Download Chicago Board of Trade (CBOT)

Mexico Risk Management Conference
Chicago Board of Trade Interest Rate Futures
Presented by:
Ted Ehret
Director of Business Development
Chicago Board of Trade
October 12, 2006
1
Mexico Risk Management Conference
Futures Market Fundamentals
• The evolution of the futures market: Cash to
forwards to futures contracts
• Futures pricing: Theory and practice
• Using futures for investment and risk
management purposes
• Swaps
• Fed Funds and Binary Options
October 12, 2006
2
Futures Market Fundamentals
The evolution of the futures markets
• 19th century agriculture
– Seasonal delivery of harvest to market
created supply and demand imbalances
– Transportation and storage problems
– Impeded trade flow between east and
Midwest
October 12, 2006
3
Futures Market Fundamentals
The evolution of the futures markets
• A temporary solution: Forward contracts
– A privately negotiated agreement in which the
buyer and seller agree on price, quality,
quantity and a future delivery date of the
commodity, such as corn, wheat…
– Users included farmers, river merchants,
grain elevators, processors, millers
October 12, 2006
4
Futures Market Fundamentals
The evolution of the futures markets
• In 1848, 82 merchants gathered above a
flour store in Chicago to form the Chicago
Board of Trade (CBOT®).
• Promote commerce and provide a
centralized marketplace where buyers and
sellers could trade
October 12, 2006
5
Futures Market Fundamentals
The evolution of the futures markets
• Drawbacks of forward contracts
– Privately negotiated
– Not standardized
• Quality
• Quantity
• Delivery place and time
– Counter-party Risks
• Default
• Bankruptcy
October 12, 2006
6
Futures Market Fundamentals
The evolution of the futures markets
• The Solution: Futures
• CBOT formalized grain trading in 1865
– Standardized contracts
– Centralized exchanges
– Price discovery
– Clearinghouses
• Margins
October 12, 2006
7
Interest Rate Margins – Speculative Rates
Maintenance
Margin
(per
contract)
Initial Margin Mark Up
Percentage
Treasury Bonds
$900
135%
$1,215
10 Year T-Note
$600
135%
$810
5 Year T-Note
$400
135%
$540
2 Year T-Note
$350
135%
$473
30-Day Fed Fund-Tier 1 (Months 1Month 4)
-Less than 21 days to expiration
-Less than 14 days to expiration
-Less than 7 days to expiration
$275
135%
$371
$225
$150
135%
135%
$304
$203
$75
135%
$104
30-Day Fed Funds-Tier 2 (Months 5 and
later)
$375
135%
$506
10 Year Swaps
$675
135%
$911
5 Year Swaps
$400
135%
$540
October 12, 2006
8
Initial Margin
(per contract)
Effective October 9, 2006 www.cbot.com/margins
Interest Rate Margins - Hedge
Maintenance Margin (per
contract)
Initial Margin
Mark Up
Percentage
Initial Margin (per
contract)
Treasury Bonds
$900
100%
$900
10 Year T-Note
$600
100%
$600
5 Year T-Note
$400
100%
$400
2 Year T-Note
$350
100%
$350
30-Day Fed Fund-Tier 1 (Month 1Month 4)
-Less than 21 days to expiration
-Less than 14 days to expiration
-Less than 7 days to expiration
$275
100%
$275
$225
$150
100%
100%
$225
$150
$75
100%
$75
30-Day Fed Fund-Tier 2 (Month 5
and later)
$375
100%
$375
10 Year Swaps
$675
100%
$675
5 Year Swaps
$400
100%
$400
October 12, 2006
9
Effective October 9, 2006 www.cbot.com/margins
Interest Rate Margins – Intra-Market Spread Margins
Spreads - Interest Rates Group
Ratio
Spread Credit %
3:2
5 Year T-Notes vs. 10 Year T-Notes
90%
3:1
5 Year T-Notes vs. Treasury Bonds
80%
3:2
2 Year T-Notes vs. 10 Year T-Notes
80%
2:1
10 Year T-Notes vs. Treasury Bonds
80%
1:1
2 Year T-Notes vs. 5 Year T-Notes
85%
1:1
10 Year T-Note Futures vs. 10 Year Swap
85%
1:2
10 Year Swap vs. 5 Year Swap
85%
1:1
5 Year Swap vs. 5 Year Note
90%
1:3
Treasury Bond vs. 2 Year T-Note
75%
1:1
10 Year T-Note vs. 5Year Swap
85%
October 12, 2006
10
Effective October 9, 2006 www.cbot.com/margins
Futures Market Fundamentals
The evolution of the futures markets
Futures Contract:
A legally binding agreement to buy or to sell a standardized
commodity or financial instrument at some time in the future,
at a price agreed upon today and traded on an organized
and regulated futures exchange.
