Capital Markets and Investments

Fixed Income 7

Sid Dastidar

Topics

Hedging interest rate risk with forward rate agreements

Defaultable Risk: The Eurodollar Market and Libor

Swaps

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2

Spot rates and borrowing/lending

0.5

1.5

r0.5

r1
r1.5

rN
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Hedging future cash flows

Typical

problem: Firm has cash flows arriving at some

point in the future, is worried about future interest rate
fluctuations, and would like to lock in interest rates
today.
Most firms are not in the business of betting on interest rates.
E.g., $500 million arriving in 6-months.

How

to handle this risk? Spot rates do not allow you to

manage this directly.

Forward

rates: contract today to borrow/lend at a

prespecified rate in the future.
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4

Forward rates

0.5

1.5

r0.5

Forward rates
r1

r0.5
r3

rN
5
5

Another perspective: CFO scenario

You

are GE capital. In 2001: you purchased Heller Financial

and you assumed their debt, including a huge number of
floating-rate bonds.
Then, the economy is doing well and Greenspan has interest rates on
the rise.
You are worried that rates may increase further and your floating
payments are increasing.

The bonds are not callable until 2008. How to get rid of this floating
rate risk?

Forwards

agreements and interest rate swaps

We will first cover forwards.

Swaps are packages of forwards.
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What is a forward rate?

Simplest example: suppose you want to borrow or lend $50 million

in 6M for a period of 6M. You can do this transaction
The in 6M for 6M forward rate from now is the rate at which you can
borrow or lend in 6-months for a period of 6-months.
Its not an option. You are locked into borrowing or lending at the
forward rate.
Denote the forward rate as 0.5f0.5 : 0.5 refers to a 6-M period.

More generally: the forward rate is the interest rate on a loan that
begins in m-years and lasts for n-years, the in m-years for n-years
forward rate
Notation: mf.n is the rate for borrowing and lending that starts in m-years
and lasts for n-years (in m-years for n-years)

Examples:
1f.5 : rate on a 6-month loan, 1 year from now
5f.5: rate on a 6-month loan, 5 years from now

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Are forward rates important?

Forward rates, along with spot rate, allow for the complete portfolio of
borrowing and lending.

Not just starting now, but starting at any point of time in the future for any
given period of time.

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Goal: how to price a forward contract

Price a forward: find the forward rate.

How? No-arbitrage arguments.

Take two alternative investments:

1. Invest $1 at the 1-year spot rate today
2. Invest $1 at the 6-M spot rate. In 6 months, re-invest the
proceeds at the forward rate for the next 6 months.

Since the forward rate is contracted today, both strategies

are risk-less and have the same cost today.

By the principle of No-Arbitrage, they must have the same

value in 1 year! Solve for the forward rate.
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Spot and forward rates

r1

r.5
0
1
.5f.5
Scenario 1: Invest $1 in at 1-year spot
In 1 year, it is worth
Scenario

Scenario 1
Scenario 2

V1 (1 r1 / 2) 2

2: year spot rate and forward

Invest $1 for 6M at 6M spot rate. In 6M it is worth: 1 r.5 / 2

At 6M, re-invest at .5f.5 for 6M when it is worth (note compounding of

forward rates is the same as spot rates)

V2 (1 r.5/2)(1 .5f.5/2)

No-Arbitrage

Two investments have the same initial investment and are both riskless (all
rates are known today). The terminal values must be the same!

By no-arbitrage:

Solve for .5f.5:

V1 (1 r1/2) 2 (1 r.5/2)(1.5 f.5/2) V2

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One period forward rates

Solving for the forward rate, we have

(1 r1/2) 2

1
.5 f .5 2
(1 r.5 /2)

If the forward rate is anything else, there is an arbitrage (next homework).

Forward rates are derivatives on the spot rates

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Example 1: Current rates

If

the spot rates are 6-month: r.5=5.15% and 1-year:

r1=4.95%.

What

is the in 6M for 6M forward rate?

Solve the following equation:

2

(1 0.0495/2) (1 0.0515 / 2)(1 .5 f.5 / 2)

To get

(1 0.0495/2) 2
1 4.75%
.5 f .5 2
1 0.0515 / 2

Interpretation?

Why is it lower?

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Example 2

Suppose current rates were reversed: 6-month: r.5=4.95%

and 1-

year: r1=5.15%.
What

is the in 6M for 6M forward rate?

(1 0.0515/2) 2
1 5.35%
.5 f .5 2
1 0.0495 / 2

Interpretation?

Why is it higher?

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Terminology: long versus short

You

are long the forward if you have locked in to invest

at the forward. Payoffs are similar to buying (going long
) a bond
Win if rates decrease (youve invested at a higher rate)

Lose if rates increase

The

other side (short) is guarantee to pay the forward

rate.
Exposed to floating rate risk.
Like shorting a bond.

Alternative

to forward contract: do nothing and borrow at

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floating rate.
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Different Forward Rates

Forward rate for borrowing/lending for 6 months starting in k years:

6-month spot rates in the future

k .5

for k 1,..., m

Forward rate for borrowing/lending for j-years starting 6 months from now:

Spot rate curve, in 6-months

.5

f j for j 1,..., n

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General formula for 6-month forward rates

The general formula for the 6-month rate, m-years in the future is:

(1 rm .5 /2) 2m1

1
m f .5 2
2m
(1 rm /2)
rate

Where rm is the m-year spot

Where did this come from?

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Interpretation of forward rates mf.5

mf.5

is the rate you can lock in now for 6-month borrowing/lending starting in
m years

Forward rates contain information about the markets guess of what the 6month rate will be in the future
Forward rates tell us something about future spot rate!

