CHAPTER 11: BOND AND INTEREST RATE FUTURES CONTRACTS

PROBLEMS AND QUESTIONS WITH SOLUTIONS

1. Explain the differences between forward and futures contracts.

Both futures and forward contracts are agreements to buy (or sell) commodities or assets at
future dates. Futures contracts, though, are marketable contracts, traded on organized futures
exchanges that provide marketability by standardizing contracts, establishing trading rules, and
providing for clearinghouses for guaranteeing and intermediating contracts. Most futures
contracts are closed prior to expiration and have both an initial and maintenance margin
requirement. Forward contracts, in contrast, are less standard and more tailor-made, are usually
held to delivery, and may not require margins.

2. Define and explain the functions provided by futures exchanges.

Futures exchanges standardize contracts, thereby making the contracts more marketable; they
establish rules for delivery and set price and position limits, which ensures an orderly market;
they provide a continuous market by allowing trading by locals; and they provide a
clearinghouse to guarantee and intermediate contracts.

3. Explain why the price on an expiring futures contract must be equal or approximately
equal to the spot price on the contract's underlying asset.

Arbitrage ensures that the price on an expiring futures contract (f T) will be equal or
approximately equal to the spot price on the contract's underlying asset (S T). If fT > ST,
arbitrageurs could profit by going short in the futures contract and long in the spot market: buy
the asset on the spot market at S T, then sell it on the futures contract at fT to earn a profit of fT
ST. As arbitrageurs go short in the futures contract, they will push the futures price towards S T.
In contrast, if fT < ST, arbitrageurs could profit by going long in the futures contract and short in
the spot market: buy the asset on the futures contract at f T, then sell it in the spot market at S T to
earn a profit of ST fT. In this case, arbitrageurs, by going long in the futures contract, will push
the futures price up towards ST.

4. What is the major economic justification of the futures market?

Although the futures markets provide opportunities for speculators to profit, the primary use of
the market is to provide various economic entities with a tool for hedging their future cash flow
or asset/liability positions against price changes. Thus, the economic justification for such
markets is in providing insurance.

5. Define price limits and explain why they are used by the exchanges.

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Price limits specify the maximum and minimum prices at which a contract can trade during a
day. The purpose of the limits is to stop margin accounts from losing their values too quickly.

6. Suppose you took a short position in a June Eurodollar futures at R D = 5.5%. Determine
the futures settlement prices and your positions profits and losses given the following
LIBOR at the June futures expiration: 4.75%, 5.00%, 5.25%, 5.5%, 5.75%, 6%, and
6.25%. Determine your profits and losses if you had taken a long position in the June
contract at RD = 5.5%.

At RD = 5.5%, the price on the futures is $986,250:

100 5.5(90 / 360)

f0 $1,000,000 $986,250
100

The settlement price per $100 face value is S T = fT = 100 LIBOR(.25);

the settlement price per $1 million face value is [(100 LIBOR(.25))/100])
$1,000,000.

The profits and losses on short and long position at expiration are:

7. Suppose you took a long position in a September T-bill futures priced at IMM index 95.5.
What would be your profit or loss on the position if the price of a spot 91-day T-bill were
trading at YTM of 5% (Actual/365day-count convention) at the September expiration?

At index of 95.5, the price on the futures is $988,750:

100 4.5(90 / 360)

f0 $1,000,000 $988,750
100
At YTM of 5%, the price on spot T-bill is $987,910:

$1,000,000
ST $987,910
(1.05) 91/ 365
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At expiration, the futures holder could buy the bill on the futures contract at
$988,750 and then sell it on the spot market for $987,910 for a loss of $840.
Alternatively, the futures holders could close her position at expiration by
going short in an expiring contract with a futures price equal to the spot
price of $987,910. By closing, the futures holder would owe the
clearinghouse $840.

8. Define a forward rate agreement (FRA). Provide your own

example of an FRA.

A forward rate agreement is a contract that requires a cash payment or

provides a cash receipt based on the difference between a realized spot rate
such as the LIBOR and a pre-specified rate. For example, the contract could
be based on a specified rate of Rk = 6% (annual) and the three-month LIBOR
(annual) in five months and a notional principal of $10 million. In five
months the payoff would be

[LIBOR .06] (91 / 365)

Payoff ($10,000,000)
1 LIBOR(91 / 365)

If the LIBOR at the end of five month exceeds the specified rate of 6%, the
buyer of the FRA (or long position holder) receives the payoff from the seller;
if the LIBOR is less than 6%, the seller (or short position holder) receives the
payoff from the buyer.

