Treasury Futures Contracts Chapter 17

1. Treasury Futures ContractsChapter 17

2. Futures Contract - Definition An investor who takes a long (short) position in a futures contract agrees to buy (sell) specified units of the underlying asset (or its cash value) on a specified maturity date at a currently specified futures price. The futures price is determined when the contract is written and is specified in the contract. The futures price is set so that no payment is made when the contract is written; that is, at initiation, the futures contract has a zero market value. As the contract matures, however, the investor must make or receive daily instalment payments toward the eventual purchase of the underlying asset . The total of the daily instalments and the payment at maturity will equal the futures price set when the contract was initiated.

3. Futures Contract - Definition The daily instalments are determined by the daily change in the futures price. If the futures price goes up, the investor who is long in the futures contract receives a payment from the investor who is short that equals the change in the daily futures price. This process is called marking to market on futures exchanges. The effect of marking to market is to rewrite the futures contract each day at the new futures price . Hence the value of the futures contract after the daily settlement will always be zero, since the value of a newly written futures contract is zero.

4. Treasury Futures Specification: T-note

5. Treasury Futures Specification: T-note

6. Delivery process Source: Chicago Board of Trade

7. Volume of Trading Treasury Futures Specification

8. Commodity Trading Advisors (CTAs) • Futures prices may show persistence, at times. • CTAs use “trend-chasing” strategies in futures markets. • During 2008, CTAs were extremely successful in • generating high returns. This is due to secular increase • in commodity futures prices and fall in interest rates. • The behaviour of institutional investors in futures markets • is tracked by CFTC, which periodically publishes the • positions taken by institutions in futures markets.

9. Source: Herding Amongst Hedge Funds in Futures Markets Michael S. Haigh, Naomi E. Boyd and Bahattin Buyuksahin U.S. Commodity Futures Trading Commission

10. Uses of Treasury Futures Contracts • T-note futures contracts are used to hedge mortgage • positions and MBS positions. • T-bond futures are used to extend duration or hedge • duration risk. • Relative value traders exploit any dislocations between • cash and futures prices that are introduced by CTAs.

11. Treasury Futures Deliveries

12. Concept of Conversion FactorExample: CF of 4.75%, 5/15/2014 T-note to Sep 2007 Futures Conversion factors are a way to make each deliverable issue Equally desirable for delivery. They reward delivery of high coupon debt, and penalize the delivery of low coupon debt.

13. Concept of Conversion FactorCFs of all deliverable issues

14. Concept of Basis A concept that is widely used in the analysis of the Treasury contract is the basis. Let P be the clean price of the deliverable T-note, CF be its conversion factor, and H be the futures price at date t for maturity at date s. Recognizing that futures contracts permit delivery on any business day of the delivery month, we interpret s as the last business day of the delivery month in a positive-carry market and interpret s as the first business day of the month in a negative-carry market. The basis B is defined as P - CF xH. – cash price minus The conversion factor times the futures price.

15. Concept of BasisBasis of all deliverable issues

16. Basis of CTD tends to converge as futures contract approaches its maturity Source: J P Morgan

17. Concept of Cash and Carry The logic behind this principle works as follows: If the price at which an investor can sell a bond in the forward market (at the maturity date of the forward contract) is higher than the cost of financing the bond, the investor should sell forward and finance the bond. Otherwise, the investor should buy forward and sell the bond in a repurchase transaction. Let’s consider a strategy in which the trader finances a deliverable T-bond and sells futures as of September 7, 2007, shown in Figure 17.1 .

18. Concept of DeliveryOpening leg of a carry trade

19. Concept of DeliveryClosing leg of a carry trade

20. Net Basis and Forward Price Forward price Forward price is the cost of carrying the bond for delivery Revenue from delivery

21. Net Basis and Forward Price

22. Implied Repo Calculations Example 17.4 September 2007 T-note futures were quoted at 109.484. The deliverable bond 4.75%, May 15, 2014, was selling at a flat (clean) price of 102.2340 for settlement on September 5, 2007. The conversion factor of this bond was 0.9335. Determine its implied repo rate. If the actual repo rate was 4.83%, was there an arbitrage?

23. Implied Repo Calculations Implied repo rate is the rate at which the net basis is zero for the cheapest deliverable bond.

24. Implied Repo Calculations

25. Implied Repo Calculations

26. Duration Bias in Deliveries

27. New Long Bond Futures Contract Source: Chicago Board of Trade

28. Session - Conclusions/Main insights • Treasury note futures contracts are extremely liquid and can be used for hedging interest rate risks. • CTAs use futures contracts to exploit persistence and momentum-based price movements in futures contracts. • The concept of basis is used to determine how well futures and cash prices move together. • Net basis is used to determine the profitability of cash and carry arbitrage. • Implied repo rate is the rate earned on a portfolio with short futures and a financed cash position.