October 12, 2006
11
Futures Market Fundamentals
The evolution of the futures markets
Important Features For A Successful Futures Contract
• Clear understanding of contract performance
• Contract is clearly defined
• Balanced transaction
– No bias toward either side of the transaction
• Broad cross section of buyers and sellers
• Good exchange environment and support
• Price is the only element that is subject to
negotiation
October 12, 2006
12
Futures Market Fundamentals
Futures pricing: Theory and practice
October 12, 2006
13
Futures Market Fundamentals:
Futures pricing: Theory and practice
CBOT US Treasury Futures Complex
• 2 Year US Treasury Notes Futures
• 5 Year US Treasury Notes Futures
• 10 Year US Treasury Notes Futures
• 30 Year US Treasury Notes Futures
October 12, 2006
14
Futures Market Fundamentals:
Futures pricing: Theory and practice
Notional Value
(US$ Billions)
2-Year Note
148,167
$29.6
699,609
$139.9
5-Year Note
502,258
$50.2
1,402,786
$140.3
1,002,582
$100.3
2,217,489
$221.8
380,692
$38.1
778,035
$77.8
2,033,699
$218.2
5,097,919
$579.8
10-Year Note
Bond
As of September 30, 2006
October 12, 2006
15
Month-End
Open Interest
Notional
Value
(US$ Billions)
Average
Daily Volume
Futures Market Fundamentals:
Futures pricing: Theory and practice
• Treasury futures contracts are based on a 6% coupon
• There are several issues that are deliverable into a Treasury
futures contract
• Treasury futures prices track the “cheapest to deliver”
security, the single instrument that generally stands out as
the “cheapest” or most economical to deliver--which may
not be a 6% instrument
October 12, 2006
16
Futures Market Fundamentals
Futures pricing: Theory and practice
Example: 10 Year US Treasury Note Futures Contract
October 12, 2006
Trading Unit
(Quantity)
One U.S. Treasury note having a face value
at maturity of $100,000 or multiple thereof.
Deliverable
Grades
(Quality)
U.S. Treasury notes maturing at least 6 1/2
years, but not more than 10 years, from the
first day of the delivery month. The invoice
price equals the futures settlement price
times a conversion factor plus accrued
interest. The conversion factor is the price
of the delivered note ($1 par value) to yield
6 percent.
Contract Months
(Delivery Time)
March, June, September and December.
Last Trading Day
Seventh business day preceding the last
business day of the delivery month.
Last Delivery Day
Last business day of the delivery month.
17
Futures Market Fundamentals:
Futures pricing: Theory and practice
Example: 10 Year US Treasury Note Futures
Other standardized futures contract terms include:
Delivery Method
(Place)
Federal Reserve book entry, wire transfer
system.
Price Quote
Points ($1,000) and 32nds of a point; for
example 101-16 equals 101 16/32.
October 12, 2006
Tick Size
½ of 1/32 of a point ($15.625)
Trading Hours
Open Outcry: 7:20 a.m. – 2:00 p.m.,
Chicago time, Mon - Fri
Electronic: 6:00 p.m. – 4:00 p.m., Chicago
time,
Sun - Fri
18
Futures Market Fundamentals:
Futures Pricing: Theory and practice
Cash - Futures Relationship
Futures contracts are a good proxy for the cash instruments
because cash and futures prices generally highly correlated
because both are affected by the same economic factors.
October 12, 2006
19
Futures Market Fundamentals:
Futures pricing: Theory and practice
Basis
The difference between the current cash price and
the futures price of the same commodity.
Basis = Cash Price - (Futures Price x Conversion factor)
October 12, 2006
20
Futures Market Fundamentals:
Futures pricing: Theory and practice
Cost of Carry
• Reflects the net cost of financing or “carrying” the
instrument, i.e., buying, financing and holding it until delivery
• Factors affecting cost of carry will vary by instrument
October 12, 2006
21
Futures Market Fundamentals:
Futures pricing: Theory and practice
Convergence
• As time to delivery approaches, the market price and
futures prices “converge”
• Convergence reflects the decay in the cost of carry
• During delivery months, the basis narrows and should
approach zero
October 12, 2006
22
Futures Market Fundamentals:
Futures pricing: Theory and practice
Convergence
Sep Futures Price
Cost of Carry
Cash Price
Jan
October 12, 2006
Mar
23
Sep
Futures Market Fundamentals:
Futures pricing: Theory and practice
Delivery
Exchange of the actual underlying commodity or financial
instrument to settle the obligations of the futures contract
–
The potential for delivery influences the cash-futures
price relationship
–
Futures contracts can be either physical delivery or
cash - settled
October 12, 2006
24
Futures Market Fundamentals:
Futures pricing: Theory and practice
Cash Settled
Physical Delivery
Today:
Buy or sell contract
at today’s futures
price.