9. Given an FRA with the following terms:

Notional principal = $20 million
Reference Rate = LIBOR
Contract rate = Rk = .05 (annual)
Time period = 90 days
Day-count convention = Actual/365

Show in a table the payments and receipts for long and short
positions on the FRA given
possible spot LIBORs at the FRAs expiration of 4%, 4.5%, 5%,
5.5%, and 6%.

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10. Date Clearinghouse Record Expl
ai 1. June 20 Mr. A agrees to buy September T-bond futures from the n
clearinghouse at $95,000. how
2. June 20 Ms. B agrees to sell September T-bond futures to the the
clearinghouse for $95,000.
3. June 25 Mr. D agrees to buy September T-bond futures from the
clearinghouse at $94,500.
4. June 25 Mr. E agrees to sell September T-bond futures to the
clearinghouse for $94,500.
5. June 28 Mr. B agrees to buy September T-bond futures from the
clearinghouse for 94,250.
6. June 28 Mr. D agrees to sell September T-bond futures to the
clearinghouse for $94,250.
7. July 3 Mr. E agrees to buy September T-bond futures from the
clearinghouse at $96,000.
8. July 3 Mr. A agrees to sell September T-bond futures to the
clearinghouse for $96,000.

clearinghouse would record the futures trades in a-d. Include the

clearinghouse's payments and receipts needed to close each
position.
a. Mr. A buys a September T-bond futures contract from Ms. B for
$95,000 on June 20.
b. Mr. D buys a September T-bond futures contract from Mr. E for
$94,500 on June 25.
c. Ms. B buys a September T-bond futures from Mr. D for $94,250
on June 28.
d. Mr. E buys a September T-bond futures from Mr. A for $96,000
on July 3.

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 Offset Action CH Receipt
Entry 5 cancels Entry 2 CH pays Ms. B $750 -$750
Entry 6 cancels Entry 3 Mr. D pays CH $250 $250
Entry 7 cancels Entry 4 Mr. E pays Ch $1,500 $1,500
Entry 8 cancels Entry 1 CH pays Mr. A $1,000 -$1,000
0.00

11. Suppose on March 1, you take a long position in a June T-bill

futures contract at RD = 5%.
a. How much cash or risk-free securities would you have to
deposit to satisfy an initial margin requirement of 5%?
b. Calculate the values of your equity account on the following
days, given the following
discount yields:

3/2 5.1%
3/3 5.2%
3/4 5.0%
3/5 4.8%
3/8 4.7%
3/9 5.0%

c. If the maintenance margin requirement specifies keeping the value of the equity
account equal to 100% of the initial margin requirement each day, how much cash
would you need to deposit in your commodity account each day?

a. Initial margin requirement:

100 5(90 / 360)

f0 $1,000,000 $987,500
100
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 Initial Margin = M0 = (.05)($987,500) = $49,375.

b. and c.

12. Ms. Hunter is a money market manager. In July, she anticipates needing cash in
September that she plans to obtain by selling ten $1 million-face value T-bills she currently
holds. At the time of the anticipated September sale, the T-bills will have a maturity of 91
days. Suppose there is a September T-bill futures contract trading a discount yield of R D =
6%.
a. If Ms. Hunter is fearful that short-term interest rates could increase, how could she
lock in the selling price on her T-bills?
b. Show in a table Ms. Hunter's net revenue at the futures' expiration date from closing
the futures position and selling her 10 T-bills at possible discount yields of 5%, 6%,
and 7%. Assume no quality, quantity, or timing risk.

a. Ms. Hunter needs to go short in 10 September T-bill futures contracts at f0 = $985,000.

100 6(90 / 360)

f0 $1,000,000 $985,000
100

b. At Delivery, Ms. Hunter closes the futures contracts at f T = ST and sells the ten T-bills on
the spot market at ST. Her hedged revenue is $9.85 million regardless of rates.

RD fT = ST Futures Profit T-Bill Sale Hedged Revenue

T-Bill Sale + Futures
% 10(985,000 fT) (10)(ST) Profit

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 5.00 $987,500 -$25,000 $9,875,000 $9,850,000
6.00 $985,000 $0 $9,850,000 $9,850,000
7.00 $982,500 $25,000 $9,825,000 $9,850,000

13. Suppose Ms. Hunter anticipates a cash inflow of $9.875 million in September that she
plans to invest in 10 $1 million face-value T-bills with a maturity of 91 days. Suppose there
is a September T-bill futures contract trading at a discount yield of RD = 5%.
a. If Ms. Hunter is fearful that short-term interest rates could decrease, how could she
lock in the purchase price on her T-bills?
b. Show in a table Ms. Hunter's net costs at the futures' expiration date from closing the
futures position and buying her 10 T-bills at possible discount yields of 4%, 5%, and
6%. Assume no quality, quantity, or timing risk.

a. Ms. Hunter needs to go long in 10 September T-bill futures contracts at f0 = $987,500.

