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Interest Rate Futures, Swaps and CDS

• Interest-rate futures contracts

• Pricing Interest-rate futures

• Applications in Bond portfolio management

• Interest rate Swaps

• Credit Default Swaps

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Basics of Futures

• Definition– A futures contract is an agreement between a buyer (seller)

and an established exchange or its clearinghouse in which the buyer (seller) agrees to take (make) delivery of an asset at a specified price at the end of a designated period of time.

• Opening position• Liquidating a position

– Liquidation before settlement– Hold until settlement

• delivery• Cash settlement

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Basics of Futures• Role of Clearinghouse

– When an investor takes a position in the futures market, the clearinghouse takes the opposite position and agrees to satisfy the terms set forth in the contract.

– Give instruction of delivery in the day of settlement• Margin requirement

– Initial margin– Maintenance margin– Variation margin– Leverage is involved when taking position in futures

• Marking to market– As futures price changes, the proceeds accrue to the trader’s margin account

immediately.• Difference from Forwards

– More standardized and low default risk

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Risk and Return Characteristics

• Page 583

• Leverage aspect

Details on Interest Rate Futures Contracts• Short-term Interest rates

– Treasury bills futures contract– Eurodollar futures contract– Federal funds futures contract

• Long-term Interest Rates– Treasury bond futures– Treasury notes futures– Municipal note index futures– Other countries have similar future contracts on

government bonds

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Eurodollar Futures

• A Eurodollar CD is a dollar-denominated CD issued outside of the US. The interest rate paid on Eurodollar CDs is the LIBOR.

• Three-month LIBOR is the underlying for the Eurodollar futures contract.

• The face value for the contract is $1 million.

• Contract is quoted on an index price basis

• Value of a change of one basis point

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Example

• The index price for an Eurodollar futures is 94.52. Imply an expected LIBOR of ____

• What if the settlement index price is 95?

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Eurodollar CD Futures

• Traded on – International Monetary Market of Chicago

Mercantile Exchange – London International Financial Futures Exchanges

• Underlying asset: 3-month Eurodollar CD

• Face value is &1 million, price quoted as: 100 – annualized futures LIBOR

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Treasury Bond Futures

• Underlying asset is $100,000 par value of a hypothetical 20-year 6% coupon bond

• CBOT allows the seller to deliver one of several Treasury bonds that the CBOT declares is acceptable for delivery.

• Conversion factor: • Invoice price (example see page 586)

– Invoice price = contract size*futures contract settlement price*conversion factor + accrued Interest

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Pricing Interest Rate Futures

• A 20-year 100-par-value bond with a coupon rate of 12% is selling at par.

• The bond is the deliverable for a futures contract that settles in three months.

• Current 3-month interest rate is 8% per year

• What should be the price of the futures contract?

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What will you get from the futures contract?

• If you take long position in the futures– After 3 months, pay futures price– Get the bond– Pay accrued interest

• If you take short position in the futures– Deliver the bond after 3 month– Get futures price and accrued interest

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Cash-and-carry trade

• You decide to hold the hold the bond and take a short position in futures– Sell futures at P– Get accrued interest– Purchase bond by borrowing money

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Reverse cash-and-carry trade

• Buy the futures contract at P

• Sell the bond for ?

• Invest the proceed for 3 months at 8% per year

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Theoretical Futures Price

• F=P[1+t(r-c)]– Where r is financing rate, c is current yield, P is

cash market price, and F is futures price and t is time, in years to the futures delivery date

– R-c is the net financing cost

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Bond Portfolio Management Applications

• Speculating on the movement of interest rate

• Controlling the interest rate risk of a portfolio

• Creating synthetic securities for yield enhancement

• Hedging

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Creating Synthetic Securities for Yield Enhancement

• Consider an investor who owns a 20-year treasury bond and sells treasury futures that call for the delivery of that particular bond 3 months from now.

• Synthetic 3-month T bill.• Yield on the synthetic 3-month t-bill and yield on the

cash market treasury bill.