Buy or sell contract
at today’s futures
price.
Daily:
Pay losses/collect
profits on price
difference from
yesterday’s closing
price.
Pay losses/collect
profits on price
difference from
yesterday’s closing
price.
October 12, 2006
25
Futures Market Fundamentals:
Futures pricing: Theory and practice
Cash Settled
Physical Delivery
Settlement: Contract expires,
no further mark-tomarket payments
or receipts
October 12, 2006
26
If position not offset,
buyers must accept
delivery at the invoice
price; sellers must deliver
instrument at the invoice
price
Futures Market Fundamentals:
Futures pricing: Theory and practice
• The conversion factor is the approximate price, in
decimals, at which the note or bond would trade if it
yielded 6% to maturity (rounded to whole quarters)1.
• To calculate a cash equivalent forward price—that is, to
convert a futures price to an approximation of the
forward price of a given deliverable Treasury security—
you can multiply the futures price by the conversion
factor for that security.
1 Galen D. Burghardt at al., The Treasury Bond Basis, Third Edition (McGraw-Hill, 2005), p. 6.
October 12, 2006
27
Futures Market Fundamentals:
Futures pricing: Theory and practice
• Characteristics of Conversion Factors:
– Unique to each bond and delivery month
– Constant throughout the delivery cycle
– If the coupon is greater than 6%, then the conversion factor is
greater than 1. If the coupon is2 less than 6%, then the
conversion factor is less than 1
– Used to calculate invoice prices
– Sometimes used as a hedge ratio
2 Ibid., pp.6-7.
October 12, 2006
28
Futures Market Fundamentals:
Futures pricing: Theory and practice
®
Page 3
CBOT 10-YEAR U.S. TREASURY NOTE FUTURES CONTRACT
This table contains conversion factors for all long-term U.S. Treasury notes eligible for delivery as of August 9, 2006. (The next auction is tentatively scheduled for September 12, 2006.)
Issue
Footnotes:
Maturity
Cusip
Issuance
6% Conversion Factors
Coupon
Date
Date
Number
1.)
3 5/8
15-May-03
15-May-13
912828BA7
($ Billions) Sep. 2006 Dec. 2006 Mar. 2007 Jun. 2007 Sep. 2007
18
0.8737
-----
-----
-----
-----
Dec. 2007
-----
2.)
4 1/4
15-Aug-03
15-Aug-13
912828BH2
31
0.9040
0.9069
-----
-----
-----
-----
3.)
4 1/4
17-Nov-03
15-Nov-13
912828BR0
29
0.9012
0.9040
0.9069
-----
-----
-----
4.)
4
17-Feb-04
15-Feb-14
912828CA6
27
0.8837
0.8870
0.8902
0.8937
-----
-----
5.)
4 3/4
17-May-04
15-May-14
912828CJ7
25
0.9254
0.9273
0.9294
0.9314
0.9335
-----
6.)
4 1/4
16-Aug-04
15-Aug-14
912828CT5
23
0.8927
0.8955
0.8983
0.9012
0.9040
0.9069
7.)
4 1/4
15-Nov-04
15-Nov-14
912828DC1
23
0.8901
0.8927
0.8955
0.8983
0.9012
0.9040
8.)
4
15-Feb-05
15-Feb-15
912828DM9
23
0.8713
0.8744
0.8774
0.8806
0.8837
0.8870
9.)
4 1/8
16-May-05
15-May-15
912828DV9
22
0.8766
0.8793
0.8822
0.8851
0.8881
0.8910
10.)
4 1/4
15-Aug-05
15-Aug-15
912828EE6
21
0.8821
0.8848
0.8873
0.8901
0.8927
0.8955
11.)
4 1/2
15-Nov-05
15-Nov-15
912828EN6
21
0.8968
0.8990
0.9013
0.9034
0.9058
0.9080
12.)
4 1/2
15-Feb-06
15-Feb-16
912828EW6
21
0.8946
0.8968
0.8990
0.9013
0.9034
0.9058
13.)
5 1/8
15-May-06
15-May-16
912828FF2
21
0.9373
0.9385
0.9398
0.9410
0.9424
0.9436
14.) @
4 7/8
15-Aug-06
15-Aug-16
912828FQ8
13
0.9178
0.9194
0.9209
0.9226
0.9242
0.9259
Number of Eligible Issues:
14
14
13
12
11
10
9
Amount Eligible for Delivery ($ Blns):
318
318
300
269
240
213
188
"@" indicates the most recently auctioned US Treasury security eligible for delivery. Information contained in this publication is taken from sources believed to be reliable, but it
is not guaranteed by the Chicago Board of Trade as to its accuracy or completeness, nor as to any trading result, and is intended for purposes of information and education only.
