Prof.

Roberto Steri Derivatives I - Problem Set 3 Spring 2019

Problem Set 3
Suggested Deadline: 22/03/2019

Interest Rate Futures

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

1. Consider the following three …xed income securities on July 3rd, 2015

Type Quoted Price Coupon Rate Last Coupon Date Next Coupon Date
US Treasury Bond 98$ 10% March 1st September 1st
US Municipal Bond 98$ 10% March 1st September 1st

a) What is the cash price you should pay to purchase the US Treasury and Municipal bonds?
b) US Treasury Bills are quoted using a discount rate, that is the interest earned as a
percentage of the …nal face value. On July 3rd, 2015, a 122-day US Treasury Bill with
face value of 100$ is quoted at 10. The Bill matures on September 1st, 2015. What is
its cash price? What is the e¤ective return on the T-Bill?
c) After experimenting with Matlab, comment the following function

specifying its input, output and functionality. Write a Matlab script that calls it to
compute the cash price on date (dt ; mt ; yt ) of a US Treasury Bond with coupon rate
c, quoted price p, which paid the last coupon on date (dL ; mL ; yL ) and will pay next
coupon on date (dN ; mN ; yN ). All inputs are supposed to be valid (i.e. no input error
management is required to be implemented). Test it using the data on the Treasury
Bond above.

Solution

a) The accrued interest of the US Treasury Bond is computed using the Actual/Actual day
count convention, that is
124
5 = 3:3696$
184
where 184 are the days between March 1st and September 1st 2015, and 124 are the days
between March 1st, 2015 and July 3rd, 2015. The Treasury bond cash price is therefore

98 + 3:3696 = 101:37$

The accrued interest of the US Municipal Bond is computed using the 30/360 day count
convention, that is
122
5 = 3:3889$
180

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

where 180 are the days between March 1st and September 1st 2015 considering 30 days
per month, and 122 are the days between March 1st, 2015 and July 3rd, 2015 with the
convention, that is 30 4 + 2. The Municipal bond cash price is therefore

98 + 3:3889 = 101:39$

b) T-Bills use the Actual/360 day count convention. A quoted price of 10 means that the
annualized interest rate earned is 10% of the face value, that is
60
100 0:1 = 1:6667$
360
where 60 are the actual days between July 3rd and September 1st. The cash price C is
therefore given by:
60
100 10 = 98:33$
360
The e¤ective return on the T-Bill is computed at a fraction of the initial price, that is
1:6667
98:33
= 1:695%:
c) The following comments clarify how the function works

As a consequence, the di¤erence between any two dates, and in particular between
both the two coupon dates and today and the last coupon date, can be computed as
Mistery(dN ; mN ; yN ) Mistery(dL ; mL ; yL ) and Mistery(dt ; mt ; yt ) Mistery(dL ; mL ; yL ) re-

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

spectively. The following script computes the required cash price:

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

2. PiggyBank is a …nancial intermediary that has a short position in the Ultra T-Bond Futures
introduced by the Chicago Board of Trade (CBOT). The Ultra Bond futures di¤er from
traditional futures in that the delivery grade for the cheapest-to-deliver bond is limited to
T-Bonds with remaining maturity of at least 25 years but no more than 30 years. The Ultra
Bond contract matures in December 2014 and its settlement price is quoted at 155-16. Ultra
Bond futures, as classic T-Bond futures, allow the short party to deliver any day during the
maturity month.

a) PiggyBank is in the process of determining which bond is the cheapest-to-deliver in the

following shortlist:

What is your recommendation? What is the cost of delivering the cheapest bond?
b) PiggyBank will use the wild card play option on the delivery month. Speci…cally, CBOT
Bond Futures markets close at 2 p.m. Chicago Time, but the T-Bond Markets close at 4
p.m. The trader with the short position can wait until 8 p.m. to issue a notice to deliver
to the clearinghouse, but the contracts are always settled at the closing price at 2 p.m.,
regardless at what time the T-Bonds are actually purchased.
The following table reports hourly bond prices for the cheapest-to-deliver bond Piggy-
Bank decided to deliver in point a) for the second-last (d 1) and for the last (d) trading
days of December in which PiggyBank is allowed to play the wild card.

