FINANCING IN INTERNATIONAL MARKETS

FINANCING IN INTERNATIONAL MARKETS 3. BOND RISK MANAGEMENT Forward Price of a Coupon Bond Consider the following transactions at time T=0: i. Borrow for T 2 days at an interest rate r 2. ii. Buy a coupon bond at P + A1. Receive a coupon C at T 1. iii. Sell the bond at T 2 at the forward price F, receiving also A2. (Recall: Cash price = P + A1.) Cash flows at time T 2 : i. Pay interest on (P + A1) for T 2 days. ii. Receive interest on C for T 2 -T 1 days at the interest rate f. (f?) No arbitrage: (P+A1)*(1 + r 2 T 2 /360) C [1 + f (T 2 -T 1 )/360] + (F+A2) 1

Today T 1 days C T 1 interest rate = r 1 T 2 interest rate = r 2 T 2 days (T 2 T 1 ) days f If interest rate for T 1 days is r 1, there is an implied forward rate, f: 1 + f (T 2 T 1 )/360 = (1 + r 2 T 2 /360)/(1 + r 1 T 1 /360). No arbitrage implies: (P + A1)*(1 + r 2 T 2 /360) C (1 + f (T 2 -T 1 )/360) + (F + A2). (P+A1)*(1 + r 2 T 2 /360) C (1 + r 2 T 2 /360)/(1 + r 1 T 1 /360) + (F+A2). Assuming equality and solving for F: F = (P + A1)*(1 + r 2 T 2 /360) C (1 + r 2 T 2 /360)/(1 + r 1 T 1 /360) - A2. Example: Calculation of F for a 11% T-bond to August 23. Price = P = 84'17 84(17/32) or 84.53125. Coupon = C = 11% (payable on July 15 and January 15). As of May 23, r 1 = 8 % (two months or less) r 2 = 8¼ % (three months). T 2 = 92 days (May 23 to August 23), T 1 = 53 (May 23 to July 15). Basis for T-bonds = actual/actual. Forward price, calculated to August 23 = F =? C = 11 % (s.a.) P +A1= 84.53125 + A1 C = 11 % (s.a.) 128 days 53 days 39 days F + A2 Jan 15 Today (May 23) T 1 = July 15 T 2 = Aug 23 2

Example (continuation): Recall the previous formula: F= (P+A1)(1+r 2 T 2 /360) - C (1+r 2 T 2 /360)/(1+r 1 T 1 /360) - A2. a.- A1 (Days the seller held the coupon= January 15-May 23= 128 days) Interest (actual/actual) = (.11/2)(128/181)=.038895. A1 =.038895x100 = 3.8895. b.- A2 (T 2 = August 23 - July 15 = 39 days) Interest (actual/actual) = (.11/2)(39/184)=.0116756. A2 = 1.16756. c.- F (Convert the bond price 84'17 to 84.53125%) F = (84.53125+3.8895)(1+.0825x92/360) - 5.5[1 +.0825(92/360)] - 1.16576 [1 +.08(53/360)] = 83.5686. Bond Futures Bond risks: Price (interest rate); default; reinvestment; call; & inflation. Bond futures are used to manage price risk on bond portfolios. Design (supply) of a bond futures contract: What is the underlying security? Demand (Need for the contract?) Easy to buy and sell (liquid) Three types: Notional Bond Futures Cheapest to Deliver Bond (CDB) Futures Index-based Bond Futures 3

(1) Notional Bond Futures Hypothetical bond of fixed principal, coupon, and maturity. Example: a futures contract could be based on a (nonexistent) GBP 50,000 7% government bond and maturing in 10 years. Note: This is the notional bond behind the U.K. Long Gilt futures. Notional government bond futures trade in many exchanges: - the CBOT - the Tokyo Stock Exchange - the Deutsche Boerse in Frankfurst - LIFFE in London - the Euronext in Paris - the MEFF in Barcelona The U.S. Treasury Bond Contract Second most popular interest rate derivative instruments: CBOT U.S. T-bond and T-notes contracts. Prices are based on a (fictional) 20-year 6% U.S. Treasury bond. Different bonds can be delivered to cover a short position: Any Treasury bond with at least 15 years to maturity or to first call date, whichever comes first, qualifies for delivery. Short side delivers FV=USD 100,000 of any one of the qualifying bonds. Delivery dates (maturity): Mar, June, Sep, Dec, and two nearby months. Short position decides when, in the delivery month, delivery actually will take place (timing option). On the delivery day the buyer (long side) pays the seller for the bonds, and in return receives Fed Reserve book-entry T-bonds. Quotes: in terms of par being 100 and in 32nds of 1%. Tick size and value: 1/32 of 1% -- USD 31.25. 4

