T Bond futures & delivery
T Bond futures & delivery
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Delivery practices and conversion factor
Principal invoice price = futures settlement x conversion factor x $1000
Short makes delivery of securities in satisfaction of a maturing futures contract, the long pays a specified invoice price to the short
The conversion factor converts all securities to a nominal 6% coupon
Total invoice amount = principal invoice amount + accrued interest
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High coupons have CFs > 1, low coupons < 1 2 Examples 3 Cheapest to deliver CTD The conversion factor system is imperfect because a short is not indifferent between the basket of deliverables One security usually emerges as the cheapest to deliver The futures price will track the CTD with the basis 4 The Basis 5 CTD and implied repo rate 6 Who trades the basis? 7 Arbitrageurs, spreaders, hedgers, everyone who uses futures 7 Conversion factor effects 8 Futures prices can shift to track a different cash security Implied repo rate (IRR) Generally lowest basis = highest implied repo rate 9 Basis optionality Why would anyone buy the basis if the returns are not competitive? IRR for CTD is below prevailing short term rates (no alternative – hedging a cash position) Option on CTD changing and not fully converging to zero Similar to being long an option Short basis similar to short an option Also the wild card (see Hull page 161 Business snapshot 6.2) 10 Duration-Based Hedge Ratio VF Contract price for interest rate futures DF Duration of asset underlying futures at maturity P Value of portfolio being hedged DP Duration of portfolio at hedge maturity IC301 11 11 Example It is August. A fund manager has $10 million invested in a portfolio of government bonds with a duration of 6.80 years and wants to hedge against interest rate moves between August and December The manager decides to use December T-bond futures. The futures price is 93-02 or 93.0625 and the duration of the cheapest to deliver bond will be 9.2 years at the futures contract maturity The number of contracts that should be shorted is IC301 12 12 Limitations of Duration-Based Hedging Assumes that only parallel shift in yield curve take place Assumes that yield curve changes are small When T-Bond futures is used assumes there will be no change in the cheapest-to-deliver bond IC301 13 13 GAP Management (Business Snapshot 6.3 page 169) This is a more sophisticated approach used by banks to hedge interest rate. It involves: Bucketing the zero curve Hedging exposure to situation where rates corresponding to one bucket change and all other rates stay the same IC301 14 14 F F P D V PD 79 20 . 9 80 . 6 50 . 062 , 93 000 , 000 , 10 = ´ /docProps/thumbnail.jpeg