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Expectations theory of interest rates

Does todays forward rate, .5f.5(t), contain information about future 6-month
spot rates, r.5(t+1)?

Hypothesis:

f (t) E[r.5 (t 1) I(t)]

.5 .5

where I(t)=information at time t

Hypothesis: Forward rates forecast future spot rates.

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Testing the Expectations Hypothesis

How

would you specify a regression for testing the

expectations hypothesis?

In

practice, the regression is typically specified as:

r.5 (t 1) r.5 (t)

[.5 f .5(t) r .5(t)] e(t 1)
0

U.S.
Japan

R2

.550 (0.129) .028

.552 (0.028) .086

Forward

rates contain information about future spot rates,

but the forecast is not perfect
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The future yield curve

Expectation hypothesis: 6-month spot and forward. What about the whole
curve?

Active bond managers are interested in what the yield curve will look like
in the future.

How can it change?

Parallel shifts

Twists: i.e. steepen or flatten.

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The forward yield curve

Future Spot Curve

rn

rn
Current Spot Curve

Steepening Twist

maturity

Flattening Twist

maturity

Under which scenario would you rather be in

portfolio A instead of B? Why?
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The Forward Yield Curve

Does the current term structure contain any information about the term
structure in the future, for instance 6 months from now?

To answer this question, we can look at the forward rates .5fn as a function of
n.
This is the interest rate, 6-months from now on an n-year loan.

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The Forward Yield Curve

.5

r.5

1.5

n+0.5

.5 .5

r1
r.5

.5 1

r1.5

r.5

.5 n

rn 0.5
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The Forward Yield Curve

The general formula for the in 6-month for n-periods forward rate is:

2n1 2n

(1 rn 0.5/2)

.5 f n 2
1
(1 r.5 / 2)

Where did this come from?

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Where are we?

We know how to borrow and lend for n-periods, starting either now or in the
future.
All of this borrowing and lending was default-free.

In practice, forwards and swaps are typically used to hedge interest rate
risk of corporate and other defaultable bonds.
Need to deal with these other markets

The easiest to deal with: the Eurodollar market

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Dynamic Immunization (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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Introduction (Dynamic Immunization)

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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Forward Contracts as hedging Instruments

A futures contract is very similar to a forward. Let us see how we might
use a forward contract to hedge.
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 contracts 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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Forward Contracts as hedging Instruments

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 $1M portfolio of D = 5.1139 (DM = 4.566)
U.S. Treasury bonds.
a. Let us study the payoff to one forward contract. First, lets compute
the forward price.
t=0

1
- 1 P1
1 P1 forward price

1.5
1,000,000

$1, 000, 000

$943,396
.12
1

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Forward Contracts as hedging Instruments

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

Thus , at T = 1,

What thesecurity
can be sold for
$938, 967

Purchaser of the contract receives:

(The " long" position)

Seller of the contract receives:

(The seller is also referred to
as the writer; he is the agent
having the short position)

What he must pay

for the security.
-

$943,396
- $4,429

$943,396 $938,967
= + $4,429
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Forward Contracts as hedging Instruments

As always, if rates rise the agent with the short position

benefits (he gets to sell a security to the buyer for more than
its market value). Therein arises a hedging opportunity.

c. The remaining question is how many contracts should be

written.
On the bond portfolio we lost
VP = - DM VP r = - 4.56 ($10M) (.01)
= - $456,000
This rough analysis suggests we should have

456, 000
103 contracts, but this is not helpful.
written
4429

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Forward Contracts as hedging Instruments

5. But matters are not quite what they seem, for a number of
reasons.
(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.

This leads to:

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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). There is often cash settlement only (no exchange of
underlying securities).
4. Standardized
5. Cheapest to Deliver options

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Futures Contracts
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=

1 day

2 days

3 days

T=1

$943,396

$944,000

$943,780

$943,366

$938,967

Balance: Buyers
Cumulative Account

+$604

$384

- $30

- $4429

Balance: Writers
Cumulative Account

- $604

- $384

+ $30

+ $4429

Futures Price

So money is lost or received immediately upon the change in rates

(very important for hedging).

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Futures Contracts
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?

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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.
DFP

FP
=
FP r,
Thus,
(1 r)
where FP
r
DFP

=
=
=

futures price
prevailing interest rate
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
T (1 + r )

DFP = t
+T

P0
t=1 P 0

where P0 is the price of the underlying bond at contract signing and

t runs from its first cash flow following maturity to its final payment
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date.

Managing Duration using Futures Contracts

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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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:

Bond C

T-Bill Futures

Instruments Used in the Analysis

Coupon

Maturity

Yield

Price

4%

15 yrs

12%

455.13

9.60

1/4 yr.
12%
970,873.00

1, 000, 000

$970,853 Futures Price

1 .12

.25

--

Duration

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

Objective: perfectly hedge the portfolio of C bonds.
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Managing Duration using Futures Contracts

Solution: write T-bill futures, but how many? Two relationships hold:
(i) Vp = PCNC + FPT-Bill NT-Bill
Vp = portfolio value
PC = bond C price

Nc = # of C bonds
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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Managing Duration using Futures Contracts

Now, assume a shift in term structure from 12% to 13%.
The relevant prices are now:
PC = $418.39

FPTBill =

$1, 000, 000

$968,523
.13
1

Loss on portfolio

= 21,972 Pc
= 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
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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.
(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
contracts 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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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--vis the above
calculation?

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Summary and Conclusion

We now have another 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 and swaps are other
alternatives. This is our next topic.

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