Interest rate Derivatives

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 Ch26, 28 & 29 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 Ch26, 28 & 29 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 Ch26, 28 & 29 Risk and Return Characteristics • Page 613 • Leverage aspect Ch26, 28 & 29 Treasury Bill Futures • It is based on 13-week treasury bill with a face value of $1 million – Seller needs to deliver to the buyer at the settlement date a Treasury with 13 weeks remaining to maturity – Index price = 100 – (yd*100) • Where yd = D/F*(360/t) – A change of one basis point will change the dollar discount, and the invoice price, by Ch26, 28 & 29 Example • The index price for a Treasury bill futures contract is 92.52. Then – Yd –D – Invoice price (how much the buyer needs to pay) Ch26, 28 & 29 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 Ch26, 28 & 29 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 618) – Invoice price = contract size*futures contract settlement price*conversion factor + accrued Interest Ch26, 28 & 29 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? Ch26, 28 & 29 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 Ch26, 28 & 29 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 Ch26, 28 & 29 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 Ch26, 28 & 29 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 Ch26, 28 & 29 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 Ch26, 28 & 29 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. Ch26, 28 & 29 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 Ch26, 28 & 29 Hedging • • • • Cross hedging Short hedge Long hedge Hedge ratio Ch26, 28 & 29 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 Ch26, 28 & 29 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 Ch26, 28 & 29 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 Ch26, 28 & 29 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 Ch26, 28 & 29 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 yearsThe asset growth effect exists in PACAP markets Ch26, 28 & 29 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 Ch26, 28 & 29 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. – Single-name credit default swap – Basket 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 Ch26, 28 & 29 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 729. • Exhibit 29-2 – CDS settlement Ch26, 28 & 29 Basket Credit Default Swaps • First-to-default basket swap • k-to-default basket swap Ch26, 28 & 29 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. See the example on page 731 to 732. • Credit default index swap (physical delivery) – EX 29-3 Ch26, 28 & 29 Synthetic CDOs • A synthetic CDO is so named because the collateral manager does not actually own the pool of assets on which it has the credit risk exposure. • A sythetic CDO absorbs the credit risk, but not the legal ownership, of the reference obligation. • A CDS allows institutions to transfer the credit. Ch26, 28 & 29 Exercises • Chapter 26, Problems 4, 11. • Chapter 28, problem 2 • Chapter 29, problems 11, 12, 13, 14 Ch26, 28 & 29