Hedging and Duration Management with Fixed Income Futures

Hedging and Duration Management with Fixed Income Futures Taipei Interest Rate Futures Conference November 20, 2003 Nick Ronalds, CFA Senior Vice President ABN AMRO Incorporated 312. 855. 7094

“The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk. ” Peter Bernstein, Against the Gods. 312. 855. 7094

Comments by Tony Latter, Deputy Chief Executive, Hong Kong Monetary Authority n. Derivatives have brought substantial benefits to the commercial community, in facilitating hedging and hence business planning more generally, and have enabled the financial institutions to offer a progressively wider range of services and greater efficiency in the intermediation process, as well as to exploit market imperfections and other trading opportunities for their own gain. November 5, 2001, Hong Kong See http: //www. info. gov. hk/hkma/eng/speeches/speechs/tony/20011106. htm for complete text of his comments. 3 312. 855. 7094

“The hardest thing to convey to a controller is that if you’re doing nothing, you’re speculating. ” Christine Snouffer, Treasury Risk Manager, Fellowes Corp. 312. 855. 7094

Advantages of Futures n Low transactions costs – Transaction costs can be as little as 5% of cash market for comparable exposure. price transparency n Positions can be offset n System financial integrity n Off-balance sheet items. n “Level playing field” for all participants n 5 312. 855. 7094

ABN AMRO Futures n. Global Capabilities - Local presence and Expertise n. Full product range including: Interest rates, equity indices, energy, metals, grains, softs as well as O-T-C metals and energy products. n. Membership on all major futures exchanges around the world 6 312. 855. 7094

ABN AMRO Futures n 450 Futures professionals in nine offices (Paris, London, New York, Chicago, Singapore, Sydney, Hong Kong, Tokyo and Seoul) n. Expect to clear and/or executed 350 Million contracts in 2003. n. Backed by the resources of ABN AMRO Bank. (Group capital of 31. 1 euros) 7 312. 855. 7094

Key Areas of Futures Expertise n. Open Outcry Execution in Fixed Income Derivatives including: Eurodollar, Treasury Bond & Note futures. n. Open outcry and electronic execution of all major U. S. and non-U. S. equity index and fixed income futures. n. Client-focused access to global futures markets, including our 24 -hour desk, access to our local specialists around the world, and electronic execution where available. n. Options Strategies n. Electronic Delivery of Client Trade and Clearing Data 8 312. 855. 7094

ABN AMRO Futures - Highlights n. A range of electronic Order Entry Solutions suited to client needs. n. Global Capabilities - Local presence and expertise n. Number one in Execution Volume for CME Eurodollar Futures & Options n. No. 2 overall in CME execution volume in 2002, including interest rates and equity futures. n. Top Five in Execution Volume in CBOT Treasury Futures& options 9 312. 855. 7094

World Futures Volume 10 312. 855. 7094

World Options on Futures 11 312. 855. 7094

Total World Futures + Options on Futures 12 312. 855. 7094

Global Futures & Options by Subgroup 13 312. 855. 7094

Part 1 A Conceptual Introduction 312. 855. 7094

A Conceptual Introduction To Treasury Futures: n They are highly liquid contracts with low transactions costs. n Treasuries are traded on the Chicago Board of Trade (CBOT). There are March, June, September and December contracts. n They are priced off of a basket of cash Treasury notes or bonds (CBOT). n The Treasuries in the basket can be delivered at expiration of the futures contract , assuring a strong correlation to the Treasury market. 15 312. 855. 7094

Other Bond Futures n. Other sovereign debt futures such as the German Bund contract, for the most part are structured similarly to the U. S. Treasury Futures contracts. 16 312. 855. 7094

Treasury Futures Are Used To: n Hedge fixed income securities - Sovereign debt, Treasuries, Corporates, MBS, Agencies, etc. n Create synthetic money market vehicles that can be traded as part of an arbitrage strategy in conjunction with other real or synthetic money market instruments. n Achieve portfolio allocation strategies that unbundled the decision of market exposure from relative value decisions. n Extend or shorten duration. n Speculate on the direction of interest rates. – Remember: doing nothing = speculation 17 312. 855. 7094

