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Chapter 12

Chapter 12. Interest Rate Futures: Fundamentals. Definition. Futures are marketable forward contracts.

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Chapter 12

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  1. Chapter 12 Interest Rate Futures: Fundamentals

  2. Definition • Futures are marketable forward contracts. • Forward contracts are agreements to buy or sell a specified asset (commodity, index, debt security, currency, etc.) at an agreed-upon price (f) for purchase or delivery on a specified date (delivery date: T).

  3. Futures Exchanges • Futures are traded on organized exchanges;,such as the: • Chicago Board of Trade, CBOT • Chicago Mercantile Exchange, CME • The exchanges provide marketability: • Listings • Standardization • Locals • Clearinghouse

  4. Futures Exchanges

  5. Futures Exchanges

  6. Futures Exchanges

  7. Futures Exchanges • Futures exchanges are typically structured as membership organization with a fixed number of seats and with the seat being a precondition for direct trading on the exchange. • On most futures exchanges, there are two major types of futures traders/members: commission brokers and locals. • Commission brokers buy and sell for their customers. They carry out most of the trading on the exchanges, serving the important role of linking futures traders. • Locals,on the other hand, trade from their own accounts, acting as speculators or arbitrageurs. They serve to make the market operate more efficiently.

  8. Futures Exchanges • Standardization • The futures exchanges provide standardization by specifying the grade or type of each asset and the size of the underlying asset. • Exchanges also specify how contract prices are quoted. For example: • The contract prices on T‑bill futures are quoted in terms of an index equal to one hundred minus a discount yield. • A T‑bond is quoted in terms of dollars and 1/32s of a T‑bond with a face value of $100.

  9. Futures Exchanges • Continuous Trading • Many security exchanges use market‑makers or specialists to ensure a continuous market. • On many futures exchanges, continuous trading also is provided, but not with market‑makers or specialists assigned by the exchange to deal in a specific contract. • Instead, futures exchanges such as the CBOT, CME, and LIFFE provide continuous trading through locals who are willing to take temporary positions in one or more futures.

  10. Futures Exchanges • Delivery Procedures • Only a small number of contracts that are entered into lead to actual delivery. • Most futures contracts are closed prior to expiration. • Nevertheless, detailed delivery procedures are important to ensure that the contract price on a futures contract are determined by the spot price on the underlying asset and that the futures price converges to the spot price at expiration.

  11. Futures Exchanges • Alliances and 24-Hour Trading • In addition to providing off-hour trading via electronic trading systems, 24-hour trading is also possible by using futures exchanges that offer trading on the same contract. • The CME, LIFFE, and SIMEX all offer identical contracts on 90-day Eurodollar deposits. • This makes it possible to trade the contract in the U.S., Europe, and the Far East. • Moreover, these exchanges have alliance agreements making it possible for traders to open a position in one market and close it in another. A similar alliance exists between SFE, CBOT, and LIFFE on U.S. T-bond contracts.

  12. Futures Exchanges • The exhibit on the next slide lists various interest rate futures contracts traded on the CBOT, CME, LIFFE, and other exchanges. • Of these contracts, the four most popular are • T‑bonds • T‑notes • Eurodollar deposits • T‑bills

  13. Futures Exchanges

  14. T‑Bill Futures • T‑bill futures contracts call for the delivery (short position) or purchase (long position) of a T‑bill with a maturity of 91days and a face value (F) of $1 million. Futures prices on T‑bill contracts are quoted in terms of an index. • This index, I, is equal to 100 minus the annual percentage discount rate, RD, for a 90-day T-bill:

  15. T‑Bill Futures • Given a quoted index value or discount yield, the actual contract price on the T‑bill futures contract is:

  16. T‑Bill Futures • Example: A T-bill futures contract quoted at a settlement index value of 95.62 (RD = 4.38%) would have a futures contract price (f0) of $989,050 and an implied YTMf of 4.515%:

  17. T‑Bill Futures • Expiration months on T‑bill futures are March, June, September, and December, and extend out about two years. • The last trading day occurs during the third week of the expiration month, on the business day preceding the issue of spot T‑bills. • Under the terms of the contract, delivery may occur on one of three successive business days with the delivered T-bill having a maturity of 89, 90, and 91 days.

  18. Eurodollar Futures Contract • A Eurodollar deposit is a time deposit in a bank located or incorporated outside the United States. • A Eurodollar interest rate is the rate that one large international bank is willing to lend to another large international bank. • The average rate paid by a sample of London Euro‑banks is known as the London Interbank Offer Rate (LIBOR). • The LIBOR is higher than the T-bill rate, and is used as a benchmark rate on bank loans and deposits.

  19. Eurodollar Futures Contract • The CME's futures contract on the Eurodollar deposit calls for the delivery or purchase of a Eurodollar deposit with a face value of $1 million and a maturity of 90 days. • The expiration months on Eurodollar futures contracts are March, June, September, and December and extend up to ten years.