Example: The price moves from 61'07 to 61'08. Long side makes: (1/32) x (.01) x (USD 100,000) = USD 31.25. If the price moves from 61'07 to 60'31, the long side loses: (8/32) x (.01) x (USD 100,000) = USD 250. Characteristics of three Notional Bond Futures (2) Cheapest-to-Deliver Bond (CDB) Futures Several traded bond futures contracts allow for actual delivery of one of a number of bonds against the futures contract. Short side (the seller) makes the choice of which bond to deliver. Some of the deliverable bonds will cost less than others. the seller chooses the "cheapest to deliver. 5

Equilibrium price for a deliverable T-bond future During the delivery month, traders will compare the value of a cash bond (deliverable) to its equivalent in the futures market. Long side pays an invoice price (I), representing the cash price as a percentage of face value, plus accrued interest on the cash bond. The invoice price is the futures price (Z), times an exchange conversion factor (cf): I = Z x cf. The same bond in the cash market may be purchased at P+A1. Then: P = Z x cf. Calculating cf: - Setting the YTM on the CDB = 6% (s.a.) - Divide the resulting price by 100. - Rounded down maturity to the nearest quarter. (If there is an extra quarter, subtract A1.) Note: For the UK Long gilt set the YTM on the CDB = 7% (s.a.). Example: Calculation of cf. (A) T-bond futures & no Accrued interest: U.S. Treasury 10% May 2030 In March 2010, we observe: C = 10% Maturity = 20 yrs. and two months. (Rounding down, 20 yrs). Z = 90. First payments to be made after 6 months. Setting the YTM = 6%, i=1 to 40 5/(1+.03) i + 100/(1+.03) 40 = 146.2295. Dividing by 100: cf = 1.462295. Calculation of I: I = Z x cf = 90 x 1.462295 = 131.60659. Actual cash payments = 1.3160659 x USD 100,000 = USD 131,606.59. A buyer of the T-bond futures pays USD 131,606.59 & receives a Federal Reserve book-entry transferring the property of this T- 6

(C) T-bond futures & Accrued interest. C = 10% Maturity = 18 yrs and 4 months (round down= 18 yrs and 3 months). Z = 92-4/32. YTM = 6 %. Discounting all the payments back 3 months from today: 5 + i=1 to 36 5/(1+.03) i + 100/(1+.03) 36 = 148.665. The interest rate for a 3-month period is ((1+.03).5-1) = 1.489%. Discounting back to today: 148.665/1.0149 = 146.48398. Subtracting A1= 2.5 Price = 146.48398-2.5 =143.98398. Then, cf = 1.4398398. Calculation of I: I = 92.125 x 1.4398398 = 132.64524. Actual cash payment = USD 132,645.24. For USD 132,645.24, a T-bond futures buyer receives the 10% U.S. Treasury with 18 years and 4 months to maturity. Explanatory Factors of CDB YTM set at 6%. Option features associated with the delivery process: (1) Delivery option: Short side has a choice of cash bonds for delivery. (2) Wild card option: Futures market closes at 2PM (Chicago time) and sets futures settlement price (I is fixed). Short side has until 8PM to declare delivery. The wild card option is a six-hour put option, with X=I. If P < I by 8PM, the short side exercises this put. Both the delivery option and the wild card option have positive value. In general, P > Z x cf. 7

Example: Value of embedded options. Date: October 2, 2000. Underlying Instrument: Sep 27 2013 8% U.K. Long Gilt. Hedging Instrument: U.K. Long Gilt Dec futures. Z = 113.27. P = 123.05 cf = 1.08356. r 2 = 5.50% T 2 = 90 (10/2/00 to 12/31/00). Value of deliverable options (on Dec 31, 2000):? Example (continuation): Steps: (1) Calculate the carry component, which is equal to the interest income received minus the financing cost: Carry = A2 (P + A1) x r 2 T 2 /360 = 1.98895 (123.05 + 0.110497) x.055 x 90/360 = 0.29545 (2) Basis = Carry + delivery options value. Basis = P Z x cf = 123.05-113.27 x 1.08356 = 0.31516. Option value = 0.31516 0.29545 = 0.019665. That is, the option value represents 6.24% of the basis. 8