Hour d 1 d
07-08 am 107:58$ 107:57$
08-09 am 107:56$ 107:56$
09-10 am 107:57$ 107:55$
10-11 am 107:54$ 107:54$
11-12 pm 107:55$ 107:53$
12-01 pm 107:54$ 107:52$
01-02 pm 107:56$ 107:53$
02-03 pm 107:57$ 107:49$
03-04 pm 107:58$ 107:49$

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

Should PiggyBank rationally play the wild card on day d 1? If PiggyBank decides to
wait until day d for delivery, what is the cost of delivering the bond if it plays the wild
card? Would you expect futures prices to go up, down or remain unchanged if CBOT
would ban wild card play?
c) Suppose today is October 15th 2014 and the markets have not opened yet. PiggyBank
will deliver the bond with CUSIP 912810QA9 on December 15th 2014. The last coupon
has been paid on August 15th, 2014 (60 days ago) and next will be paid on February
15th, 2015. You are given the following data on the continuously compounded LIBOR
rates:
Day Days From Today LIBOR
December 15th, 2015 62 0:20%
February 15th, 2015 124 0:23%
What is the fair futures price that PiggyBank should expect to see on its trading termi-
nal? How much cash should PiggyBank expect to receive at maturity when it closes its
position?
d) Are there arbitrage opportunities in the market? If this in the case, should PiggyBank
implement either a cash-and-carry strategy (i.e. long on the asset, short on the futures) or
a reverse cash-and-carry strategy (i.e. short on the asset, long on the futures)? Describe
the exact sequence of transactions to implement your strategy, and specify the exact day
when you execute each transaction.
e) Suppose PiggyBank originally entered the contract to make speculative pro…ts out of its
outright position. Should the yield-to-maturity (YTM) of the cheapest-to-delivery bond
either increase or decrease in order to make PiggyBank successful? Why?

Solution

a) The table below illustrates the steps to determine the cheapest-to-deliver bond:

Recall that the Ultra Bond contract requires a delivery grade with residual maturity of at
least 25 years but no more than 30 years at the futures contract maturity. Therefore issue
CUSIP 912810FP8 is not eligible, and the cheapest bond to deliver is CUSIP 912810QA9
with a cost of delivering of 2.13$.

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

b) On day d 1 PiggyBank will certainly not play the wild card. After the market closes
at 2 p.m. the bond price is increasing from the settlement price of 107.56. Therefore,
with a short position, il would be more expensive for PiggyBank to deliver the asset. If
PiggyBank plays the wild card, it will purchases the bond at 107.49$ on day d for delivery.
The cost of delivering the bond is 2 $, since the cost of delivering is the di¤erence between
the quoted price and the product of the conversion factor and the settlement price, that
is
107:49 0:6784 155:5 = 2$
If CBOT would decide to ban wild card playing, futures prices would go up (i.e. it would
be more expensive to buy). Indeed, futures price already incorporate the value of this
option for the short party.
c) US Treasury Bonds and futures adopt the Actual/Actual day count convention. The
no-arbitrage cash price F0 of the futures contract is

F0 = (S0 P V (C)) er T

where P V (C) is the present value of the residual coupons until maturity T , S0 is the
cash price of the bond, and r is the LIBOR rate to maturity. In 2014 there are 365 days.
The time to maturity is 62 days (between October 15th 2014 and December 15th 2014),
because both today and the end date should be included in the day count (bonds are
settled after markets are closed, and today markets are not open yet). The cash price of
the cheapest-to-deliver bond is
accrued interest
z }| {
60
S0 = 107:62 + 1:75 = 108:19$
184
where 60 are the days between August 16th 2014 and October 14th 2014 included, and
184 are the days between the two coupon dates (August 16th 2014 and February 15th
2015 included). Since no coupons will be paid before maturity (December 15th 2014),
P V (C) = 0. Hence, PiggyBank should expect to receive 108:19$ at maturity, in that
62
F0 = S0 er T = 108:19 e0:002 365 = 108:23$

The quoted futures price PiggyBank should expect to see at maturity is therefore
accrued interest
z }| {
60 + 62
108:23 1:75
184 = 157:83$
0:6784
| {z }
conversion factor

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

d) In order to check the presence of arbitrage opportunities, one can compare the cash price
from the quoted futures settlement price and the no-arbitrage cash price under the chosen
cheapest-to-deliver bond. The cash price implied by the quoted futures settlement price
is
60 + 62
155:5 0:6784 + 1:75 = 106:65$
184
Futures contracts are relatively cheap compared to their no-arbitrage price. Therefore,
PiggyBank can implement the following reverse cash-and-carry strategy:

e) The yield-to-maturity (YTM) of the cheapest-to-delivery should increase to make Piggy-

Bank successful. PiggyBank has a short position, and an increase in interest rates would
make the cheapest-to-delivery bond less expensive to deliver.

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

3. Suppose we are in December and consider the following interest rate structure in the Eurodol-
lar futures and cash markets.

March Eurodollar Futures 99:10

June Eurodollar Futures 98:96
3-Month Cash Investment 0:70%
6-Month Cash Investment 0:80%
9-Month Cash Investment 0:90%

All Eurodollar futures use an actual/360 day count convention and are based on a $1 million
face value and suppose we are exactly respectively 3 months and 6 months away from the
maturity of March and June Eurodollar contracts.

a) Using only the available contracts, which is the best investment for the next six months?
b) If tomorrow’s March 2014 Eurodollar futures price advances by 2 basis points, how much
would the value of a long position in 200 contracts change?
c) An investor expects the yield curve to steepen in the near future. The following table
reports data on Eurodollar contracts with maturities of 3 months and 2 years.