  20. Eurodollar Futures Contract • Like T‑bill futures contracts, Eurodollar futures are quoted in terms of an index equal to 100 minus the annual discount rate, with the actual contract price found by using the following equation:

  21. Eurodollar Futures Contract • Example, given a settlement index value of 95.09 on a Eurodollar contract, the actual futures price would be $987,725:

  22. Eurodollar Futures Contract • The major difference between the Eurodollar and T‑bill contracts is that Eurodollar contracts have cash settlements at delivery, while T‑bill contracts call for the actual delivery of the instrument. • When a Eurodollar futures contract expires, the cash settlement is determined by the futures price and the settlement price.

  23. Eurodollar Futures Contract • The settlement price or expiration futures index price is 100 minus the average three‑month LIBOR offered by a sample of designated Euro-banks on the expiration date: Expiration Futures Price = 100 ‑ LIBOR

  24. T‑Bond Futures Contracts • The most heavily traded long-term interest rate futures contract is the CBOT’s T-bond contract. • The contract calls for the delivery or purchase of a T‑bond with a maturity of at least 15 year. • The CBOT has a conversion factor to determine the actual price received by the seller. • The futures contract is based on the delivery of a T-bond with a face value of $100,000.

  25. T‑Bond Futures Contracts • The delivery months on the contracts are March, June, September, and December, going out approximately two years. • Delivery can occur at any time during the delivery month. • To ensure liquidity, any T‑bond with a maturity of 15 years is eligible for delivery, with a conversion factor used to determine the actual price of the deliverable bond. • Since T‑bonds futures contracts allow for the delivery of a number of T‑bonds at any time during the delivery month, the CBOT's delivery procedure on such contracts is more complicated than the procedures on other futures contracts.

  26. T‑Bond Futures Contracts • T‑bond futures prices are quoted in dollars and 32nds for T‑bonds with a face value of $100. • Thus, if the quoted price on a T-bond futures were of 106-14 (i.e., 106 14/32 or 106.437), the price would be $106,437 for a face value of $100,000.

  27. T‑Bond Futures Contracts • The actual price paid on the T-bond or revenue received by the seller in delivering the bond on the contract is equal to the quoted futures price times the conversion factor, CFA, on the delivered bond plus any accrued interest: Seller’s Revenue = (Quoted Futures Price)(CFA) + Accrued Interest

  28. T‑Bond Futures Contracts • Example: At the time of delivery, if the delivered bond has a CFA of 1.3 and accrued interest of $2 and the quoted futures price is 94-16, then the cash received by the seller of the bond and paid by the futures purchaser would be $124.85 per $100 face value: Seller’s Revenue = (94.5)(1.3) + 2 = 124.85

  29. T‑Note Futures Contracts • T‑note contracts are similar to T-bond contracts, except that they call for the delivery of any T‑note with maturities between 6 1/2 and 10 years; • The five-year T-note contracts are also similar to T-bond and T-note contracts except that they require delivery of the most recently auctioned five-year T-note. • Both contracts, though, have delivery procedures similar to T-bond contracts.

  30. Forward Contracts and Forward Rate Agreements (FRA) • Forward contracts for interest rate products are private, customized contracts between two financial institutions or between a financial institution and one of its clients. • Interest rate forward contracts predate the establishment of the interest rate futures market. • A good example of an interest rate forward product is a forward rate agreement, FRA.

  31. Forward Contracts and Forward Rate Agreements (FRA) • A FRA requires a cash payment or provides a cash receipt based on the difference between a realized spot rate such as the LIBOR and a pre-specified rate. • For example, the contract could be based on a specified rate of Rk = 6% (annual) and the three-month LIBOR (annual) in five months and a notional principal, NP (principal used only for calculation purposes) of $10M.

  32. Forward Contracts and Forward Rate Agreements (FRA) • In five months the payoff would be • If the LIBOR at the end of five months exceeds the specified rate of 6%, the buyer of the FRA (or long position holder) receives the payoff from the seller. • If the LIBOR is less than 6%, the seller (or short position holder) receives the payoff from the buyer.

  33. Forward Contracts and Forward Rate Agreements (FRA) • If the LIBOR were at 6.5%, the buyer would be entitled to a payoff of $12,267 from the seller; • If the LIBOR were at 5.5%, the buyer would be required to pay the seller $12,297.

  34. Forward Contracts and Forward Rate Agreements (FRA) • In general, a FRA that matures in T months and is written on a M-month LIBOR rate is referred to as a T x (T+M) agreement. • Thus, in this example the FRA is a 5 x 8 agreement. • At the maturity of the contract (T), the value of the contract, VT is

  35. Forward Contracts and Forward Rate Agreements (FRA) • FRAs originated in 1981 amongst large London Eurodollar banks that used these forward agreements to hedge their interest rate exposure. • Today, FRAs are offered by banks and financial institutions in major financial centers and are often written for the bank’s corporate customers. • They are customized contracts designed to meet the needs of the corporation or financial institution.