The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications and regulations.
To receive updated conversion factors automatically via e-mail, please visit the Exchange's website at www.cbot.com to subscribe.
October 12, 2006
29
Futures Market Fundamentals:
Futures pricing: Theory and practice
• For example, consider a 5 1/8% coupon note
with nine years and seven months remaining
to maturity, which is deliverable into the
nearby 10-year Treasury note futures
contract:
– Futures Price:
107.609375 (107-19+)
– Conversion Factor: 0.9385
– Futures price * Conversion Factor =
Cash
Equivalent
107.609375 *
October 12, 2006
0.9385
30
= 100.9914 (100-31+)
Futures Market Fundamentals
Using futures for investment and risk
management purposes
October 12, 2006
31
Futures Market Fundamentals:
Using futures for investment and risk management
purposes
Speculating
Seeking to profit from buying and selling futures by anticipating
future price movements.
– Speculators assume the price risk that hedgers seek to
reduce.
– Speculators add liquidity and capital to the futures
markets.
October 12, 2006
32
Futures Market Fundamentals:
Using futures for investment and risk management
purposes
Hedging
Initiation of a position in the futures market that is
intended as a temporary substitute for the purchase
or sale of the actual commodity at a later date.
October 12, 2006
33
Futures Market Fundamentals:
Using futures for investment and risk management purposes
To Hedge With Financial Futures:
• Choose the contract that most closely describes the nature
of the underlying risk
• Choose the expiration month that most closely matches the
time period to be addressed
• Buy or sell the appropriate number of futures contracts to
cover your exposure
October 12, 2006
34
Futures Market Fundamentals:
Using futures for investment and risk management
purposes
Hedging
Sell (or go short) futures:
• to protect against exposure to falling prices or rising rates
• to preserve portfolio value by locking in a selling price
October 12, 2006
35
A Short Hedge
If the firm has an inherent long position (i.e., is already
holding the commodity or instrument) . . .
V
long cash
position
October 12, 2006
36
P
Hedging the On-The-Run 10-year
Dollar Value of a Basis Point
(DV01)
• Change in dollar price of security for
one basis point change in yield
• Larger (smaller) DV01s indicate larger
(smaller) price volatility
37
Hedging the On-The-Run 10-year
• Goal: Hedge your position by selling enough 10-year
Treasury futures that will almost exactly offset the
change in your cash Treasury note position
• Find the Right Number of Futures Contracts
– divide the DV01 of your actual Treasury position by
the futures DV01 to arrive at the hedge ratio. The
DV01 of the futures is driven by the cheapest-todeliver security in the basket 4 ¼ % 8/2013.
October 12, 2006
38
Hedging the On-The-Run 10-year
October 12, 2006
39
Hedging the On-The-Run 10-year
October 12, 2006
40
Hedging the On-The-Run 10-year
October 12, 2006
41
Hedging the On-The-Run 10-year
Calculating the DV01 of the Futures contract
Futures DV01 = CTD DVO1/CTD Conversion Factor
= 0.05719/0.9069
= 0.0631
October 12, 2006
42
Hedging the On-The-Run 10-year
Hedge Ratio = Portfolio DV01/Futures DV01
= 7.879/0.0631
= 125 contracts
October 12, 2006
43
Hedging the On-The-Run 10-year
October 12, 2006
44
Hedging the On-The-Run 10-year
October 12, 2006
45
Hedging the On-The-Run 10-year
October 12, 2006
46
Hedging the On-The-Run 10-year
October 12, 2006
47
Caveats on Hedging
• Futures hedges are imperfect.
• Hedging effectiveness impacted by
unexpected changes:
•
•
•
•
Value of strategic delivery options.
Term financing rates.
Slope of deliverable yield curve.
Credit of cash market position.
• Manage your position.
48
To learn more buy
The Treasury Bond Basis: An InDepth Analysis for Hedgers,
Speculators, and Arbitrageurs
Galen Burghardt, Terrence Belton,
Morton Lane, and John Papa,
McGraw-Hill, Third Edition, 2005
Visit www.cbot.com/ir
49
Interest Rate Swap Futures
Futures Market Fundamentals:
Interest Rate Swap Futures
• CBOT Swap futures employ an internal rate of return
formula to express the fixed rate of a forward-starting
swap as the price of a 6% coupon note.
• The underlying contract reference is the rate for a
forward-starting IMM-date interest rate swap –
specifically, the par rate for a plain vanilla interest rate
swap with forward start date on the third Wednesday
(“IMM Wednesday”) of the futures contract’s expiration
month.