Traders cannot buy a cash bond and make immediate delivery during the period prior to the delivery month. Thus, they compare F (forward price of the bond) to its futures equivalent: Basis after carry (BAC): BAC = F - Z x cf. The BAC indicates the cost, in terms of forward dollars, of buying a cash bond and delivering it against the futures contract. A trader wants to minimize the BAC (cost: F & revenue: Z x cf) CDB is the bond with the smallest BAC. Example: Determine CDB against the June 1990 T-bond futures contract. Today is April 16. Assuming an 8% short rate and a futures price (Z) equal to 92'03 (92.09375). Conversion Value of Selected Deliverable T-Bonds, April 16, 1990 Maturity Coupon cf June Future Invoice Price (I) (or 1st call) (%) (Z) (Z x cf) Nov. 15, 2006 14 1.5400 92.09375 141.82438 Aug. 15, 2015 10(5/8) 1.2820 92.09375 118.06419 Nov. 15, 2016 7½ 0.9453 92.09375 87.05622 May. 15, 2016 7¼ 0.9185 92.09375 84.58811 9

Example (continuation): Forward Value of Deliverable T-Bond, Calculated from April 16 to June 1, with a Short Rate of 8% Maturity Price Accrued Accrued Forward (or 1st call) (P) Interest Coupon Interest Price BAC (4/16) (6/1) Nov. 15, 2006 143'15 5.87845 7.0000 0.64674 143.20085 1.37647 Aug. 15, 2015 118'13 1.76105 0 3.11119 118.28449 0.22030 Nov. 15, 2016 87'10 3.14917 3.7500 0.34647 87.27584 0.21962 May. 15, 2016 84'27 3.04420 3.6250 0.33492 84.81283 0.22472 The 7½ November 15, 2016, has the smallest BAC and hence is CDB. Example (continuation): Calculations for first bond: (1) Calculation of I = Z x cf As of June 1, 1990, there are 16 yrs and 5 months to call. Round down to the nearest quarter. Then, Price = 154.00, cf = 1.5400. The June future is at 92 (3/32) or 92.09375, I = 92.09375 x 1.5400 = 141.82438. 10

(2) Calculation of F. Data: P = 143.46875 & C= 14. As of April 16, accrued interest from November 15 is calculated as A1 = (14/2) x (152/181) = 5.87845. On June 1, there will be 17 days of accrued interest from May 15: A2 = (14/2) x 17/184 = 0.64674 Assuming an 8% short rate, the coupon paid on May 15 may be reinvested at the forward interest rate f given by 1+f x (17/360) = 1 +.08 x (46/360). 1 +.08 x (29/360) Calculation of F: F = (143.46875+5.87845)(1+.08x46/360)-7.0 x 1+.08 x 46/360 -.64674= 1+.08x29/360 = 143.20085. Finally, BAC = 143.20085-141.82438 = 1.37647. Hedging With Bond Futures Key concept: basis point value (bpv). bpv = change in the bond's price for a 1 bp movement in yield. We want to determine the optimal hedge ratio. Assume that the spread between the bond yields is constant. We have two bonds: A with a with a bpv A =2 and B with a bpv B = 1. For 1 bp rise in yields the price of the A will fall by 2. the price of the B will fall by 1. Long position: USD 1 in Bond A, Hedging position: We need to be short USD 2 of the bond B. hedge ratio of bond B: number of units of bond B needed to create a hedged position against another bond, A: hedge ratio of bond B = -(bpv A /bpv B ) = -2. 11

Similarly, if we use bond futures to hedge we have hedge ratio future = -(bpv bond /bpv future ). Note: For CDB futures: bpv future = bpv CDB / cf. Comparing the above equations, we see that the hedge ratio for a CDB hedge ratio CDB future = -(bpv bond /bpv CDB )xcf. Example: The bpvs of the bonds in previous examples are: Maturity Coupon bpv (or 1st call) (%) Nov. 15, 2006 14.1133 Aug. 15, 2015 10 5/8.1162 Nov. 15, 2016 7½.0919 (<= CDB, with cf = 0.9453) May. 15, 2016 7¼.0894 Interpretation: If yields drop 10 basis points, the price of the 14% Nov. 15, 2006, will rise by 1.133%, from 143.469 to 144.602. Consider a Eurobond with a bpv =.145. hedge ratio = - (.145/.0919) x 0.9453 = -1.4915. To hedge USD 10M of this bond, short 149 (-1.4915x100) T-futures. If the August 15, 2015, bond subsequently became CDB: hedge ratio = - (.145/.1162) x 1.2820= -1.5997 (sell 11 more contracts). 12