100 5(90 / 360)

f0 $1,000,000 $987,500
100

b. At delivery, Ms. Hunter closes the futures contracts at f T = ST and buys ten T-bills on the
spot market at ST. Her hedged cost is $9.875 million:

RD fT = ST Futures Profit T-Bill Cost Hedged Cost

% 10(fT 987,500) (10)(ST) T-Bill Cost Futures Profit
4.00 $990,000 $25,000 $9,900,000 $9,875,000
5.00 $987,500 $0 $9,875,000 $9,875,000
6.00 $985,000 -$25,000 $9,850,000 $9,875,000

14. Bryce National Bank is planning to make a $10 million short-term loan to Midwest
Mining Company. In the loan contract, Midwest agrees to pay the principal and an
interest of 12% (annual) at the end of 180 days. Because Bryce National sells more 90-day
CDs than 180-day CDs, it is planning to finance the loan by selling a 90-day CD now at
the prevailing LIBOR of 8.25% and then 90 days later (mid-September) sell another 90-
day CD at the prevailing LIBOR. The bank would like to minimize its exposure to interest
rate risk on its future CD sale by taking a position in a September Eurodollar futures
contract trading at 92 (IMM index).
a. How many September Eurodollar futures contracts would Bryce National Bank need
to effectively hedge its September CD sale against interest rate changes? Assume
perfect divisibility.

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 b. Determine the total amount of funds the bank would need to raise on its CD sale 90
days later if the LIBOR is 7.5% and if it is 9% (assume futures are closed at the
LIBOR). What would the banks debt obligations be at the end of the 180-day period?
What is the banks effective rate for the entire 180-day period?

a.
100 (8)(90 / 360)
f 0 (Sept ) ($1,000,000) $980,000
100
Bank' s CD Debt in September $10,000,000(1.0825) 90 / 365 $10,197,391
$10,197,391
nf 10.4055 Short Eurodollar Futures Contracts
$980,000
.
b.

LIBOR (R) .075 .09

(1) Spot 90-Day CD price and closing Eurodollar
futures price: ST = fT = $1m/(1 + R)90/365 $982,326 $978,975
(2) Futures Profit: $24,203 $10,666
f = nf[f0-fT] = 10.4055[$980,000-fT]
(3) Debt on 1st CD: $10,197,391 $10,197,391
$10m(1.0825)90/365
(4) Total Funds to finance for next 90 days: $10,221,594 $10,186,725
Row 3 Row 2
(5) Debt at end of the next 90 days:
[Row 4](1 + R)90/365 $10,405,505 $10,405,502
(6) Rate paid for 180-day Period:
Rate = [Row (5)/$10,000,000]365/180 8.394% 8.394%
(allow for slight rounding differences)

15. As an alternative to a nine-month, 10% fixed-rate loan for $10 million, the Zuber
Beverage Company is considering a synthetic fixed rate loan formed with a $10 million
floating-rate loan from First National Bank and a Eurodollar strip. The floating-rate loan
has a maturity of 270 days (.75 of a year), starts on December 20th, and the rate on the
loan is set each quarter. The initial quarterly rate is equal to 9.5%/4, and the other rates
are set on 3/20 and 6/20 equal to one fourth of the annual LIBOR on those dates plus 100
basis points: (LIBOR % + 1%)/4. On December 20th, the Eurodollar futures contract
expiring on 3/20 is trading at 91 (IMM index), and the contract expiring on 6/20 is trading
at 92, and the time separating each contract is .25/year.
a. Explain how Zuber could use the strip to lock in a fixed rate. Calculate the rate the
Zuber Company could lock in with a floating-rate loan and Eurodollar futures.
b. Calculate and show in a table the companys quarterly interest payments, futures
profits, hedged interest payments (interest minus futures profit), and hedged rate

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 for each period (12/20, 3/20, and 6/20) given the following rates: LIBOR = 10% on
3/20 and LIBOR = 9% on 6/20.

a. To obtain a synthetic fixed-rate loan, Zuber would obtain the floating-

rate loan and go short in a Eurodollar strip: short in 10 3/20 Eurodollar
futures contracts and short in 10 6/20 contracts.