October 12, 2006
51
Futures Market Fundamentals:
Interest Rate Swap Futures
• Contract specifications call for each contract to be cash
settled with reference to the pertinent ISDA (International
Swaps and Derivatives Association, Inc.) Benchmark
Rate on the last day of trading.
• ISDA Benchmark mid-market par swap rates are
collected at 11:00 a.m. New York time by Reuters
Limited and Garban Intercapital plc and are published on
Reuters page ISDAFIX3. (Source: Reuters Limited.)
• Daily publication occurs around 11:30 a.m. New York
time.
October 12, 2006
52
Futures Market Fundamentals:
Interest Rate Swap Futures
• The $100,000 nominal size of each contract signifies the
notional par value of an interest rate swap that
exchanges semiannual fixed-rate payments for floatingrate payments.
• The fixed payments are based on a 6% annual rate, and
the floating payments are based on 3-month LIBOR
(London Interbank Offered Rate).
October 12, 2006
53
Futures Market Fundamentals:
Interest Rate Swap Futures
• Swap futures trade in price terms and are quoted in
points ($1,000 per one point), 32nds of points
• ($31.25 per one 32nd), and halves of 32nds of points
($15.625).
• As with CBOT U.S. Treasury Note and Bond futures,
the expiration cycle for Swap futures is March, June,
September, and December.
October 12, 2006
54
Futures Market Fundamentals:
Interest Rate Swap Futures
• Key Benefits: It’s a futures contract
– Standardization
• A Swap futures contract transforms its underlying reference swap
rate into an index number that essentially looks and behaves like
the price of a 6% coupon note. The mapping from the par swap
rate to the contract price is standardized and one-to-one. So is the
mapping from the par swap rate to key characteristics of the
contract’s price behavior, including:
– Interest rate sensitivity of price (i.e., the contract’s DV01change in the underlying
forward swap rate) and
– Convexity of the contract price with respect to the underlying forward swap rate.
• By creating such standardization, CBOT Swap futures offer market
participants a convenient device for gauging the relative utility and
effectiveness of alternative positions and strategies.
October 12, 2006
55
Futures Market Fundamentals:
Interest Rate Swap Futures
• Key Benefits: It’s a futures contract
–
–
–
–
–
–
–
Position Scalability
Trade Scalability
Administrative Convenience and Low Operational Cost
Transparency
High-Grade Credit Exposure
Capital Efficiency
Off-Exchange Trading
October 12, 2006
56
Futures Market Fundamentals:
Interest Rate Swap Futures
• Key Benefits
– Off-Exchange Trading
•
•
•
•
October 12, 2006
Exchange-For-Physical (EFP)
Exchange-For-Swap (EFS)
Exchange-For-Risk (EFR)
Wholesale
57
Futures Market Fundamentals:
Interest Rate Swap Futures
CBOT 10-Year Swap Futures and OTC 10-Year Swaps
Correlations of (a) daily changes in forward-starting swap rates implied by prices of nearby CBOT
10-Year Interest Rate Swap futures with (b) daily changes in ISDA Benchmark Rates for OTC spot
10-year interest rate swaps.
1.00
Full Period Correlation = 0.98
Moving Quarterly (63 Business Day) Correlation
0.95
Correlation for mid-2002 to year-end 2005 is 0.98.
Moving quarterly correlation has never run less than 0.95.
Data Sources: Chicago Board of Trade, International Swaps and Derivatives Association
October 12, 2006
58
Dec-05
Aug-05
Apr-05
Nov-04
Jul-04
Mar-04
Nov-03
Jul-03
Mar-03
Nov-02
Jul-02
0.90
Futures Market Fundamentals:
Interest Rate Swap Futures
CBOT 5-Year Swap Futures and OTC Spot 5-Year Swaps
Correlations of (a) daily changes in forward-starting swap rates implied by prices of nearby
CBOT 5-Year Interest Rate Swap futures with (b) daily changes in ISDA Benchmark Rates
for OTC spot 5-year interest rate swaps.
Full Period Correlation = 0.93
Moving Quarterly (63 Business Day) Correlations
1
0.9
Correlation for mid-2002 to year-end 2005 is 0.93.
Moving quarterly correlation typically exceeds 0.90.
Data Sources: Chicago Board of Trade, International Swaps and Derivatives Association
October 12, 2006
59
Dec-05
Sep-05
Jun-05
Apr-05
Feb-05
Nov-04
Aug-04
Jun-04
May-04
Mar-04
Jan-04
Nov-03
Sep-03
Jul-03
Apr-03
Feb-03
Dec-02
Oct-02
Aug-02
Jul-02
0.8
Futures Market Fundamentals:
Interest Rate Swap Futures
• Liquidity
June 6, 2006 – The Chicago Board of Trade
(CBOT®) announced that Citigroup and Goldman
Sachs & Co. will join the existing market maker and
provide liquidity to all market participants in CBOT
5-Year and 10-Year Swap futures beginning in July
2006.
