K.Cuthbertson, D.

Nitzsche 1
Version 1/9/2001
FINANCIAL ENGINEERING:
DERIVATIVES AND RISK MANAGEMENT
(J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche



LECTURE

T-Bond Futures
K.Cuthbertson, D. Nitzsche 2


Details of Contracts and Terminology

Hedging with T-Bond Futures

Pricing T-Bond Futures

Market Timing
Topics
K.Cuthbertson, D. Nitzsche 3


Details of Contracts and Terminology

K.Cuthbertson, D. Nitzsche 4
Long T-bond futures position
Holder can take delivery of a long maturity T-bond at
expiration, at a price F
0
agreed at t=0.

Speculation
Think long rates will fall in the future, then buy a T-Bond
future
If rates do fall, then F increases and close out at profit

Hedging
Lock in a price today, for delivery or sale of the underlying
T-Bonds

Arbitrage
Keeps the cash market T-bond price (S) and the futures
price,F broadly moving together
Contract and its Uses
K.Cuthbertson, D. Nitzsche 5
27
th
July 2000s

Settlement price(CBT), Sept. delivery
= 98-14 (= 98
14/32
) =$98.4375 per $100 nominal

Contract size, z = $100,000

Face value one contract:
FVF
0
=z(F
0
/100)=z ($98.4375 / $100) = $98,437.50.


Tick size = 1/32 of 1%
Tick value = $31.25 per contract


US, T-Bond Futures Contract
K.Cuthbertson, D. Nitzsche 6
.
Table 6.2 : US T-Bond Future (CBOT)
Contract Size $ 100,000 nominal, notional US Treasury Bond with
8% coupon
Delivery Months March, June, September, December
Quotation Per $ 100 nominal
Tick Size (Value) 1/32 ($ 31.25)
Last trading day 7 working days prior to last business day in expiry
month
Delivery day Any business day in delivery month (sellers choice)
Settlement Any US Treasury Bond maturing at least 15 years
from the contract month (or not callable for 15 years)
Margins $ 5,000 initial; $ 4,000 maintenance
Trading Hours 8 am 2 pm Central Time
Daily Price Limit 96/30 pnts $ 3,000
K.Cuthbertson, D. Nitzsche 7
Adjusts price of actual bond to be delivered by assuming
it has an 8% yield to maturity, , which then matches that
of the notional bond in the futures contract.
(also with maturity > 15yrs)

If the coupon on the bond actually delivered > 8%
then CF > 1

If the coupon on the bond actually delivered < 8%
then CF < 1



Conversion Factor, CF
K.Cuthbertson, D. Nitzsche 8
CTD bond is one with smallest raw basis:

[6.1] Raw Basis = B
T
F
T
CF
T

B
T
= spot (clean) price of eligible bond for delivery
F
T
= settlement futures price
CF
T
= conversion factor of a deliverable bond.




Cheapest to Deliver
K.Cuthbertson, D. Nitzsche 9
Hedging
with
T-Bond Futures
K.Cuthbertson, D. Nitzsche 10
Hedging an Existing Bond Position
Spot Position: 1st May Futures : 1st May (September delivery)
10%, 2005 Treasury Bond (YTM = 10.12%) CF of CTD bond = 1.12
Nominal Bond holding NB
0
= $1m

Size of one contract z = $100,000
Current Price S
0
= $101 ($101 per $100) Price of futures F
0
= 110-16 ($110.50)
Market Value, Spot = TVS
0
= NB
0
(S
0
/100) = $1,010,00
Duration D
s
= 6.9
Number of futures contracts
10
0
0
=
|
|
.
|

\
|
=
CTD
f
s
f
CF
D
D
FVF
TVS
N
Face Value FVF
0
= z F
0
=$110,500
Duration D
F
= 7.2
Tick value of 1/32 equals $31.25
K.Cuthbertson, D. Nitzsche 11
FINANCIAL ENGINEERING:
Outcome of the Hedge : 1st August
Spot Market (On 1st August) September Futures (On 1
st
August)
S
1
= 98-16 ($98.5)
Value of spot position TVS
1
= (S
1
/100)B
= (98.5/100)$1m
= $985,000
F
0
= 110-16 ($110.5)
F
1
= 108-16 ($108.5 per $100)
Loss on spot position = ((S
0
S
1
)/ 100) B
= (101 98.5)/100)$1m = $25,000
Gain on short futures
= N
f
z (F
0
F
1
)/100

