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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. October 12, 2006 64 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 October 12, 2006 65 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 October 12, 2006 66 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. October 12, 2006 67 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. October 12, 2006 68 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 70 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 October 12, 2006 73 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. October 12, 2006 74 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 75 Appendix October 12, 2006 76 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 October 12, 2006 77 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 October 12, 2006 78 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 October 12, 2006 79 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? October 12, 2006 80 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 October 12, 2006 81 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. October 12, 2006 82 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. October 12, 2006 83 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. October 12, 2006 84 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. October 12, 2006 85 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. October 12, 2006 86 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. October 12, 2006 87 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 October 12, 2006 90