The Users of Treasury Futures: n Broker/dealers who hedge their fixed income inventories or opt to express interest rate views with futures. n Portfolio managers who may opt to hedge, manage duration, or make preemptive allocation decisions based upon the pattern of funds coming in or leaving the fund. These managers may work for a mutual fund, pension fund, insurance company, bank, or the treasurers department of a corporation. n CTAs and hedge funds who may hedge or speculate on the direction of interest rates. 18 312. 855. 7094

Treasury Note and Bond Futures Cover 4 Points on the US Yield Curve. Contract Details Include the Following: 19 312. 855. 7094

Cash and Futures Markets Price Notations : The fractional part of the price is denoted in 32 nds i. e. 107 -25 = 107 25/32 = 107. 78125 in Decimal and 107 -25 ¹ 107. 25 decimal. Cash market price progression : 107 -25, 107 -25+, 107 -26 … T-Bond futures price progression : 102 -25, 102 -26, 102 -27 … 10 -Year / 5 -Year T-Note futures price progression : 104 -25, 104 -255, 104 -26… 2 -Year T-Note price progression : 103 -2500, 103 -2525, 103 -2550. . . 20 312. 855. 7094

Review of Duration n. Duration tells you by what percentage a bond or bond portfolio will change in price with a 100 bp change in yield. 21 312. 855. 7094

The Number of Different Treasuries that May be Delivered into the December 2003 Contracts? Treasuries n 2 -yr Note n 5 -yr Note n 10 -yr Note n Bond - 3 - 5 - 9 - 28 22 312. 855. 7094

23 312. 855. 7094

24 312. 855. 7094

Part 2 Conversion Factors, etc. 25 312. 855. 7094

Conversion Factors n Conversion factors adjust the price of a deliverable bond or note, with different coupon, maturity and yield characteristics, to the equivalent price of an 6. 00 % coupon. n To calculate invoice price of treasury issue, to be delivered into the futures contract. n Securities with coupons > 6. 00 % will have conversion factors > 1. 0000 to reflect a premium. n Securities with coupons < 6. 00 % will have conversion factors < 1. 0000 to reflect a discount 26 312. 855. 7094

Ex: Nov 6, 2003. Five Year Note issues deliverable against the Dec-03 Five Year Futures Contract These would be the (Last Delivery Date Dec 31, 2003) prices if yields were 6% 27 312. 855. 7094

Conversion Factors n. In effect, as you can see, what conversion factors are doing is establishing the relative values of the various deliverable issues. 28 312. 855. 7094

Conversion Factors u Conversion Factors (CF) are used to determine futures invoice price : FIP = (FP x CF) + AI where: FIP = Futures Invoice Price FP = Futures Price CF = Conversion Factor AI = Accrued Interest 312. 855. 7094

Conversion factors n. There’s one little problem with the conversion factors. n. They don’t do a perfect job of establishing relative prices of the deliverable bonds! n. As a result, some bonds are slightly “cheaper” than others, and one will be the “cheapest to deliver, ” or CTD. 30 312. 855. 7094

Pricing-“Cost of Carry Model” The price of a futures should be: Price of CTD Costs of storage & insurance, as a % of spot = 0 Futures = S(1 + rf + c - y)t Repo rate The “coupon” In this case, the repo or financing cost is higher than the coupon, so futures are above spot. 31 312. 855. 7094

Basis and Convergence Price Basis CTD { Futures x Conversion Factor Convergence at expiration Delivery Month 312. 855. 7094 32

Part 6 Constructing a Basic Hedge 312. 855. 7094

Hedge objective n. What is the objective of a hedge? n. To establish a position with a hedge instrument such that changes in the value of the hedge instrument exactly offset changes in the value of the instrument being hedged. 34 312. 855. 7094

Dollar Value of a Basis Point (BPV or DV 01) n. With Treasury futures, we equate the values of the instrument being hedged and the hedge instrument using the value of a basis point. 35 312. 855. 7094

Dollar Value of a Basis Point (BPV or DV 01) n Definition : It is the dollar change in the price of cash instrument due to a basis point (0. 01) change in the yield. n Since it represents the sensitivity to a given change in yield, it is useful, among other things, when constructing precise hedges. 36 312. 855. 7094

Using “BPV” to Hedge a Fixed Income Position With Treasury Futures Number of contracts required = BPV cash issue BPV futures Where: BPV futures = BPV cheapest-to-deliver CTD conversion factor 37 312. 855. 7094

