Interest Rate Futures

Jie Zhu

Shanghai University

Sepbtember 2022

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Forward Rate Agreement

A forward rate agreement (FRA) is an agreement that a certain rate

will apply to a certain principal during a certain future time period
An FRA is equivalent to an agreement where interest at a
predetermined rate, RK is exchanged for interest at the market rate
It is a non-standard contract.
Traded in the OTC market.

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Settlement of FRA

Suppose the current time is 0. Consider a forward rate agreement

where a company X is agreeing to lend money to company Y for the
period of time between T1 and T2 .
Which party is in the long/short position?
De…ne:
1. RK : the rate of interest agreed to in the FRA
2. RF : the forward interest rate for the period between T1 and T2 ,
calculated today
3. RM : The actual interest rate observed in the market at T1 for the
period between T1 and T2
4. L : the principal underlying the contract
For simplicity, we assume that RK , RF , and RM are all measured with
a compounding frequency consistent with the maturity. For example,
if T2 T1 = 0.5, then they are semiannual compounding; if
T2 T1 = 0.25, then they are quarterly compounding and so on.
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Settlement of FRA
At T1 , normally company Y would borrow at rate RM from a usual
loan for the period [T1 , T2 ].
The FRA means it will borrow at rate RK .
The gain/loss from an FRA for company Y is thus
L(RM RK )(T2 T1 ) .
Note this gain/loss is realized at T2 , yet company Y should already
know its present value at T1
L(RM RK )(T2 T1 )
.
1 + RM (T2 T1 )
FRA is usually settled at T1 . The above equation shows the value of
FRA to the long party. Similarly, the value of FRA to the short party
at T1 is given as
L(RK RM )(T2 T1 )
1 + RM (T2 T1 )
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Example

Suppose that a company enters into an FRA that speci…es it will

receive a …xed rate of 4% on a principal of $1 million for a 3-month
period starting in 3 years. If 3-month LIBOR proves to be 4.5% for
the 3-month period the cash ‡ow to the lender will be

1, 000, 000 (0.04 0.045) 0.25 = $1, 250

at the time 3.25 years from now. The FRA will be settled in 3 years
with a payo¤
1, 250
= $1, 236.09
1 + 0.045 0.25
to the lender.

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Valuation of FRA

To value an FRA we …rst note that it is always zero when RK = RF .

Value of FRA where a …xed rate RK will be received on a principal L
between times T1 and T2
R2 T2
L(RK RF )(T2 T1 ) e

where RF is the forward interest rate between T1 and T2 , which is

determined today. R2 is the spot interest rate between today and T2 .
Similarly, value of FRA where a …xed rate RK will be paid on a
principal L between times T1 and T2
R2 T2
L(RF RK )(T2 T1 ) e

Note that R2 is continuous compounding, and RK and RF are

compounded with the frequency consistent with the maturity.

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Day Count Conventions

For coupon bonds, unless the trading day is exactly the same as the
coupon payment date, otherwise the trading price should include the
accrued yet not paid interest.
The day count de…nes the way in which interest accrues over time.
The day count convention is usually expressed as X /Y . X de…nes the
way in which the number of days between the two dates is calculated,
and Y de…nes the way in which the total number of days in the
reference period is measured.

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Day Count Conventions

Three day count conventions that are commonly used in the US:
1. Treasury Bonds: Actual/Actual
2. Corporate Bonds: 30/360
3. Money market instrument: Actual/360

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Example
Suppose a treasury bond has a face value of $100, coupon rate is 8%,
and coupon payment dates are March 1 and September 1. What is
the interest earned between March 1 and July 3? Note that there are
124 days between March 1 and July 3, and there are 184 days
between March 1 and September 1, thus the interest is
124
4 = 2.6957
184
Now suppose it is a corporate bond in the previous example. With the
30/360 rule, the number of days between March 1 and September is
180, and the number of days between March 1 and July 3 is
(4 30 + 2) = 122, thus the interest is
122
4 = 2.7111
180
Which bond shall we choose between Feb 28 and March 1? Treasury
bond or corporate bond?
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Quoted Price for Money Market Instrument

The prices of money market instruments are sometimes quoted using

a discount rate
This is the interest earned as a percentage of the …nal face value.
For example, if the price of a 91-day Treasury bill is quoted as 8, this
means the annualized rate of interest earned is 8% of the face value.
Suppose the face value is $100, the interest can be earned on the bill
is 100 0.08 91/360 = $2.022
The market price for the bill is thus 100 2.022 = $97.978
The actual interest rate for the 91-day period is
2.022/(100 2.022) = 2.064%

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Quoted Price for Money Market Instrument

In general, the relationship between the cash price and quoted price of
a Treasury bill in the US is
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.

