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One can use T-bill and Eurodollar futures to speculate on, or hedge against changes in, short-term (3-months to a year) interest rates. The longs profit when interest rates fall; the shorts profit when interest rates rise (and fixed income instrument prices fall). The T-bill futures market is thinly traded (illiquid). Total open interest on Sept 13, 2002 was only 863 contracts. Total open interest of Eurodollar futures on Sept 13th was almost 4.5 million contracts. The 1-month LIBOR futures contract is quite liquid.
David Dubofsky and 10-1 Thomas W. Miller, Jr.
T-bill Futures, I.
Underlying asset is $1MM face value of 3-month Tbills IMM Index = 100 dy
(A surprisingly difficult formula!)
F P 360 dy F t
Where: F = face value = $1,000,000 for a T-bill futures contract P = price t = days to maturity (91 days for a 3-month T-bill)
David Dubofsky and 10-2 Thomas W. Miller, Jr.
F P 365 r P t
This is called the bond equivalent yield (if t < 182 days)
David Dubofsky and 10-3 Thomas W. Miller, Jr.
One tick = $12.50 = 1/2 basis point change in the yield. The contract is cash-settled. To speculate, go long T-bill futures if you think that 3-month Tbill prices will rise (yields on 3-month T-bills will fall). Sell T-bill futures to bet on falling prices (rising yields).
David Dubofsky and 10-4 Thomas W. Miller, Jr.
Eurodollar Futures, I.
When foreign banks receive dollar deposits, those dollars are called Eurodollars. Underlying asset is the 90-day $1,000,000 Eurodollar time deposit interest rate; LIBOR Cash settled (A surprisingly IMM Index = 100 aoy difficult formula!)
F P 360 aoy P t
If the IMM Index is 95.19, then the futures LIBOR is 4.81%. (100 95.19 = 4.81) LIBOR rises => IMM index falls.
David Dubofsky and 10-7 Thomas W. Miller, Jr.
------------92.35 ----------
138 138 138 138 158 138 138 138 EST.VOL 238903
56 56 56 56 102 96 96 97
On July 28, 1999, a firm plans to borrow $50 million for 90 days, beginning on September 13, 1999. The firm will borrow at the Eurodollar spot market on September 13th. (For ease of presentation, the loan begins on the expiration date of the September futures contract, September 13, 1999. Loans beginning on any other date will mean that the hedge possesses some basis risk.) The current spot 3-month Eurodollar rate is 5.3125%. However, this rate does not matter to the firm because the bank will not be borrowing at the current spot 3-month rate. timelinetimelinetimelinetimelinetimelinetimelinetimelinetimeline.
Subliminal Hint
David Dubofsky and 10-12 Thomas W. Miller, Jr.
The firm will be borrowing in the spot market 47 days hence. Thus, on July 28th, the interest rate at which the firm will be borrowing on September 13th is unknown. The firm fears that when it comes time to borrow the funds in the Eurodollar spot market, interest rates will be higher (Eurodollar Index will be lower). Such a situation calls for a short hedge using Eurodollar futures contracts. (Why does it call for a short hedge?) On July 28, 1999, the closing price for September Eurodollar futures was 94.555. (IMM Index) Assuming transactions costs of zero, by shorting 50 Eurodollar futures contracts on July 28, 1999, the firm can lock in a 90-day borrowing rate of 5.445%. Rate: 100 94.555.
Thus, in this case, there is no profit or loss on the futures contracts because the firm went short at 94.555.
David Dubofsky and 10-14 Thomas W. Miller, Jr.
To calculate the futures profit on the 50 contracts, one must recall that each full point move in the IMM Index (i.e., 100 basis points) represents $2,500 for one futures contract. The delivery day futures price is 1005.845 = 94.155. Thus, (94.555 94.155) * 2500 * 50 = $50,000
Here too, the net interest expense for the firm is $730,625 - $50,000 = $680,625.
David Dubofsky and 10-15 Thomas W. Miller, Jr.
The net interest expense for the firm equals the interest expense with the 5.045% rate, plus the loss on the futures position. It is the same as the two previous cases: $630,625 + $50,000 = $680,625.