Locked-in Rate = [100 Index] + BP/100

3/20: R3/20 = [100 91] + 1% = 10%
6/20: R6/20 = [100 92] + 1% = 9%
Current Rate = 9.5%

Synthetic fixed Rate [ (1.095) .25 (1.10) .25 (1.09) .25 ] 1 / .75 1 .095

b.
1 2 3 4
Date LIBOR Futures Settlement price: Futures Profit***
profit = [(f0 fT)/100]
fT = 100 LIBOR(.25) ($1m)(10)
12/20 0.085
3/20 0.100 97.50 25,000
6/20 0.090 97.75 25,000
5 6 7
Date Quarterly Interest Hedged Debt Hedged Rate
.25(LIBOR+.01)($10m) Col 5 Col 4 [(4)(Col 6)]/$10m
12/20 237,500 237,500 0.095
3/20 275,000 250,000 0.100
6/20 250,000 225,000 0.090
*** f0(3/20) = 100-9(.25) = 97.75

*** f0(6/20) = 100-8(.25) = 98

16. XSIF Trust is planning to invest $10 million for one year. As an alternative to a one-year
fixed-rate note paying 8.5%, XSIF is considering a synthetic investment formed by
investing in a Second National Bank one-year floating-rate note (FRN) paying LIBOR
plus 100 basis points and a Eurodollar futures strip. The FRN starts on 12/20 at 9%
(LIBOR = 8%) and is then reset the next three quarters on 3/20, 6/20, and 9/20. On
December 20th, the Eurodollar futures contract expiring on 3/20 is trading at 91 (IMM
index), the contract expiring on 6/20 is trading at 92, and the contract expiring on 9/20 is
trading at 92.5; the time separating each contract is .25/year, and the reset dates on the
floating-rate note and the expiration dates on the futures expiration are the same.

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 a. Explain how XSIF Trust could use a strip to lock in a fixed rate.
Calculate the rate XSIF could lock in with a floating-rate note
and Eurodollar futures.
b. Calculate and show in a table XSIFs quarterly interest
receipts, futures profits, hedged interest return (interest plus
futures profit), and hedged rate for each period (12/20, 3/20,
6/20, and 9/20) given the following rates: LIBOR = 9.5% on
3/20, LIBOR = 9% on 6/20 and LIBOR = 7% on 9/20.

a. To obtain a synthetic fixed-rate investment, XSIF could invest in the

floating-rate note and go long in 10 Eurodollar strips: long 3/20, 6/20, and
9/20 Eurodollar futures contract.

Locked-in Rate = [100 Index] + BP/1003/20: R3/20 = [100 91] + 1% = 10%

6/20: R6/20 = [100 92] + 1% = 9%
9/20: R3/20 = [100 92.5] + 1% = 8.5%
Current Rate = 9%
Synthetic fixed Rate [(1.09) .25 (1.10) .25 (1.09) .25 (1.085) .25 ]1 1 .0912364

b.

17. Given: (1) 121-day spot T-Bill trading 98.318 to yield 5.25%; (2) 30-day risk-free rate of
5.15%; (3) a T-Bill futures contract with an expiration of T = 30 days.
a. What is the equilibrium T-bill futures price and its implied futures YTM (annualized)?
b. Explain what a money market manager planning to invest funds for 30 days should do
if the price on the T-bill futures were trading at 98.8. What rate would the manager
earn?

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 c. Explain the arbitrage a money-market manager could execute if she were holding a
121-day T-bills and the T-bill futures were trading at 98.

a.
f 0 S0 (1 R f ) T
f 0 98.318(1.0515) 30 / 365 98.7246

365 / 91
100
YTM f .05283
98.7246

b. A money market manager currently planning to invest for 30 days in a T-bill at 5.15%
could benefit with a greater return by creating a synthetic 30-day investment by buying a
121-day bill and then going short at 98.8 in the T-bill futures contract expiring in 30 days.
For example, using the above numbers, if a money market manager were planning to
invest 98.318 for 30 days, she could buy a 121-day bill for that amount and go short in
the futures at 98.8. Her return would be 6.13%, compared to 5.15% from the 30-day spot
T-bill:

365 / 30
98.8
R 1 .0613
98.318

c. A money manager currently holding 121-day T-bills could obtain an arbitrage by selling
the bills for 98.318 and investing the proceeds at 5.15% for 30 days, then going long in
the T-bill futures contract expiring in 30 days. Thirty days later the manager would
receive 98.7246 from the investment and would pay 98 on the futures to reacquire the
bills for a cash flow of .7246 per $100 par.

18. In the table below, the IMM Index prices on three T-bill futures contracts with expirations
of 91, 182, and 273 days are shown.