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Quotations for Treasury Bonds

Treasury bond prices are quoted in dollars and thirty seconds of a

dollar
The quoted price is for a bond with a face value of $100
For example, for a bond with a face value of $100, 100, a quote of
90-05 indicates the quoted price is $90, 156.25
The quoted price, which investors refer to as the clean price, is not
the actual cash price, which is called the dirty price. In general

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

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Example

Suppose it is March 5, 2007. The Treasury bond maturing on July

10, 2012 with a coupon rate of 11% is quoted at the price of 95-16 or
$95.50.
The coupon is paid twice a year and thus the most recent coupon
date is January 10, 2007
The number of days between January 10 and March 5 is 54, whereas
the number of days between January 10 and July 10 is 181
The accrued interest is
54
5.5 = 1.64
181
Thus the cash price is

95.5 + 1.64 = 97.14

for a face value of 100.

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Treasury Bond Futures

Treasury bond futures prices are quoted in the same way as the
Treasury bond prices.
One contract involves the delivery of $100, 000 face value of the bond
Treasury bond futures contract allows the short party to choose to
deliver any bond that has a maturity of more than 15 years and that
is not callable within 15 years.
The conversion factor de…nes the cash price when a particular bond is
delivered

cash price = most recent settlement price conversion factor

+ accrued interest

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Example

Suppose the settlement price is 90-00, the conversion factor for the
bond delivered is 1.3800, and the accrued intereTst on this bond at
the time of delivery is $3 per $100 face value. The cash received by
the short party is then

90.00 1.38 + 3 = 127.20

per $100 face value.

A party with the short position in one contract would deliver bonds
with a face value of $100, 000 and receive $127, 200.

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Conversion Factor

The conversion factor is de…ned as the bond price per dollar of

principal on the …rst day of the delivery month.
For simplicity, it is assumed that the interest rate for all maturities
equals 6% per annum (semiannual compounding).
The bond maturity and the times to the coupon payment dates are
rounded down to the nearest 3 months for the purposes of the
calculation.
If after rounding, the bond lasts for an exact number of 6-month
periods, the …rst coupon is assumed to be paid in 6 months.
If after rounding, the bond does not last for an exact number of
6-month periods, the …rst coupon is assumed to be paid after 3
months and accrued interest is subtracted.

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Example 1

Consider a 10% coupon bond with 20 years and 2 months to

maturity. To calculate the conversion factor, the bond is assumed to
have exactly 20 years to maturity. The …rst coupon payment is
assumed to be made after 6 months. Assume the face value is 1. The
discount rate is 6% per annum with semiannual compounding. The
conversion factor of the bond is
40
0.05 1
∑ 1.03i +
1.0340
= 1.4623.
i =1

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Example 2

Consider a 8% coupon bond with 18 years and 4 months to maturity.

To calculate the conversion factor, the bond is assumed to have
exactly 18 years and 3 months to maturity. The …rst coupon payment
is assumed to be made after 3 months. The value at the time 3
months from now is
36
0.04 1
0.04 + ∑ i
+ = 1.2583
i =1 1.03 1.0336
p
The interest rate for a 3-month period is 1.03 1 = 1.4889%.
Hence the present value of the bond is 1.2583/1.014889 = 1.2399.
This is the conversion factor for this bond.

