A Second Approach to Interest Rate Risk

Management: Dynamic Immunization with

Interest Rate Futures Contracts

A. Introduction:

1. A drawback to immunizing via the duration of bond

portfolios is the need to rebalance in response to rate
shifts. This may create large transaction costs as the
number of bonds bought or sold may end up being very
large. Another way, in principle, is to use interest rate
futures contracts of some type.
 

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2. There are two advantages of immunizing with interest rate
futures:
 
(i) the composition of the bond portfolio remain
unchanged and duration adjusted using the futures
contracts.
(ii) transactions costs of trading futures are much less
than bond trading costs.
 
These considerations are especially important when the
bonds trade in “thin” markets.

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A futures contract is very similar to a forward. Let us see how we
might use a forward contract to hedge.
 
B. Forward Contracts as hedging Instruments
 
1. Recall that a long position in a forward contract represents an
obligation to buy a prespecified security at a prespecified price (the
forward price) at a prespecified future date. The short position
(writer) has the obligation to sell.
 
2. The forward price is set so that it costs nothing to enter into
such a contract (no money exchanges hands at the contract’s
signing aside from a transactions fee).

3. Thus a forward contract must represent the right to buy the

security at its fair market value from the perspective of today.
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4. Consider a forward contract to buy 6 month T-bills in 1 year
which will have an aggregate face value of $1M.
 
Assume the term structure is flat at r = 12%.
Our objective is to hedge the $10 M portfolio of D = 5.1139 (DM =
4.566) U.S. Treasury bonds.

a. Let us study the payoff to one forward contract. First, let’s

compute the forward price.

t=0 1 1.5 2 3
- 1P 1 1,000,000

$1, 000, 000

1 P1  forward price   $943,396
 .12 
1   4
 2 
b. Suppose, when T = 1 arrives, r = 13%.
The actual price of the T-bills at that time will be
$1, 000, 000
 $938,967
 .13 
1  
 2 
Thus , at T = 1,
What the security What he must pay
can be sold for for the security.
$938, 967 - $943,396
Purchaser of the contract receives:  - $4,429
(The " long" position)

Seller of the contract receives: $943,396 – $938,967

(The seller is also referred to as = + $4,429
the “writer”; he is the agent
having the “short position)
If the contract specifies cash settlement at expiration, these amounts are 5

exchanged between the two parties.

5. Some important caveats:
(i) If rates rose to 13% at t = 0 the portfolio would immediately have
lost money at t = 0. Yet, the forward contracts would not make
an offsetting payment until t = 1.
(ii) The duration of the bonds at t = 1 is different from the duration at
t = 0. The correct number of written contracts from the
perspective of t = 0 may not be correct from the perspective of t
= 1.
(iii) Forward contracts, not being exchanges traded, are
cumbersome to work with.
a. There may be credit problems with the counterparty.
b. Forwards are not traded on an anonymous exchange: there are
“face-to-face” transactions costs.
c. Early termination requires the agreement of both parties, which may
not be forthcoming.
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These problems are solved by:
C. Futures Contracts

1.A futures contract is very similar to a forward contract (the

language “futures price” replaces the language “forward price”
even as the number is the same), but with the “marking to
market feature.”
 
2.Again, no money changes hands at signing.

3.These contracts for Treasury securities are exchange traded (very

low transactions costs).

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4. To illustrate the “marking to market” feature, suppose we had
contracted to buy the above security at a FP (futures price) of
$943,396. Let us normalize our time so that t = 0 is the date of
signing the contract.
 As interest rates change, suppose the FP in successive days
moves according to:
T= 0 1 day 2 days 3 days T=1

Futures Price $943,396 $944,000 $943,780 $943,366 $938,967

Balance: Buyer’s 0 +$604 $384 - $30 - $4429

Cumulative Account

Balance: Writer’s 0 - $604 - $384 + $30 + $4429

Cumulative Account

So money is lost or received daily upon the change in rates (very

important for hedging). This is referred to as “daily settlement.”
5. Three questions:
What is the futures/forward connection?
How would you dis-entangle yourself from a futures contract?
How could you speculate using futures contracts?
6. Summary points regarding futures:
(i) They are exchange traded
(ii) They are settled daily (“marking to market”)
(iii) Closing out a futures position is easily accomplished by
entering into an offsetting trade. Most contracts are closed out
this way prior to expiration.
(iv) Contracts not closed out before maturity are settled by
delivery (choice of instrument and date of delivery). A few
contracts are settled in cash (e.g., stock index futures).