3 months 2 years
Quoted Price 98:415 96:595

Which speculative strategy (calendar spread) could the investor adopt to "trade the yield
curve" and pursue her goal? How much would he investor’s pro…t if the spread widens
by 10%? How much would he lose if the spread decreases to 100 bp?
d) Consider a 10-year Eurodollar futures contract quoted as 95: A forward rate agreement
(FRA) for the same period allows to lock the interest rate at 4:5%. The FRA is settled
exactly 10 years and 3 months from now. Forward rates are quoted with continuous
compounding and with an actual/365 day count convention, while futures rates are
quoted with quarterly compounding and with an actual/360 day count convention.
Because of daily settlement in futures contracts and because the settlement occurs in
10 years for the Eurodollar contract, the Ho-Lee model (1986) predicts the following
convexity adjustment to account for the di¤erence between continuously compounded
forward rates RF OR and futures rates RF U T
1
RF OR = RF U T 2
TB TE
2
where TB is the beginning of the period when the interest rates are locked, TE is the end
of the period when the interest rates are locked, and is the standard deviation of the

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

change in the short-term interest rate in one year. An econometrician estimates to be

1:025%. Transaction costs account for approximately 0:1% with continuous compounding
and with an actual/365 day count convention. Are there available arbitrage opportunities
in the market?

Solution

a) The following investment options are available in the market:

– invest cash for 6 months at a rate of 0:80%
– invest for 3 months at a rate of 0:70% and lock the next 3-month rate with the March
Eurodollar Futures at 0:90%:The implied return on investment is:
90 90
1 + 0:007 360
1 + 0:009 360
1
180 = 0:808%
360

– enter a short position in June Eurodollar futures, and invest now in the 9-months
spot investment at a rate of 0:90% and sell it in June (when it has 90 days until
maturity). Since Eurodollar futures are settled in cash, this yields:
270
1+0:009 360
90
1+0:0104 360
1
180 = 0:828%
360

Therefore, the best investment opportunity is the third one.

b) An investor with a long position in 200 contracts on January 30, 2013 will experience a
value increase of 200 25 2 = 10; 000$.
c) The investor can speculate the spread between short-term and long-term interest rates
increases by buying 3-month "cheap" futures and selling 2-year "expensive" futures. The
current spread is 98:415 96:595 = 182 bp. If the spread widens to 182 1:1 = 200:2 bp,
the gain on the position is (200:2 182) 25 = 455 $. If the spread decreases to 100 bp,
the loss would be (182 100) 25 = 2050 $.
d) The convexity adjustment is
1 2 1 2
TB TE = 10 10:25
2 2
The futures rate is 5% with quarterly compounding and with an actual/360 day count
convention, that is 360
90
ln 1 + RF4U T = 360
90
ln 1 + 0:05
4
= 4:9 69% with continuous com-
pounding and an actual/360 day count. The value of implied by the no-arbitrage
condition between forward and futures rates is such that
4:969 1 2 4:5
10 10:25 = RF OR =
100 2 100

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

This yields = 0:9566%. Using the econometrician’s estimate ( = 1:025%) the interest
rate di¤erential is
4:969 1 4:5
(0:0125)2 10 10:25 = 0:000332
100 2 100
which is lower than the transaction costs in absolute value. Therefore, there are no
available arbitrage opportunities in the market.

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

4. The following table reports the term structure of assets (e.g. loans) and liabilities (e.g. de-
posits) of SafeBank
Maturity (months) Assets (mln $) Liabilities (mln $)
3 50 328:71
6 60
9 100
12 140

The annualized continuously compounded yield-to-maturity (YTM) of SafeBank’s assets and

liabilities are respectively 12% and 10%. Three-month T-Bill futures contracts of size 1 mln
$ are available on the market. Their underlying asset is a three-month Treasury Bill (zero
coupon) with 100$ face value, and the futures are priced at 87:933$ with a contract size of
10000$.

a) Compute the present value of SafeBank’s assets and liabilities (with continuous com-
pounding).
b) De…ne SafeBank’s duration gap as the di¤erence of the durations of SafeBank’s assets and
liabilities. Compute SafeBank’s duration gap. How much will SafeBank approximately
earn (or lose) if SafeBank’s interest rates increase from 12% and 10% to 13% and 11%?
c) Propose a strategy that employs the futures contracts described above to allow SafeBank
to hedge interest rate risk arising from its duration gap. How many futures contracts
should SafeBank either buy or sell?
d) After implementing the strategy, how much would SafeBank either gain or lose from its
assets and liabilities and its futures position if interest rates increase from 12% and 10%
to 13% and 11%, and if 3-month T-Bill yield-to-maturity increases by 100 bp? And
if interest rates decrease from 12% and 10% to 11% and 9%, and if 3-month T-Bill
yield-to-maturity decreases by 100 bp?
e) After implementing the strategy, how much would SafeBank either gain or lose from its
assets and liabilities and its futures position if interest rates increase from 12% and 10%
to 15% and 11%, and if 3-month T-Bill yield-to-maturity increases by 100 bp?
f) Give an economic interpretation of the results at points d) and e).