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Hedging

• Hedging: taking a futures position as a temporary substitute for transactions to be made in the cash market at a later date.

• The outcome of a hedge will depend on the relationship between the cash price and the futures price

• The difference between cash price and futures price is basis

• The risk that the basis will change in an unpredictable way is basis risk

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Hedging

• Cross hedging

• Short hedge

• Long hedge

• Hedge ratio

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Allocating Funds between Stocks and Bonds

• An alternative way to reallocate assets is to buy and sell interest rate futures and stock index futures

• Benefits– Transaction costs are lower– Market impact costs are avoided – Activities of the money managers employed by the

pension sponsor are not disrupted

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Interest Rate Swaps

• Two parties agree to exchange periodical interest payments. The dollar amount fo the interest payments exchanged is based on a predetermined dollar principal, notional principal amount.

• Fixed-rate payer

• Floating-rate payer

• Viewed as a package of forward contracts

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Example

– For the next five years party X agrees to pay party Y 10% per year, while party Y agrees to pay party X 6-month LIBOR (the reference rate).

– The nominal principal amount is $50 million– Interest payments are exchanged every 6 months– X is a fixed-rate payer– Y is a floating rate payer

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Relationship between buy and sell sides

• Fixed-rate payer: pays fixed rate; has bought a swap; is short in bond market

• Floating-rating payers: pays floating rate in the swap; has sold a swap; is long the bond market

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Calculation of the Swap Rate

• Example: – A swap starts from today, Jan 1 of year 1 (swap

settlement date)– The floating rate payments are made quarterly

based on actual/260– The reference rate is 3-month LIBOR– The nominal amount of the swap is $100 million– The term of swap is 3 years

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Credit Derivatives

• Credit derivates are used by bond portfolio managers to control the credit risk of a portfolio, including– Asset swap

– Total return swap

– Credit default products• Credit default swaps

– Single name swaps

– Basket swaps

– Index swaps

• Default options

– Credit spread products

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Credit Default Swap

• Credit default swaps are used to shift credit exposure to a credit protection seller. Credit default swaps operate like a standby letter of credit or insurance policy. The underlying asset is named as a reference obligation. (page 693)– Single-name credit default swap– Credit default swap index

• In the absence of a credit event, the buyer will make a quarterly swap premium payment over the life of the swap. If a credit event occurs, then i) no more premium payment will be paid by the buyer, and ii) a termination value is determined for the swap.

• CDS can be settled in cash or physically• CDS can be written on a regular bond or an ABS

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Single-Name Credit Default Swap

• Assume that the reference entity is XYZ Corp and the underlying is $10 million par value (nominal amount of the contract).

• The swap premium – the payment from the CDS buyer to the seller, is 200 basis points. This is annual rate.

• Single-name CDS calls for a quarterly payment of the swap premium – formula on page 696.

• Exhibit 29-1 – CDS settlement

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Credit Default Swap Index

• The credit risk of a standardized basket of reference entities is transferred between the protection buyer and seller.

• Separate indexes for investment grade and high-grade names• For CDS index, the swap payment continues to be made by the

buyer. However, the amount of the quarterly payment is reduced since the notional amount is reduced as result of a credit event for a reference entity. (page 702)

• Every 6 months a new index series is created by the index provider.

• Swap premiums on an index CDS are exchanged once a quarter on about the 20th day of March, June, September, and december

Index CDS Written on Corporate, Sovereign, and Municipal Debt Issuers• Active traded index CDS on corporate bonds

– CDS.NA.IG (investment grade)– CDX.NA.HY (junk bonds)– iTraxx Europe

• Index CDS on leverage loans – LCDS

• Index CDS written on sovereign government bonds– iTraxx SovX Western Europe index etc (page 703)

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Other Index CDSs

• Index CDSs Written on Tranches of ABSs– Written on different tranches of ABS

• Index CDSs Written on Tranches of commercial Mortgage-backed securities

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