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D. Managing Duration using Futures Contracts  
1. The futures price represents the price of a security to be issued in
the future (its future price). This security will have a duration.
D FP
Thus,  FP = - FP r,
(1  r)
where FP = futures price
r = prevailing interest rate
DFP = duration of the underlying security at
maturity of the futures contract.
 Just as before, this duration can be written as
  Ct   MV T  
 T  (1 + r ) t   (1 + r ) T  
D FP =  Σ t   +T  
 t=1  P 0   P0 
    
   
where P0 is the price of the underlying bond at contract
signing and t runs from its first cash flow following maturity
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to its final payment date.
The futures contract itself does not have a duration. The futures
price, however, and its sensitivity to rate changes depends on the
duration and yield of the underlying security expected to prevail at
the contract maturity date.
 

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2. An example: We want to hege a $10M portfolio of Bond C, using a T-Bill
Futures contract calling for the delivery of $1 MM face value of T-bills
having 90 days remaining until maturity.
  => Duration of T-Bill Futures = 90 days, or .25 year.
The relevant facts are below:
Instruments Used in the Analysis
Coupon Maturity Yield Price Duration
Bond C 4% 15 yrs 12% 455.13 9.60
T-Bill Futures -- 1/4 yr. 12% 970,873.00 .25

 
 1, 000, 000 
  $970,853  Futures Price 
  1  .12  
   
  4  

The $10 m portfolio of Bond C represents 21,972 bonds.

Objective: perfectly hedge the portfolio of C bonds.
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3. Solution: write T-bill futures, but how many? Two relationships hold:

(i) ΔVp = ΔPCNC + ΔFPT-Bill NT-Bill

Vp = portfolio value Nc = # of C bonds

PC = bond C price NT-Bill = # of T-bill futures
FPT-Bill = T-bill futures prices

  (ii) and: DP VP = DCPCNC + DT-Bill FPT-Bill NT-Bill

  VP = $10 m NC = 21,972
DP = 0 (desired) DT-Bill = .25 years
DC = 9.6 years FPT-Bill = $970,873
PC = $455.13
(We want DP = 0; equation (ii) implies:

0 = 10M (9.6) +.25 (970,873) NT-bill

Solve for NT-bill

Solution: write (sell short) 395.5 T-Bill Futures contracts; NT-bill = – 395.50
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4. Now, assume a shift in term structure from 12% to 13%.
 
The relevant prices are now:
  $1, 000, 000
 $968,523
PC = $418.39 FPTBill =  .13 
1  
 4 

Loss on portfolio = 21,972 ΔPc

= 21,972 x (418.39 – 455.13)
= - $807,251

Gains on Futures = - 395.5 (968,523 – 970,873)

= $929,425; we are overhedged, as
expected
E. Caveats
 
1. Our discussion has ignored a number of institutional details which are
relevant for bond traders. For instance:
 
(i) Both buyer and seller of a futures contract must establish margin
accounts with the exchange.
 
(ii) Some contracts allow the contract to be settled at expiration by the
delivery of any of a number of specified set of financial instruments. This
applies to all CBOT Treasury Note and Bond futures contracts. If you have
shorted one of these contracts you will want to deliver with the cheapest
bond available that satisfies the contract’s terms.
 
(iii) Most traders will close out the contract before expiration by taking the
offsetting position in the futures markets. The number of futures contracts
outstanding that have not been closed with an offsetting position is referred
to as open interest.
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F. Other Instruments

1. T-bill futures are no longer traded. At the “short end of the

curve,” the action is now all in Eurodollar futures which
have cash settlement based on 3 month LIBOR.

2. Consider a 10 year T-bond contract. This is for $100,000

face value of deliverable bonds. What would differ vis-à-vis
the above calculation?
 

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G. Summary: Forward Contracts versus Futures Contracts

Forwards Futures
(i) private contract between exchange traded (anonymous)
two counterparties
(ii) non standard, custom standard contract
tailored contracts
(iii) one delivery date choice of delivery date (may
specified be choice of instrument to be
delivered)
(iv) “settled” at maturity “daily settlement”
(v) cash settlement or contracts usually closed out
physical delivery at prior to expiration
expiration
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H. Summary and Conclusion
 
We now have a second approach to the management of such risk
using interest rate futures contracts.
 
This method is to be preferred as it minimizes transaction costs
relative to a bonds only approach. Eurodollar futures are an
alternative. This is our next topic.

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