  36. Forward Contracts and Forward Rate Agreements (FRA) • Most FRAs do follow the guidelines established by the British Banker’s Association. • Settlement dates do tend to be less than one year (e.g., 3, 6, or 9 months), although settlement dates going out as far as four years are available. • The NP on a FRA can be as high as a billion and can be drawn in dollars, British pounds and other currencies.

  37. Forward Contracts and Forward Rate Agreements (FRA) • FRAs are used by corporations and financial institutions to manage interest rate risk in the same way as financial futures are used. • Different from financial futures, FRAs are contracts between two parties and therefore are subject to the credit risk of either party defaulting. • The customized FRAs are also less liquid than standardized futures contracts.

  38. Futures Positions • A futures holder can take one of two positions on a futures contract: a long position (or futures purchase) or a short position (futures sale). • In a long futures position, the holder agrees to buy the contract's underlying asset at a specified price, with the payment and delivery to occur on the expiration date (also referred to as the delivery date). • In a short futures position, the holder agrees to sell an asset at a specific price, with delivery and payment occurring at expiration.

  39. Clearinghouse • To provide contracts with marketability, futures exchanges use clearinghouses. • The exchange clearinghouse is an adjunct of the exchange. • It consists of clearinghouse members (many of whom are brokerage firms) who guarantee the performance of each party of the transaction and act as intermediaries by breaking up each contract after the trade has taken place.

  40. Clearinghouse: Example • Suppose in early June Speculator A buys a September T-bill Futures contract from Speculator B for f0 = $987,500 (IMM = 95, RD = 5) • A is long • B is Short

  41. Clearinghouse • The clearinghouse (CH) would come in after Speculators A and B have reached an agreement on the price of the September T-bill contract, becoming the effective seller on A's long position and the effective buyer on B's short position. • Once the clearinghouse has broken up the contract, then A's and B's contracts would be with the clearinghouse. The clearinghouse, in turn, would record the following entries in its computers.

  42. Clearinghouse

  43. Clearinghouse • The intermediary role of the clearinghouse makes it easier for futures traders to close their positions before expiration. • To see this, suppose that in June, short-term interest rates drop, leading speculators such as C to want to take a long position in the September T-bill contract.

  44. Clearinghouse • Seeing a profit potential from the increased demand for long positions in the September contract, suppose Speculator A agrees to sell a September T-bill futures contract to Speculator C for $988,750 (RD = 4.5% and Index = 95.5). • Upon doing this, Speculator A now would be short in the new September contract, with Speculator C having a long position, and there now would be two contracts on September T-bills. • After the new contract between A and C has been established, the clearinghouse would step in and break it up. • For Speculator A, the clearinghouse's records would now show the following.

  45. Clearinghouse The clearinghouse accordingly would close Speculator A's positions by paying her $1,250 at expiration.

  46. Clearinghouse • Since Speculator A's short position effectively closes her position, it is variously referred to as a closing, reversing out, or offsetting position or simply as an offset. • Thus, the clearinghouse makes it easier for futures contracts to be closed prior to expiration. • The expense and inconvenience of delivery causes most futures traders to close their positions instead of taking delivery.

  47. Clearinghouse • As the delivery date approaches, the number of outstanding contracts, referred to as open interest, declines, with only a relatively few contracts still outstanding at delivery.

  48. Clearinghouse • At expiration (T), the contract prices on futures contracts established on that date (fT) should be equal (or approximately equal for some contracts) to the prevailing spot price on the underlying asset (ST). • If fT does not equal ST at expiration, an arbitrage opportunity would exist. Arbitrageurs could take a position in the futures market and an opposite position in the spot market.

  49. Clearinghouse • For example, if the September T-bill futures contracts were trading at $990,000 on the delivery date in September and the spot price on T-bills were trading at $990,500, an arbitrageur could • go long in the September contract, • take delivery by buying the T-bill at $990,000 on the futures contract, • then sell the bill on the spot at $990,500 to earn a risk-free profit of $500. • The arbitrageur’s efforts to take a long position, though, would drive the contract price up to $990,500.

  50. Clearinghouse • On the other hand, if fT exceeds $990,500, then an arbitrageur would reverse their strategy, pushing fT down to $990,500. • Thus at delivery, arbitrageurs will ensure that the price on an expiring contracts is equal to the spot price. • As a result, closing a futures contract with an offsetting position at expiration will yield the same profits or losses as purchasing (selling) the asset on the spot and selling (buying) it on the futures contract.

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