FMP 19 -INTEREST RATE FUTURES Flashcards
What are the most commonly used day count conventions in the United States?
- Actual/Actual (in period)
- 30/360
- Actual/360
The Actual/Actual convention is used for Treasury bonds, while 30/360 is used for corporate and municipal bonds, and Actual/360 is used for money market instruments.
What is the formula to calculate interest earned between two dates using day count conventions?
Interest earned = (Number of days between dates / Number of days in reference period) × Interest earned in the reference period
This formula helps in calculating the interest based on the defined day count convention.
What is the difference between clean price and dirty price for a US Treasury bond?
Clean price is the quoted price of the bond, while dirty price (cash price) includes accrued interest since the last coupon date.
Cash price = Quoted price + Accrued interest.
How is the conversion factor for a Treasury bond futures contract defined?
The conversion factor is set equal to the quoted price the bond would have per dollar of principal on the first day of the delivery month, assuming a 6% per annum interest rate with semiannual compounding.
This factor adjusts the price received for the bond during futures contracts.
What is the formula to calculate the cost of delivering a bond into a Treasury bond futures contract?
Cost of delivering = (Most recent settlement price × Conversion factor) + Accrued interest
This equation determines the total cash received for the bond delivered in the contract.
What impact does the level and shape of the yield curve have on the cheapest-to-deliver Treasury bond decision?
The yield curve influences which bond is cheapest to deliver based on its price and accrued interest relative to the futures contract price.
A steeper yield curve may affect the decision on which bond minimizes costs.
How is the theoretical futures price for a Treasury bond futures contract calculated?
The theoretical futures price is calculated using the current price of the underlying bond, the conversion factor, and the interest rates involved.
This price reflects the expected future value of the bond.
What is the Eurodollar futures contract convexity adjustment?
The convexity adjustment accounts for the curvature in the relationship between bond prices and interest rates, modifying the futures price to better reflect expected changes in rates.
This adjustment is important for accurately pricing Eurodollar futures.
What is a duration-based hedge ratio?
A duration-based hedge ratio is calculated to determine the amount of futures contracts needed to hedge a specific position based on the duration of the underlying asset.
This strategy is used to mitigate interest rate risk.
True or False: The Actual/Actual day count convention is used for corporate bonds in the United States.
False
The Actual/Actual convention is used for Treasury bonds, while 30/360 is typically used for corporate bonds.
What is the relationship between the cash price and quoted price of a Treasury bill?
P = 360 × (100 - Y) / n
Where P is the quoted price, Y is the cash price, and n is the remaining life of the Treasury bill in days.
Fill in the blank: The cash price of a bond equals the quoted price plus _______.
Accrued interest
This calculation is essential for determining the total cost of purchasing a bond.
What is the primary purpose of using interest rate futures contracts?
To hedge a company’s exposure to interest rate movements.
This use of futures helps manage financial risk associated with fluctuating interest rates.
What defines the cheapest-to-deliver bond in a Treasury bond futures contract?
The cheapest-to-deliver bond is the one with the lowest cost based on the difference between quoted bond price and the adjusted futures price using the conversion factor.
The decision is made by comparing all deliverable bonds.
What is the cheapest-to-deliver bond?
The bond that a party with a short position in a futures contract chooses to deliver, based on cost considerations.
What factors determine the cheapest-to-deliver bond?
- Yield Levels
- Yield Curve Slope
When bond yields exceed 6%, which type of bonds are favored for delivery?
Low-coupon long-maturity bonds
When bond yields are less than 6%, which type of bonds are favored for delivery?
High-coupon short-maturity bonds
What happens when the yield curve is upward-sloping regarding bond delivery?
Bonds with a long time to maturity are favored.
What happens when the yield curve is downward-sloping regarding bond delivery?
Bonds with a short time to maturity are favored.
What is the theoretical futures price related to?
The spot price adjusted by the present value of the coupons.
What is the formula for determining the futures price (F0)?
F0 = S0 - I, where I is the present value of the coupons.
In the futures contract, what does T represent?
The time until the futures contract matures.
What does r represent in the futures price formula?
The risk-free interest rate applicable to a time period of length T.
What is a Eurodollar?
A dollar deposited in a U.S. or foreign bank outside the United States.
What is the Eurodollar interest rate equivalent to?
The London Interbank Offered Rate (LIBOR).
What does a three-month Eurodollar futures contract allow traders to do?
Speculate on a future three-month interest rate or hedge exposure to it.
How does a one-basis-point move in the futures quote affect contracts?
Corresponds to a gain or loss of $25 per contract.
What is the settlement price change from 99.325 to 99.285 for long and short positions?
Long position loses $25; short position gains $25.
What is the relationship between the futures quote and interest rate?
The futures quote is 100 minus the futures interest rate.
What does the convexity adjustment account for?
Differences between actual forward rates and rates implied by futures contracts.
What is the formula for the convexity adjustment?
Convexity Adjustment = 1/2 * σ * T1^2.
What does the variable σ represent in the convexity adjustment formula?
The standard deviation of the change in the short-term interest rate in 1 year.
What is the duration-based hedge ratio formula?
N* = P * DP / (VF * DF).
What is the significance of the duration of the underlying asset in hedging?
It should be as close as possible to the duration of the asset being hedged.
When interest rates rise, what happens to interest rate futures prices?
They decrease.
When interest rates drop, what happens to interest rate futures prices?
They increase.
What is the expected duration of the bond portfolio in the example provided?
6.80 years.
What is the current futures price in the example?
93-02, or 93.0625.
What is the face value of each futures contract in the example?
$100,000.
What is the purpose of using the December T-bond futures contract?
To hedge the value of the portfolio.
What is the current futures price for the T-bond contract?
93-02 or 93.0625.
What is the face value of each T-bond futures contract?
$100,000.
What will the futures contract price be for the T-bond?
$93,062.50.
What is the expected duration of the bond portfolio in 3 months?
6.80 years.
What type of bond is the cheapest-to-deliver in the T-bond contract?
A 20-year 12% per annum coupon bond.
What is the current yield on the cheapest-to-deliver bond?
8.80% per annum.
What will the duration of the cheapest-to-deliver bond be at maturity of the futures contract?
9.20 years.
What position does the fund manager require in T-bond futures to hedge the bond portfolio?
A short position.
If interest rates go up, what happens to the short futures position?
A gain will be made.
If interest rates decrease, what happens to the bond portfolio?
A gain will be made.
What is the strategy called when financial institutions match the average duration of their assets and liabilities?
Duration matching or portfolio immunization.
What effect does duration matching have on the value of the portfolio with small parallel shifts in interest rates?
It ensures little effect.
What is a weakness of duration matching?
It does not immunize against nonparallel shifts in the zero curve.
What is typically more volatile, short-term rates or long-term rates?
Short-term rates.
What could happen to short- and long-term rates in terms of their direction?
They might move in opposite directions.
What is required in addition to duration matching to fully manage interest rate exposure?
Other tools like swaps, FRAs, bond futures, Eurodollar futures.