T-bill Contract Days to Expiration IMM Index

March 91 93.764
June 182 93.3092
September 273 91.8607
Spot 182-Day T-bill: YTM = .0625

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 a. Calculate the actual futures prices and the YTMs (annualized) on the futures.
b. Given the spot 182-day T-bill is trading at annualized YTM of 6.25%, what is the
implied 91-day repo rate?
c. If the carrying cost model holds, what would be the price of a 91-day spot T-bill?
d. What would be the equilibrium price on the March contract if the actual 91-day repo
rate were 4.75%? What strategy would an arbitrageur pursue if the IMM index price
were at 93.764?

a. Given the IMM index or discount yield (RD = 100 IMM Index) the actual
futures price on a T-bill futures is found using the formula:

100 R D %(90 / 360)

f0 $1,000,000
100

Given the futures price f0, the implied YTM is found using a face value of $1million and a
maturity of 91 days:
365 / 91
$1,000,000
YTM f 1
f0

The futures prices and implied yields on the March, June, and September contracts are shown
below in Columns 4 and 5 in the table:

(1) (2) (3) (4) (5)

Days to IMM Implied
Contract Expiration Index f0 YTM
March 91 93.764 $984,410 .065
June 182 93.3092 983,273 .07
September 273 91.8607 979,652 .086

b. The implied 91-day repo rate is the rate obtained from a synthetic 91-day T-bill formed by
purchasing the spot 182-day T-bill at YTM of 6.25%, or price of S(182) = $1,000,000/
(1.0625)182/365 = $970,223, and going short in the T-bill futures contract expiring in 91 days in
order to lock in a selling price of $984,410. Buying at $970,223 and selling at $984,410
ninety-one days later yields a rate of 6%:
365 / 91
$984,410
YTM syn 1 .06
$970,223

c. Given a 91-day repo rate of 6%, the price on a 91-day spot T-bill with a face value of $1
12
 million would be $985,578 = $1,000,000/(1.06)91/365.

d. Given the price of $970,223 on the spot 182 T-bill, the equilibrium price on the March
contract would be $981,513 given a repo rate of 4.75%:

f0(91) = S0(182) (1+R)91/365

= $970,223 (1.0475)91/365 = $981,513

If the IMM index price were 93.764, then the March futures would be trading at $984,410:

100 (100 93.764)(90 / 360)

f0 $1,000,000 $984,410
100

In this case, the T-bill futures would be overpriced. To exploit this, an arbitrageur would short
the March futures contract and borrow $970,223 at 4.75% for 91 days to finance the purchase of
a 182-day T-bill. At expiration (91 days later), the arbitrageur would sell the T-bill on the futures
contract for fM0 = $984,410, and repay the debt of $981,513 = $970,223 (1.0475)91/365, for a
positive cash flow of $2,897: Cash Flow = $984,410 $981,513 = $2,897.

19. Short-Answer Questions:

a. What was the primary factor that contributed to the dramatic growth in the futures
trading over the last twenty years?
b. What is a hedge called in which the asset underlying the futures contract is not the
same as the asset being hedged?
c. A bond manager who hedged her expected sale of 10-year, AA bonds in early
September with a CBOT T-bond futures would be subject to what types of hedging
risks?
d. How much cash or risk-free securities would a speculator have to deposit in a
commodity account if he goes long in one September T-bond futures contract at 95 and
the initial margin requirement is 5%?
e. Who ensures that the price on an expiring futures contract is equal or approximately
equal to its spot price?
f. What is the number of futures contracts outstanding at a given point in time called?
g. How does a physical futures market provide continuous trading without market makers
or specialists?
h. What is the trading referred to when exchange members trade for both their clients
and themselves?
i. What is the actual price on a T-bill futures contract, if its quoted IMM index price is
92?
j. What is the implied YTM on a September T-bill futures contract that is trading at 93
(IMM Index Price)?
k. What is the expiration futures price per $100 face value on an expiring Eurodollar
futures contract if the three-month LIBOR is 5% on the expiration day?
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l. What is the major difference between the Eurodollar and the T-bill futures contracts?
m. How much would the actual Eurodollar futures price change, if the IMM index moves
one point?
n. What is the implied futures YTM on a March T-bill futures contract trading at 93.75
(IMM index)?

a. The introduction of financial futures

b. Cross hedge
c. Quality and quantity risk
d. $4,750
e. Arbitrageurs
f. Open interest
g. Through locals: scalpers, day-traders, and position-traders.
h. Dual trading
i. $980,000
j. 7.34%
k. 98.75
l. The Eurodollar contracts have cash settlement at delivery while T-bill contracts call for
actual delivery
m. $2,500
n. 6.52%.

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