Using “BPV” to Hedge a Fixed Income Position n n On Nov 6, a trader wants to hedge a $10 M long position in a 30 yr bond treasury, the 5 3/8 of 02/15/31. The treasury issue has a BPV of $146. 10 per $100, 000, i. e. The BPV of the portfolio is $14, 610 per $10 Million. The trader wants to hedge this position using the Dec-03 bond futures contract. On Nov 6, the CTD issue for the Dec-03 bond futures contract was the 6 7/8 of 08/15/25. This issue had a conversion factor of 1. 1049 and a BPV of $145. 10 per $100, 000. 38 312. 855. 7094

BPV of Futures n. Remember, the invoice price of a treasury delivered into a futures contract is – Price x Conversion Factor +AI n. Since we multiply the futures price by the conversion factor to get the invoice price, which should be very close to the market value of the bond… 39 312. 855. 7094

BPV of Futures n. To get the basis point value of the futures, we need to divide the BPV of the bond by the conversion Factor: – BPV (Futures) = Price (CTD)/CF 40 312. 855. 7094

Using “BPV” to Hedge a Fixed Income Position BPV of Future = BPV CTD / Conversion Factor of CTD = $145. 10 / 1. 1049 = $131. 32 per $ 100, 000. Hedge Ratio = BPV of portfolio / BPV of future = $14, 610 / $131. 32 = 111 The trader should sell 124 of the Dec-03 bond futures contracts. 41 312. 855. 7094

Hedging with Financial Futures : n Choose the futures contract that most closely describes the nature of the underlying risk in order to minimize yield-curve risk. n Choose the futures expiration month that most closely matches the time period to be addressed while keeping in mind that the “nearby” contract is the most liquid. n The right hedge ratio will equalize the “BPV”s of the hedged issue and the futures position, but some immunization risk (yield-curve risk) may still remain. 42 312. 855. 7094

Important Question! n. Suppose you have hedged a bond portfolio with a 5. 50 % yield. n. Now you hedge that portfolio, removing market risk n. What will the yield on your portfolio now be? 43 312. 855. 7094

Using Futures to Adjust Duration 312. 855. 7094

Duration Management 45 312. 855. 7094

Adjusting Duration of a Bond Portfolio Containing Futures Hedge Ratio Target Bond Portfolio = BPV Bond Portfolio BPV Futures BPV 46 312. 855. 7094

Duration Management Closing Date : Nov 6, 2003 Coupon Maturity # of MM/DD/YY Contracts Settlement Date : Nov 10, 2003 Quoted Price (32 nds) Market Price Total Modified Equivalent (P+AI) Market Price Duration (Decimal) # * (P+AI) 3. 375 04/30/04 400 101 -03 1. 011494 40, 459, 760 0. 481 0. 19 3. 500 11/15/06 315 102. 21+ 1. 043363 32, 865, 935 2. 816 0. 89 6. 500 02/15/10 125 115 -02 1. 165285 14, 566, 063 5. 170 0. 65 4. 875 02/15/12 154 104 -16+ 1. 056151 16, 264, 725 6. 730 1. 04 Weighted Cash Position 994 104, 156, 482 2. 78 47 312. 855. 7094

Managing Duration n. Your portfolio duration is 2. 78 n. Suppose you want a portfolio with the return and volatility characteristics provided by a duration of 5. 0? 48 312. 855. 7094

Basis Point Values Duration x Portf Value x. 0001 n Portfolio BVP: – 2. 78 x. 0001 x $104, 156, 482 = $27, 799. 56 n Target BVP: – 5. 00 x. 0001 x $104, 156, 482 = $52, 078. 24 n Dec-03 Five Year Treasury Futures BPV: – BPV of CTD: $39. 50 per $100, 000 – Conversion Factor of CTD: . 8908 – BPV of futures: $39. 50/. 8908 = $44. 34 49 312. 855. 7094

Adjusting Duration of a Bond Portfolio Containing Futures Hedge Ratio = $52, 078. 24 - $27, 799. 56 $44. 34 = 547. 56, or buy 548 contracts. 50 312. 855. 7094

“Today the Chicago Board of Trade closed early to stop and smell the flowers. ” 51 312. 855. 7094

The End 52 312. 855. 7094