October 12, 2006
60
Futures Market Fundamentals:
Interest Rate Swap Futures
Swap Futures
Contract
Size
Minimum
Bid/Ask Spread
Customary
Bid/Ask Spread
5-Year
$200 Mln Notional
Approx
0.7 bps
Approx
0.35 bps
2,000 Contracts
1/32nd
0.5/32nds
$200 Mln Notional
Approx
0.6 bps
Approx
0.4 bps
2,000 Contracts
1.5/32nds
1/32nd
10-Year
October 12, 2006
61
Futures Market Fundamentals:
Interest Rate Swap Futures
Swap Futures Open Interest
60,000
55,000
50,000
45,000
40,000
35,000
30,000
25,000
20,000
15,000
0
1/
/1
09
0
4/
/0
09
0
8/
/2
08
0
1/
/2
08
0
4/
/1
08
0
7/
/0
08
6
6
6
6
6
6
6
6
6
6
6
6
6
62
0
1/
/3
07
0
4/
/2
07
0
7/
/1
07
0
0/
/1
07
0
3/
/0
07
0
6/
0
9/
/2
06
/1
06
October 12, 2006
Federal Funds Futures and Binary
Options on the Target Federal Funds Rate
October 12, 2006
63
Futures Market Fundamentals:
Federal Funds
•
•
•
•
•
•
•
•
•
•
•
30 Day Fed Fund Futures
Contract Size $5 million
Tick Size $20.835 per 1/2 of one basis point (1/2 of 1/100 of one percent of $5 million
on a 30-day basis rounded up to the nearest cent).
Price Quote 100 minus the average daily fed funds overnight rate for the delivery
month (e.g. a 7.25 percent rate equals 92.75)
Contract Months First 24 calendar months
Last Trading Day Last business day of the delivery month. Trading in expiring
contracts closes at 2:00 pm, Chicago time on the last trading day.
Settlement The contract is cash settled against the average daily fed funds overnight
rate, rounded to the nearest one-tenth of one basis point, for the delivery month. The
daily fed funds overnight rate is calculated and reported by the Federal Reserve Bank
of New York.
Trading Hours Open Auction: 7:20 am - 2:00 pm, Central Time, Monday - Friday
Electronic: 6:01 pm - 4:00 pm, Central Time, Sunday – Friday
Ticker Symbols Open Auction: FF Electronic: ZQ
Daily Price Limit N/A
Margin Information Find information on margins requirements for the 30 Day Fed
Fund Futures.
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Futures Market Fundamentals:
Federal Funds
• To protect against the anticipated lowering of the fed
funds target rate, you can buy CBOT fed funds futures
sufficient to essentially offset a loss of that magnitude.
• The first task in structuring such a hedge is to determine
the appropriate number of futures contracts to use.
• To hedge a US $1 billion portfolio against a lower Fed
Funds rate
•
•
Hedge ratio = Actual number of days in a month X $ amount hedged
30
$5 million
Buy 200 contracts
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Futures Market Fundamentals:
Federal Funds
• Using Fed Funds Futures to forecast Federal Funds
Target Rate
– FF futures implied rate =
target x db/d + [ (target+0.25) x p + target x (1-p) ] x da/d
• Target is the current target fed funds rate.
• p is the probability that the FOMC will raise the target rate 25 bps and (1-p) is the
probability that it will leave the target unchanged.
• db is the number of days in the month for which the current level of the target rate
applies, i.e., the number of days before and including the FOMC meeting date.
• da indicates the number of days in the month for which the FOMC’s next setting
of the target rate will apply, i.e., the number of days in the month after the FOMC
meeting date.
• d is the total number of days in the month. Note that d = db + da
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Futures Market Fundamentals:
Federal Funds
Let’s emphasize that this is an approximation, insofar as
it takes the rate implied by the FF futures contract price
(i.e., 100 minus rate) as an unbiased estimate of the
target fed funds rate. In fact, the rate that enters into the
valuation of the FF futures contract is not the target fed
funds rate, but rather the effective fed funds rate. The
effective fed funds rate seldom equals the target rate.
Indeed, the gap between the two – the Diff – is
frequently several basis points.
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Futures Market Fundamentals:
Federal Funds
30 Day Federal Funds Futures
• Settlement Price
– The contract is cash settled against the average effective overnight
fed funds rate, rounded to the nearest one-tenth of one basis point, for
the delivery month. The daily effective fed funds rate is calculated and
reported by the Federal Reserve Bank of New York. The monthly
average is understood to include non-business days (weekends and
holidays); the rate that applies to any non-business day is the effective
overnight fed funds rate for the preceding business day.
