Day Count and Quotation Conventions
Contracts that trade in US – Other countries have products with similar features
Day Counts – Defines the way in which interest accrues over time.
Interest earned over a reference period ( time between two coupon payments) and (Y)
Computation is of interest earned over some other period (X)\
Day count is generally expressed as X/Y
When calculating the interest earned between two dates
“X” defines the way in which the number of days between two dates is calculated
“Y” defines the way in which the total number of days in the reference period is measured.
Interest earned between two dates is given by

( ∗ h )

Actual / Actual (in period) Day count convention in India is

30/ 360 ACTUAL/365 day basis
Actual/360
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Numerical Examples and why day count
Bond with FV $100 coupon dates are March 1 and Sep 1
conventions are important
Coupon rate is 8%, compute interest between March 1
and July 3.
The actual/ actual (in period) day count is
used for Treasury Bonds
• Actual/ actual (in period) = 124/ 184 * 4 = 2.6957
• 30/360 = 122/ 180 *4 = 2.7111
The 30/360 day count is used for corporate
• Actual/360 = 124/360*8 = 2.7555
and municipal bonds
US Treasury Bond FV $100, Coupon 7% Semi annual
The actual/360 day count is used for money
Payments on January 7 and July 7
market instruments
In this case the interest earned for entire year
Compute accrued interest ? For period between July 7
is 365/360 the quoted rate and August 9
What is the interest when this is corporate bond or money
Convention vary across countries market instrument?
Actual/365 – Australia and New Zealand
LIBOR actual/360 for all currencies except
GBP where it is actual/365
Euro-denominated and GBP bonds are dealt
in actual/ actual (in period)
Indian market actual / 365
DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Thursday, 02 May 2024 4
 PRICE QUOTATIONS OF US TREASURY BILLS AND BONDS

US Treasury Bills US Treasury Bonds

The prices of money market instruments are
Treasury bond prices in the US are quoted in
sometime quoted using a “discount rate”
Dollars and thirty seconds of a dollar
This is interest earned as percentage of the final
face value rather than as an initial price paid on 5
$120-05 or $120- which is $120.15625
instrument 32
Price of US T-bill is quoted as “8” The quoted price, which traders refer as clean price
8% interest rate is earned on the FV per 360 days is not the same as cash price paid by the purchaser
FV is $100 then interest rate earned for 91-days of the bond referred as dirty price
life of T-bill is (100*0.08*91/360) = 2.022 = +
In general, the relationship between cash price “Y” 5th March, 10% bond maturity on July 10,2038,
per $100 of face value and the quoted price “P” of quoted price is 155-16; recent coupon date is Jan
the treasury bill in the US is 10.
360
= (100 − ) where “n” is the “remaining life What is the accrued interest and what is the cash
of the treasury bill measured in calendar days” price?
Cash price of 90-day T-bill is 99 quoted price is ?
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TREASURY BOND FUTURES AND CONVERSION FACTOR

Ultra T-Bond futures and Treasury bond futures contracts are quoted in dollars and thirty second of dollar per
$100 face value like bonds discussed earlier.
The Settlement price of Treasury bond futures contract is specified to nearest thirty second of dollar
20
A quote 179-20 indicates 179- = 179.625
32
The settlement price of 10-treasury note futures contract is quoted to the nearest half of thirty second of dollar
2.5
A quote 139-025 indicates 179- = 139.078125
32
The settlement price of 5 and 2- year Treasury note futures contract is quoted even more precisely to the
nearest quarter of thirty second of dollar
13.25
A quote 125-132 indicates 125- = 125.4140625
32

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Thursday, 02 May 2024 6

CONVERSION FACTORS AND CHEAPEST BOND TO DELIVER

Conversion Factors: What is the conversion factor

Conversion factor defines the
price received for the bond by the The conversion factor for a bond is set equal to the quoted price the
party with short position bond would have per dollar of principal on the first day of the
The applicable quoted price is delivery month on the assumption that the interest rate for all
product of most recent settlement maturities equals 6% per annum (with semiannual compounding).
price * conversion factor
The accrued interest is added to the Provides a Benchmark for Comparison
quoted price 1. consider a 10% coupon bond with 20 years and 2 months to maturity.
Cash received for FV $100 = 2. bond is assumed to have exactly 20 years to maturity.
(Most recent settlement price* 3. Coupon payments are made at 6-month intervals until the end of the 20 years
Conversion Factor) + Accrued when the principal payment is made.
Interest
4. Assume that the face value is $100.
Example : Recent settlement
5. The discount rate is 6% per annum with semiannual Compounding
price is 120-16, conversion factor
is 1.5 and accrued interest is 2;
cash to be received? Value of bond
146.23 divided by face value 100 gives conversion factor of 1.4623
DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Thursday, 02 May 2024 7
CHEAPEST BOND TO DELIVER

During Delivery of the Futures Short party can

delivery many bonds (matching the contract value)

However, the cheapest bond to delivery depends on

coupon, maturity etc.