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CBOT T-Bonds & T-Notes

Factors that a¤ect the futures price:

1. Delivery can be made any time during the delivery month
2. Any of a range of eligible bonds can be delivered
3. The wild card play

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Cheapest-to-Deliver Bond

As we discussed, there are many bonds that can be delivered in the

CBOT Treasury bond futures contract.
The party with the short position can choose "the cheapest one" to
deliver
If delivered, the short party will receive

Settlement price Conversion factor + Accrued interest

The cost of purchasing a bond is

Quoted bond price + Accrued interest

The cheapest-to-deliver bond is the one for which

Quoted bond price Settlement price Conversion factor

is the least.
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Bond Futures Price

Usually the theoretical futures price is di¢ cult to determine because

of the timing of delivery and the choice of bond.
If we assume that both the cheapest-to-deliver bond and delivery date
are known, then we can determine the futures price in the usual way

F0 = ( S0 I )e rT

where T is the maturity, I is the present value of coupons during T ,

and r is the risk-free interest rate applicable to the period of T .

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Example

Suppose that, in a Treasury bond futures, the cheapest-to-deliver

bond is a 12% coupon bond with a conversion factor of 1.4000. It is
known that the delivery will take place in 270 days. Coupons are paid
semiannually on the bond. The last coupon date was 60 days ago, the
next coupon date is in 122 days, and the coupon date thereafter is in
305 days. The term structure is ‡at, and the interest rate is 10% per
annum. Assume that the current quoted bond price is $120. The cash
price of the bond is obtained by adding to this quoted price the
proportion of the next coupon payment that accrues to the holder.
Calculated the quoted futures price.

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Eurodollar Futures

A Eurodollar is a dollar deposited in a bank outside the United States

Eurodollar futures are futures on the 3-month Eurodollar deposit rate
(same as 3-month LIBOR rate)
The longest maturity for Eurodollar futures is 10 years, which means
at December 1, 2019, you may lock in a 3-month interest rate
starting from December 1, 2029.
One contract is on the interest rate earned on the principal of $1
million
A change of one basis point or 0.01 in a Eurodollar futures quote
corresponds to a contract price change of $25

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Eurodollar Futures

A Eurodollar futures contract is settled in cash

When it expires, the …nal settlement price is 100 R, where R is the
actual 3-month Eurodollar interest rate on that date.
The exchange de…nes the contract price as

10, 000[100 0.25(100 Q )]

where Q is the quoted price.

For example, if Q = 96, the futures price for each contract is given by

10, 000[100 0.25(100 96)] = 990, 000.

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Example

On February 4, 2004, an investor wants to lock in the interest rate

that will be earned on $5 million for 3 months starting on March 16,
2005. The investor goes long …ve March05 Eurodollar futures
contracts at 97.63. On March 16, 2005, the 3-month LIBOR interest
rate is 2%, so that the …nal settlement price is 98. The investor gains
5 25 100 (98 97.63) = 4, 625 on the futures. The interest
earned on the $5 million for 3 months at 2% is

5, 000, 000 0.25 0.02 = 25, 000

The total gain is thus $29, 625. This is equivalent to the interest rate
of 2.37% (5, 000, 000 0.25 0.0237 = 29, 625)
The futures trade has the e¤ect to lock in an interest rate equal to
2.37%, or (100 97.63)%.

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Forward Rates and Eurodollar Futures

Eurodollar futures contracts last as long as 10 years

For Eurodollar futures lasting beyond two years we cannot assume
that the forward rate equals the futures rate
There are two reasons:
1. Futures is settled daily where forward is settled once
2. Futures is settled at the beginning of the underlying three-month
period; FRA is settled at the end of the underlying three- month
period

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Forward Rates and Eurodollar Futures

A convexity adjustment often made is

1 2
Forward rate = Futres rate σ T1 T2
2
T1 is the time to maturity of the forward contract
T2 is the time to maturity of the rate underlying the forward contract
(90 days later that T1 )
σ is the standard deviation of the short rate (typically about 1.2%)

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Extending the LIBOR Zero Curve

LIBOR deposit rates de…ne the LIBOR zero curve out to one year
Eurodollar futures can be used to determine forward rates and the
forward rates can then be used to bootstrap the zero curve
From
R2 T2 R1 T1
f ( T1 , T2 ) =
T2 T1
we get
f (T1 , T2 )(T2 T1 ) + R1 T1
R2 =
T2
For example, If the 400 day LIBOR rate has been calculated as
4.80%, and the forward rate for the period between 400 and 491 days
is 5.30%. What is the 491 day rate?

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