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Futures Market Fundamentals:
Federal Funds
The ‘BIG’ Picture
Target FFR:
Diff =
Month Effective FFR  Averaging of  FF/FFOs
Binaries 
FOMC
Decision Tree
minusTarget FFR
Effective FFR
↕
Distribution
of Future FOMC
Policy Actions
FF and FFO price dynamics are measured in the familiar price value of
a basis point (PV01), whereas Binary price dynamics are gauged in
terms of price value of probability points (PVP).
69
Futures Market Fundamentals:
Federal Funds
Big Picture: Target FFR and Overnight Rates
Percent
4.50
2.50
Effective FFR
Target FFR (Stair-Step Line)
General Collateral RP (Jagged Line)
31-Mar-06
27-Jan-06
25-Nov-05
23-Sep-05
22-Jul-05
20-May-05
18-Mar-05
14-Jan-05
12-Nov-04
10-Sep-04
9-Jul-04
7-May-04
5-Mar-04
2-Jan-04
0.50
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Futures Market Fundamentals:
Federal Funds
CBOT Binary Options on the Target Federal
Funds Rate are so called because they offer only
two outcomes. Depending on the level of the
target fed funds rate at option expiry:
Option owner either receives $1000 or $0.
Option seller either pays $1000 or $0.
Futures Market Fundamentals:
Federal Funds
Option Payouts: Conventional vs. Binary
$2,500
Value of Conventional 95.00 Call at Expiration
$2,000
$1,500
$1,000
Value of Binary 95.00 Call
at Expiration
$500
$0
-$500
94.00
94.25
94.50
94.75
95.00
72
95.25
95.50
95.75
96.00
Futures Market Fundamentals:
Federal Funds
Binary Options Specs
•
•
•
•
Description CBOT Binary Options on the Target Federal Funds Rate are contracts
that have fixed payouts based upon the relationship between the option strike price
and the target fed funds rate (quoted in 100-minus-rate terms), as set by the Federal
Open Market Committee (FOMC). With Binary Options there is a defined risk and
reward for both the buyer and the seller: there is a payout of $1,000 (the buyer
receives and the seller pays) if the option expires in-the-money, and $0 if it does not.
Price Basis Par is on the basis of 100 points, with one point equal to $10. The price
is never less than zero points or greater than 100 points.
Minimum Price Fluctuation One point, equal to $10.
Delivery Months Customarily, options shall be listed for expiration in each of the next
four delivery months. An option’s delivery month shall be determined by the
concluding day of the regularly scheduled FOMC meeting that the option references,
as shown in the FOMC meeting calendar at the time the option is listed for trading.
The FOMC meeting calendar is maintained and published by the Board of Governors
of the Federal Reserve at http://www.federalreserve.gov/fomc/#calendars
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Futures Market Fundamentals:
Federal Funds
•
•
•
Last Trading Day An option’s last trading day shall be fixed when the option is listed
for trading, and shall be based upon the FOMC meeting calendar at the time the
option is listed for trading. For the September, 2006 option the last trading day is
September 20, 2006; for the October, 2006 option the last trading day is October 24,
2006; and for the December, 2006 option the last trading day
is December 12, 2006. For any option expiring in January 2007 or later, the last
trading day will be business day following the concluding day of the FOMC meeting
that the option references.
Trading Hours 6:00 p.m. to 4:00 p.m., Chicago time, Sunday through Friday. Trading
in an expiring option shall cease at 3:00 p.m. Eastern time (2:00 p.m. Chicago time)
on the last trading day.
.Strike Levels Option strikes shall bracket the prevailing target fed funds rate
(expressed in 100-minus-rate terms). For newly-listed delivery months, strikes shall
be listed in increments of 12.5 basis points, at the prevailing target plus twenty (20)
consecutively higher and (20) consecutively lower strikes, subject to the constraint
that strikes can never be less than 0.00 nor greater than 100.00.
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Futures Market Fundamentals:
Federal Funds
•
•
•
•
Settlement An expiring option shall be cash settled with reference to the target fed
funds rate (expressed in 100-minus-rate terms) that is in effect as of 6:00 p.m.
Eastern time on the option’s last trading day. Customarily (though not always) this will
be the outcome of the regularly scheduled FOMC meeting that the option references.
The target fed funds rate shall be as found in the most recently published Statement
of the FOMC, typically published immediately following adjournment of any FOMC
meeting. (See http://www.federalreserve.gov/fomc/#calendars. )For any binary put
option with a strike greater than the target fed funds rate (expressed in 100-minusrate terms) on the option’s last trading day, long position holders shall receive, and
short position holders shall pay, $1,000. For any binary put option with a strike equal
to or less than the target fed funds rate on the option’s last trading day, longs shall
receive, and shorts shall pay, $0.For any binary call option with a strike less than the
target fed funds rate (expressed in 100-minus-rate terms) on the option’s last trading
day, long position holders shall receive, and short position holders shall pay, $1,000.
