Derivatives (ECONM3017)

Lecture Three: Forwards and Futures II

(Interest Rate Futures)

Nick Taylor
nick.taylor@bristol.ac.uk

University of Bristol

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Table of contents

1 Learning Outcomes

2 General Information

3 Treasury Bond Futures

4 Eurodollar Futures

5 Summary

6 Reading

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Learning Outcomes

At the end of this lecture you will be able to:

1 Understand the conventions underlying the quotation of interest rate futures
contracts prices.
2 Differentiate between the main types of interest rate futures contracts.
3 Calculate the theoretical prices of Treasury bond futures contracts.
4 Appreciate the differences between forward and futures interest rates.

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General Information

Interest Rate Types

An interest rate defines the amount of money the borrower promises to pay
the lender. The rate used ultimately depends on the credit risk of the
borrower. There are three main types of interest rates:
1 Treasury Rates: The rate an investor earns on Treasury bills and

Treasury bonds.
2 LIBOR Rates: The London Interbank Offered Rate is the rate quoted

by a bank at which they are prepared to make a deposit with another

AA-rated bank. These quotes can have maturities up to 12 months.
(See also LIBID rates).
3 Repo Rates: An investment dealer can sell securities to another

company and buy them back at a slightly higher price at a later date
(the contract is the repo or repurchase agreement). This difference is
the repo rate.

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General Information (cont.)

Measuring Interest Rates

Assume an amount A is invested for 1 year at an interest rate r per annum.
The terminal value of this investment with annual compounding will be

A(1 + r ).

In general, with compounding m times per annum, the terminal value will be
 r m
A 1+ .
m

As m , terminal wealth becomes

Ae r .

Note that if the investment last n

years, then terminal wealth will be
Ae rn .

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General Information (cont.)

Spot versus Forward Interest Rates

Spot and forward interest rates are (respectively) defined as follows:
Spot Interest Rates (also known as the n-year zero coupon yield):
The n-year spot interest rate on an investment that starts today and
lasts n years.
Forward Interest Rates:
This is the rate implied by the spot rates for the period of time
between period T1 and period T2 . It is calculated as follows:
R2 T2 R1 T1
RF = ,
T2 T1
where R1 and R2 are the spot interest rates applicable over the periods
T1 and T2 , respectively.

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General Information (cont.)

Spot versus Forward Interest Rates (cont.)

Example
Consider the calculation of the forward rates using the data from the following
table (all interest rates are in % per annum terms):
Year (n) Zero Rate (over n-years) Forward Rate (for nth year)
1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.3 6.5
So, the year-4 forward rate is calculated using T1 = 3, T2 = 4, R1 = 0.046,
R2 = 0.05, and the above formula, to give 0.062.

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General Information (cont.)

Day Counts
Three day count conventions are used in the United States:
1 Actual/actual (in period).

The interest earned between two dates is based on the ratio of the
actual days elapsed to actual number of days in the period between
coupon payments (used for US Treasury bonds, and sterling bonds).
2 30/360.

This assumes that there are 30 days per month and 360 days per year
(used for US corporate and municipal bonds).
3 Actual/360.

Interest is calculated by dividing the actual number of elapsed days by

360 (used for US money market instruments).

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General Information (cont.)

Price Quotations
In general, the relationship between the cash and quoted prices of a US
Treasury bill is given by
360
P= (100 Y ),
n
where P is the quoted price, Y is the cash price, and n is the remaining life
of the Treasury bill measured in calendar days.
Clean v. Dirty Prices
The quoted price of US Treasury bonds (referred to as the clean price), is
not equal to the cash price paid by the purchaser of the bond (referred to as
the dirty price). Rather,

Cash price = Quoted price + Accrued interest since last coupon date,

where accrued interest is calculated using the actual/actual convention.

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General Information (cont.)

Clean v. Dirty Prices (cont.)

Example
Consider an 11% coupon US Treasury bond maturing on July 10, 2038, with a
quoted price of 95-16, or $95.50. Assume that the current date is March 5,
2015, and that the most recent coupon date is January 10, 2015, and the next
coupon date is July 10, 2015.
The number of days since the last coupon date is 54, and the number of days
between the last and next coupon dates is 181. Using the actual/actual
convention, the accrued interest on March 5, 2015, will be

54
$5.50 = $1.64.
181

Therefore, the cash price per $100 face value for the bond will be

$95.50 + $1.64 = $97.14,

and the cash price of a $100000 bond will be $97140.

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Treasury Bond Futures

Basic Information
Treasury Bond Futures (traded on CBOT) specify that any government
bond that has more than 15 years to maturity on the first day of the delivery
month (and not callable 15 years from that day) can be delivered. (See also
Treasury note futures, and federal funds futures).
Quotes
As with Treasury bonds, Treasury bond futures are quoted in dollars and
thirty-seconds of a dollar. One contract involves the delivery of $100000
face value of the bond.