= 10 ($100,000) (2/100) = $20,000
or
= (2 x 32) ticks x $31.25 x 10 = $20,000
NET RESULT
Net loss
Hedged = $20,000 $25,000 = $5,000
Unhedged = $25,000
K.Cuthbertson, D. Nitzsche 12

-the hedge period (eg. 3 months from May to August)
may not correspond to the maturity of the futures contract
(eg. September contract)

-the exact bond to be delivered in the futures contract is
not known, neither is the precise delivery date

-all of the methods for calculating the relative price
response in the spot and futures markets are subject to
some error, in part because it is difficult to ascertain the
CTD bond (and hence its duration)

-shifts in the yield curve may not be parallel, so we
cannot always assume, Ay
s
= Ay
F.

Risks in the Hedge
K.Cuthbertson, D. Nitzsche 13
Position Day :
The short notifies the Clearing House of intention to deliver, two
business days later

Notice of Intention Day :
The Clearing House assigns a trader who is long to accept delivery.
The short is now obligated to deliver the next business day.

Delivery Day
Bonds are delivered (with the last possible delivery day being the
business day prior to the last 7 days in the delivery month).


Wild Card Play
K.Cuthbertson, D. Nitzsche 14


On any 'position day'.
If the spot price of bonds falls between 3pm and 5pm, the short buys
the low price CTD bond in the cash market and issues a notice of
intention to deliver knowing that upon delivery she will receive the
high futures settlement price determined as of 3pm that day.

However, if the spot (bond) price does not decline, she can wait until
the next day and repeat this strategy (until the final business day
before the final delivery day in the month).

the short has an implicit option that is exercisable during the delivery
month, while the long has increased risk because she does not know
the exact price (ie. value) of the bond that will be delivered.


Wild Card Play by the short
K.Cuthbertson, D. Nitzsche 15
Pricing T-Bond Futures
K.Cuthbertson, D. Nitzsche
Figure 6.2 : Pricing a T-bond future
Deliverable bond is 10% coupon which matures 15th February 2020.
Deliverable bond pays semi-annual coupons of $(10/2) on 15th Feb. and 15th Aug.
C/2 C/2 C/2
15th Feb.
1999
1st July
1999 (= t)
15th Aug.
1999
Buy Spot Bond
AI
t
= (136/181)(10/2)
= 3.76
11th Sept.
1999 (= T)
15th Feb.
2000
Delivery of Bond in Futures
AI
T
= (27/184)(10/2) = 0.73
Arbitrage Period = 72 days
181 days 184 days
136 days 45 27 157 days
K.Cuthbertson, D. Nitzsche 17
Zero Coupon Bond
[13c] F = S exp( r (T-t) )

Coupon Paying Bond
Synthetic bond future
[6.14] Net cost (at T) of carry in cash market = (S
t
e
r(T-t)
FVC
T
)

FVC
T
applies to the coupon payments which occur between t = 1
st
of
July and T = 11
th
of September

[6.15] Invoice Price of Futures (at T): IPF = F
t
CF
t
+ AI
T


Actual futures contract and the synthetic futures both deliver one
bond at T then their cost must be equal, otherwise riskless arbitrage
profits would be possible. Equating [6.14] and [6.15] :

[6.16a] F
t
(CF
t
)

+ AI
t
= S
t
e
r(T-t)
FVC
T

[6.16b] F = (1/CF
t
) (S
t
e
r(T-t)
FVC
T
- AI
T
)
Pricing T-Bond Futures
K.Cuthbertson, D. Nitzsche 18

[6.18] S
t
= B
t
+ AI
t


[6.19b] S
t
= $130 + $4.14 = $134.14

Net cost of carry in the cash market at T, is :

[6.20] (S
t
e
r(T-t)
FVC
T
) = $134.14 e
0.03(58/365)
$5.022 = $129.76

AI
T
because of the next coupon payment on 15
th
of Feb 2000 is :

[6.21a] AI
T
= (27/184) (10/2) = 0.73

[6.21b] F = (1/CF
t
) (S
t
e
r(T-t)
FVC
T
- AI
T
)
= (1/1.22) ($129.76 $0.73) = $105.76

Pricing T-Bond Futures
K.Cuthbertson, D. Nitzsche 19
Market Timing
K.Cuthbertson, D. Nitzsche 20


Sell futures if you expect a rise in yields and therefore
require a lower duration for your existing bond portfolio


Buy futures if you expect a fall in yields and therefore
require an increased duration for your bond portfolio.

Market Timing
K.Cuthbertson, D. Nitzsche 21
END OF SLIDES