For any binary call option with a strike equal to or greater than the target fed funds
rate on the option’s last trading day, longs shall receive, and shorts shall pay, $0.All
final pays and collects shall be made on the business day following the determination
of the final settlement prices of the expiring binary options.
Trading Platform Electronic
Matching Algorithm Pro-rata with preferencing and priority orders (minimum of 25
contracts, maximum of 250 contracts)
Ticker Symbol Calls: BUSC, Puts: BUSP
October 12, 2006
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Appendix
October 12, 2006
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Futures Market Fundamentals:
Using futures for investment and risk management purposes
Hedging
Buy (or go long) futures:
• to protect against exposure to rising prices or falling rates
• to limit opportunity loss by locking in a purchase price
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A Long Hedge
If the firm has an inherent short position (i.e., is planning to
purchase or acquire the security) . . .
V
short cash
position
P
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A Long Hedge
The long hedge is created by buying the appropriate
number of futures to neutralize the exposure
V
short cash
position
long futures
position
P
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Futures Market Fundamentals:
Using futures for investment and risk management purposes
• Goal: To protect your purchasing power when
you fear yields may drop
• Pop Quiz: What do you do?
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Futures Market Fundamentals:
Using futures for investment and risk management purposes
Other Applications for Institutional Investors
•
•
•
•
•
Asset Allocation or Portfolio Rebalancing
Duration Adjustments
“Securitizing” Cash
Investing Funds During a Search
Gaining Exposure to a Market in Anticipation of an Inflow of
Funds
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Futures Market Fundamentals:
Using futures for investment and risk management purposes
• Asset Allocation
– Enforce the mix of assets as set forth in your fund's
policy.
– Perform a temporary reallocation to take advantage of
current attractive market conditions.
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Futures Market Fundamentals:
Using futures for investment and risk management purposes
Asset Allocation
Scenario:
Suppose your pension fund’s assets are divided between
$400 million in stocks and $100 million in bonds (80%/20%).
Your fund’s policy calls for a mix of 60% stock and 40%
bonds, so in order to maintain your allocation strategy, $100
million in stocks must be sold and $100 million in bonds
must be purchased.
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Futures Market Fundamentals:
Using futures for investment and risk management purposes
Asset Allocation
Strategy:
Use futures to enforce your allocation policy by buying Tbond futures and selling CBOT ®DJIA stock index futures.
This will allow your manager the time to select and
purchase/sell the actual securities he desires.
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Futures Market Fundamentals:
Using futures for investment and risk management purposes
• Securitizing Cash
– Allows you to quickly get exposure to a particular market
at times when your managers may be holding too much
cash.
– Gives you time to select which markets you want to be in
and also lessens the impact on the market, resulting in a
better price.
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Futures Market Fundamentals:
Using futures for investment and risk management purposes
Securitizing Cash
Scenario:
Your fund is required to be fully invested with no
more than 5% allocated to cash at any one time.
You recently received a $25 million cash inflow which
you are therefore obligated to invest as quickly as
possible. However, the size of the position you need
could result in an increase in the asking price of the
securities you are seeking.
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Futures Market Fundamentals:
Using futures for investment and risk management purposes
Securitizing Cash
Strategy:
Buy futures to quickly and efficiently gain exposure to
the desired market--either fixed income or equities.
Then, you gradually invest the cash over a
period of several days while simultaneously
unwinding your futures position by selling the same
number of contracts you bought.
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Futures Market Fundamentals:
Using futures for investment and risk management purposes
How Futures Make Risk and Investment Management
More Efficient
• Do not upset portfolio or change allocation on a permanent
basis.
• Do not disrupt the activities of external managers.
• Greater liquidity means decisions can be implemented more
quickly and cost-effectively than in the cash market.
• Allow time to select the securities to involve in the asset
allocation process.
• Allow you to quickly react to significant events.
October 12, 2006
88
®
CBOT
Disclaimer
The information herein is taken from sources believed to be reliable.
However, it is intended for purposes of information and education only
and is not guaranteed by the Chicago Board of Trade as to its accuracy,
completeness, nor any trading result and does not constitute trading
advice or constitute a solicitation of the purchase or sale of any futures or
options. The Rules and Regulations of the Chicago Board of Trade
should be consulted as the authoritative source on all current contract
specifications and regulations.
©2006 Chicago Board of Trade. All rights reserved.
89
The Fundamentals of
Exchange-Traded Derivatives
Futures Market Fundamentals
Presented by:
Ted Ehret
Director of Business Development
Chicago Board of Trade
[email protected]
312-435-4683
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90