Solution

a) Denote as P V (A) and P V (L) the present values of assets and liabilities. We have:
3 6 9
0:12 12 0:12 12 0:12 12 0:12 12
P V (A) = 50e + 60e + 100e + 140e 12 = 320:59 mln $
3
0:10 12
P V (L) = 328:71 e = 320:59 mln $

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

b) The duration DA of SafeBank’s assets is given by

3 6
50 e 0:12 12 60 e 0:12 12
DA = 0:25 + 0:5 +
320:59 320:59
9 12
100 e 0:12 12 140 e 0:12 12
+0:75 +1
320:59 320:59
= 0:73 years

The duration DL of SafeBank’s liabilities is given by

3
328:71 e 0:10 12
DL = 0:25 = 0:25 years
320:59
The duration gap DG is therefore positive and equal to
DG = DA DL = 0:48 years

Approximately:
P V (A)
= DA YA
P V (A)
and
P V (L)
= DL YL
P V (L)
where P V (A) and P V (L) denote the change in value of SafeBank’s assets and lia-
bilities respectively, and YA and YL denote the changes in the yields on SafeBank’s
assets and liabilities. Hence, if interest rates increase to 13% and 12%, we have
P V (A) = 320:59 0:73 0:01 = 2:34 mln $

and
P V (L) = 320:59 0:25 0:01 = 0:80 mln $
Therefore, SafeBank’s values of assets would decrease by 2:34 mln $, while the value of
liabilities only by 0:80 mln $, with a loss of 2:34 0:80 = 1: 54 mln $.
c) SafeBank can use the T-Bill futures to reduce the value on the assets to the one of
liabilities, hence eliminating its duration gap. The number of futures contracts N to sell
to reduce the SafeBank’s asset duration to DL = 0:25 is:
P V (A) (DA DL ) P V (A) DG
N= =
F DF F DF
where F = 0:87933 mln $ is the value of one futures contract, and DF = 0:25 years is
the duration of the asset underlying the contract (the zero-coupon T-Bill). Thus:
320:59 0:48
N= = 700 contracts
0:87933 0:25

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Prof. Roberto Steri Derivatives I - Problem Set 3 Spring 2019

d) If the T-Bill’s YTM increases by Y T M = 100 bp, its price B would approximately
change by B such that
B
= DF Y TM
B
Hence
B= DF B Y TM = 0:25 87:933 0:01 = 0:219 83 $

and the new price would be:

B+ B = 87:933 0:219 83 = 87:713$

As computed in point b), if interest rates increase from 12% and 10% to 13% and 11%,
the loss from SafeBank’s assets and liabilities is approximately 1:54 mln $: The futures
position would instead yield 7 1 (87:933 87:713) = 1:54 mln $, hedging interest rate
risk (approximately) completely. If SafeBank’s interest rates decrease from 12% and 10%
to 11% and 9%, and if 3-month T-Bill yield-to-maturity decreases by 100 bp, we would
have:
P V (A) = 320:59 0:73 0:01 = +2:34 mln $

and
P V (L) = 320:59 0:25 0:01 = +0:80 mln $

SafeBank’s values of assets would increase by 2:34 mln $, while the value of liabilities
only by 0:80 mln $, with a gain of 2:34 0:80 = 1:54 mln $. The loss on the futures
positions would be 7 1 (87:933 87:713) = 1:54 mln $, hedging interest rate risk
(approximately) completely.
e) If interest rates increase from 12% and 10% to 15% and 11%, and if 3-month T-Bill
yield-to-maturity increases by 100 bp, the gain on the futures position is unchanged with
respect to point d), and is 7 1 (87:933 87:713) = 1:54 mln $. The value reduction
of the liability side is also unchanged and is 0:8 mln $. However, the loss of value on
SafeBank’s assets would be 320:59 0:73 0:03 = 7:02 mln $;with a total loss of

7:02 0:8 1:54 = 4:68 mln $

f) In point d) parallel shifts of the yield curve occur, and the hedge works well. In point e),
by no-arbitrage, loans with longer maturities have higher interest rates and lose value.
The yield curve therefore steepens. This non-parallel shift makes duration-based hedging
less e¤ective.

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