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Treasury Bond Futures (cont.)

Conversion Factors
To adjust for the fact that the short position holder can deliver various
bonds, a conversion factor is applied to the price received. Specifically, the
cash received for each $100 face value of bond delivered is

(Most recent settlement price Conversion factor) + Accrued interest,

where the conversion factor for a bond is approximately equal to the value of
the bond on the assumption that the yield curve is flat at 6% with
semiannual compounding. Given the conversion factor, the short position
holder will deliver the cheapest-to-deliver bond.

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Treasury Bond Futures (cont.)

Theoretical Prices (a formula)

Given knowledge of the cheapest-to-deliver bond and the delivery date, the
following formula can be used:

F = (S I )e rT ,

where I is the present value of the coupons during the life of the futures
contract, T is the time until the futures contract matures, and r is the
risk-free interest rate applicable over this period.

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Treasury Bond Futures (cont.)

Theoretical Prices (the steps)

The following steps should be carried out:
1 Calculate the cash bond price.
2 Calculate the present value of the income to the bond.
3 Calculate the cash futures price.
4 Calculate the quoted futures price.

5 Apply the conversion factor to give the final futures price.

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Treasury Bond Futures (cont.)

Theoretical Prices (some practice)

Example
The cheapest-to-deliver bond will be a 12% coupon bond with a conversion
factor of 1.4. Delivery takes place in 270 days time. The last coupon payment
was made 60 days ago and the next coupon payment will be made in 122 days
time. The interest rate is 10%. The current quoted price of the underlying
bond is $120.

60
1 12% bond cash price = 120 + 182 6 = 121.978.
122
2 12% I = 6e 365 0.1 = 5.803.
270
3 12% f.c. cash price = F = (121.978 5.803)e 365 0.1 =
125.094.
148
4 12% f.c. quoted price = 125.094 6 183 = 120.242.
120.242
5 standard f.c. quoted price = 1.4 = 85.887.

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Eurodollar Futures

Some Details
The most popular interest rate futures contract in the US is the 3-month
Eurodollars futures (traded on CME). The contract specifies the following:
The underlying is the 3-month interest rate earned on Eurodollar
deposits (i.e., dollar deposits in a bank outside of the US).
Maturities of up to 10 years are available with the contract ending on
the third Wednesday of the delivery month.
Investors lock into the interest rate on $1 million for the 3-month
period after delivery.

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Eurodollar Futures (cont.)

Quote Conventions
The exchange defines the contract price as

10000 (100 0.25 (100 Q)),

where Q is the quoted settlement price. At maturity, we have

Q = 100 R,

where R is the actual 3-month Eurodollar interest rate on the delivery date
(expressed with quarterly compounding and an actual/360 day count
convention).

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Eurodollar Futures (cont.)

Forward v. Futures Interest Rates

Eurodollar futures contracts are similar to OTC agreements between parties
to apply particular interest rates (to each other) at a future date, say T1 and
T2 (referred to as forward rate agreements). However, they differ on two
counts:
1 Eurodollar futures contracts are settled daily, whereas forward rate
agreements are not.
2 The final settlement date of Eurodollar futures contracts is T1 , whereas
forward rate agreements are settled at T2 .

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Eurodollar Futures (cont.)

Forward v. Futures Interest Rates (cont.)

To account for the above differences a convexity adjustment is made.
Specifically,
1
Forward rate = Futures rate 2 T1 T2 ,
2
where is the standard deviation of the change in the short-term interest
rate in 1 year, and both rates are expressed with continuous compounding.

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Eurodollar Futures (cont.)

Forward v. Futures Interest Rates (cont.)

Example
Assuming that = 0.012, what is the forward rate when the 8-year Eurodollar
futures price quote is 94?
In this instance, T1 = 8 and T2 = 8.25, and the convexity adjustment is

1
0.0122 8 8.25 = 0.00475,
2

or 0.475% (47.5 basis points).

The futures rate is 6% per annum on an actual/360 basis with quarterly
compounding. This corresponds to 1.5% per 90 days, or an annual rate of
(365/90) ln 1.015 = 6.038% with continuous compounding and an actual/365
day count.
Therefore, the estimate of the forward rate given by the above equation is
6.038 0.475 = 5.563% per annum with continuous compounding.

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Summary

Conventions
Day counts and price quotations.
Treasury Bond Futures
Quotes, conversion factors, cheapest-to-deliver bonds, and theoretical prices.
Eurodollar Futures
Quotes, forward v. futures interest rates.

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Reading

Essential Reading
Chapters 4 and 6, Hull (2015).
Further Reading
Grinblatt, M., and N. Jagadeesh, 1996, Relative pricing of Eurodollar futures
and forward contracts, Journal of Finance 51, 14991522.

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