Short party receives Assume the most recent settlement

Most Recent Price * Conversion Factor + Accrued Interest price is 93-08 what is the cheapest bond to deliver

The cost of purchasing the bond is

Quoted bond price + Accrued Interest

Quoted Bond price – (Most recent price * Conversion

Factor)

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Thursday, 02 May 2024 8

 DETERMINING THE FUTURES PRICE

• Theoretical futures price for the Treasury bond contract is difficult to determine because the short party’s
timing of delivery and choice of the bond that is delivered cannot easily be valued.

• Assume that both the cheapest-to-deliver bond and the delivery date are known.

• The Treasury bond futures contract is a futures contract on a traded security (the bond) that provides the
holder with known income. It is similar to futures prices of stock or bond with known Income

=( − I)
• The futures price, F0, is related to the spot price, S0, by where I is the present value of the coupons
during the life of the futures contract, T is the time until the futures contr act matures, and r is the risk-free
interest rate applicable to a time period of length T.
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EURODOLLAR AND SOFR FUTURES
EURODOLLAR FUTURES
Very popular contract by CME group (USA) SOFR FUTURES
Underlying interest rate is 3m (90 day) US SOFR is designed to almost reflect the federal
dollar LIBOR and maturities are upto 10 years funds rates futures contract.
The settlement price is determined by 100 –R, Settlement price is 100 – average of SOFR one-day
where R is the 3-Month US dollar LIBOR on rates during the month.
settlement day One SOFR contract is designed to hedge a $5
The contracts are designed such that “1” Million Position and one basis point movement in
BASIS POINT (=0.01) Movement in futures price quote results in $41.67 gains or loss to the
quote results in a loss or gain of $25. parties.
If price rises by 1 bps the long party gains $25, Settlement price changes from 99.725 to 99.685,
while short party losses $25 and vice versa the change is 4 basis points, the long party
Settlement price changes from 99.725 to looses 4*$41.67 = $166.68
99.685, the change is 4 basis points, the long
party looses 4*$25 = $100

DERIVATIVES AND RISK MANAGEMENT :: ACV SUBRAHMANYAM Thursday, 02 May 2024 10

 Calculating the Zero Curves
Convexity Adjustments Futures contracts can be used to provide estimates
Forwards and Futures are assumed to be of forward interest rates. These can be used to
similar. This holds only for short tenures determine the zero rates.
When the contract is beyond 2 years. From interest rates chapter, we know that the
Convexity adjustments need to be made forward rate applicable to the period between times
Forward Rate = Futures Rate – c T1 and T2 is
( 2 2− 1 1)
C is the convexity adjustment =
( 2− 1)
Intuition
Where R1 and R2 are the zero rates for maturities T1
Forwards are not subjected to daily settlements,
while futures are. This allows trader with futures and T2 (Continuously compounded).
contracts to benefit form the interim movements ( 2 − 1) + 1 1
in the interest rates. 2=
2
The forward trader seeks to be compensated for
the same. Hence demands a lower rate. Therefore This equation can be used for bootstrapping
convexity adjustment is positive LIBOR and SOFR zero curves
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 DURATION BASED HEDGING STRATEGIES
VF : Contract price for one interest rate futures contract
DF : Duration of the asset underlying the futures contract at the maturity of the futures contract
P: Forward value of the portfolio being hedged at the maturity of the hedge
DP : Duration of the portfolio at the maturity of the hedge
If we assume that the change in the yield, ∆y, is the same for all maturities [only parallel shifts ]
∆P = − ∆ P. Change in Bond Portfolio
∆ =− ∆ . Change in Futures contract position
P.
= Optimal number of contracts for hedging the portfolio
.
Assuming – cheapest bond to deliver
Interest rates and Bond Futures prices move in opposite direction
Hedgers choose futures with similar duration of that the bond portfolio being hedged.
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