David Dubofsky and 10-16 Thomas W. Miller, Jr.
Because the firm will borrow $50 million in September and every 90 days three times thereafter, the firm initiates a strip hedge by selling 50 Eurodollar futures contracts in each of four delivery months: September, December, March, and June. The short positions in these 200 futures contracts are all entered on July 28th. Thus, a strip hedge can be thought of as a portfolio of singleperiod hedges. In the strip hedge shown below, the hedger has hedged borrowing costs for four successive quarters. In the following table, rates and prices that are known on July 28th appear in bold italics. In this example, note that the firm faces a new loan rate at the start of each of four successive 90-day loan periods. As an example of how to read the table, S50@94.555 means go short 50 contracts at a futures price of 94.555, and L50@ 94.35 means go long 50 contracts at a futures price of 94.35.
David Dubofsky and 10-19 Thomas W. Miller, Jr.
5.445%
5.81%
5.815%
6.05%
$25,625
$5,000
$23,125
($18,750)*
*The
$18,750 loss occurs because the June 2000 futures price rose from 93.95 to 94.10. This is a loss of 15 ticks. Each tick is worth $25. The firm sold 50 futures contracts. Therefore, 15 ticks * $25/tick * 50 contracts = -$18,750.
The effective borrowing rate for each quarter is the implied futures rate at the time the hedge is placed. This can be assured only if the firm borrows on each of the futures contracts delivery days. This is just as it is in the one-period case above. Thus, one can see that a strip hedge is a portfolio of one-period hedges. To expedite the execution of strip trades the CME offers bundles and packs for Eurodollar futures. Bundles and Packs are simply "pre-packaged" series of contracts that facilitate the rapid execution of strip positions in a single transaction rather than constructing the positions with individual contracts.
David Dubofsky and 10-22 Thomas W. Miller, Jr.
Packs: A simultaneous purchase or sale of an equally weighted, consecutive series of Eurodollar futures. The number of contracts in a pack is fixed at four.
Packs are designated by a color code that corresponds to their position on the yield curve. For example, the red pack consists of the four contracts that constitute year two on the curve, the green pack those in year three, etc. There are nine Eurodollar packs (covering years two through ten) available for trading at a given time. Distant Contract Liquidity makes identification impossible. CME color codes: Years one (contracts 1-4) through ten (contracts 37-40) are represented, respectively, by: white, red, green, blue, gold, purple, orange, pink, silver, and copper.
David Dubofsky and 10-23 Thomas W. Miller, Jr.
Out of Many Interest Rates, one is Named the Zero Rate. (Collectively, the Group of Zero Rates are Called the Zeros.)
A zero rate from time 0 to maturity T, is the rate of interest earned on an investment that provides a payoff only at time T. (think of a zerocoupon bond). Because these rates are quoted today, i.e., at time 0, they are also known as spot rates. Although sometimes we must calculate these, zeros are not mythical creatures. Treasury STRIPS.
Example
Maturity (years) 0.5 1.0 1.5 2.0 Zero Rate (%) 5.0 5.8 6.4 6.8
Zero Curve
5.9 5.8 5.7 5.6 5.5 5.4 5.3 5.2 5.1 5 0.00
Rate
0.50
1.00
1.50 Maturity
2.00
2.50
3.00
Out of Many Rates, one is Named the Forward Rate. (Collectively, they are the Forwards.)
The forward rate is the future zero rate implied by todays term structure of zero interest rates.
Expectations Theory of the Term Structure: forward rates equal expected future zero rates.
Year (n )
1 2 3 4 5
(% per annum)
10.0 10.5 10.8 11.0 11.1
(% per annum)
R 2 T2 R1T1 T2 T1
10.5%
10.8%
f2,3%
taking the log of both sides : (10.5)(2) (10.0)(1) (f1,2 )(1) (R2 )(T2 ) (R1)(T1) (f1,2 )(T2 T1) So, (R2 )(T2 ) (R1)(T1) (10.5)(2) (10.0)(1) f1,2 11.0 (T2 T1) (1)
David Dubofsky and 10-33 Thomas W. Miller, Jr.