Duration-Based Hedging Strategies Recall the definition of modified duration: 1dP=-1Σ t tc t = -D = -D* Pdr P(1+r) t+1 1+r Typical situation: position in an interest rate dependent asset (a Eurobond portfolio) is hedged using an interest rate futures contract. Assume that the change in interest rates, dr, is the same for all maturities (we only allow for parallel shifts in the yield curve). Define: F: Contract price for the interest rate futures contract D F : Duration of asset underlying futures contract S: Value of the asset (eurobond portfolio) being hedged D s : Duration of asset (eurobond portfolio) being hedged Assume that the change in interest rates, dr, is the same for all maturities (we only allow for parallel shifts in the yield curve). Then, the number of contracts required to hedge against an uncertain change in interest rates, dr, is: N=SD s (1+r F )/[F D F (1+r s )] = (S D s *)/(F D F *). This is the duration-based hedge ratio (price sensitivity hedge ratio). 13

Example: Today: It is January 19. Underlying position: EUR 20 million in Eurobonds. Duration of EUR portfolio: 7.80 years. YTM of EUR portfolio: 7.92% Expectation: Interest rates volatile over the next three months. Bank decides to hedge with June bond futures. Futures data: Futures price = 91 (08/64) Futures contract price = EUR 91,250. CDB at Euronext = 10-year 3.5% government EUR 100,000 bond Duration of CDB = 7.20 years YTM of CDB = 6.80% Example (continuation): Summary: F: Contract price for the CDB futures contract = EUR 91,250. D F : Duration of CDB underlying futures contract = 7.20 years r F : YTM of the CDB =.0680 S: Value of the eurobond portfolio being hedged = EUR 20,000,000. D s : Duration of eurobond portfolio being hedged = 7.80 years r s : YTM of the eurobond portfolio being hedged =.0792 The number of bond futures contracts is given by: N = S D s (1+r F )/[F D F (1+r s )] = (S D s *)/(F D F *) N = (EUR 20Mx7.80x(1+.0680))/[EUR 91,250x7.20x(1+.0792)] = = 234.9787 The portfolio manager should short 235 futures contracts. 14

Application: Asset Allocation Situation: A fund manager decides to invest (long-term): 25 percent in bonds 60 percent in stocks 15 percent in real estate. Usually, significant changes to the allocation are avoided because of transaction costs. Solution: Use futures to change the asset allocation indirectly. Example: A portfolio is composed: X dollars in stocks Y dollars in bonds. Manager wants to decrease her short-term bond allocation from Y to Y 1 (the reduction in bonds is matched by increasing stocks). Bond portfolio has a modified duration of D Y *. Solutions: (1) Sell bonds and buy stocks (might be too expensive) (2) Change allocation by selling T-bond futures contracts. Solution (2): Manager wants to have income D Y *Y 1 from bond position if interest rates change by 1 percent. She plans to generate that amount with income from the current bond portfolio, D Y *Y, and income from a T-bond futures position, N D F *F: D B *Y 1 = D B *Y + N D F *F. Solving for N, we get N = D B * (Y 1 - Y)/(D F *F) <0 (sell T-bonds futures contracts are sold). 15

Example: Ms. O'Neil has the following portfolio: USD 90,000,000 in an index stock portfolio that tracks the S&P 500. USD 60,000,000 in a bond portfolio with a D* of 7.8 years. Long-term, Ms. O'Neil likes her portfolio allocation. She forecasts that stocks are going to do well over the next six months. Situation: Ms. O'Neil wants to take advantage of this forecast. Transaction costs are very high. She uses futures contract to change her portfolio allocation. Data: CDB has a D* of 6.5 yrs Price of a 6-mo T-bond contract = 90. Price of 6-mo S&P 500 futures = 350. Example (continuation): Steps: (1) Eliminate the interest rate exposure: Use T-bond futures. Number of T-bond futures to sell is N = 7.8 (0-60,000,000)/(6.5 x.90 x 100,000) = -800 contracts. selling 800 T-bonds futures completely wipes out interest rate risk (completely liquidating the bond investment position). (2) Increase long stock position: Use S&P 500 futures. Number of contracts to buy is N = 60,000,000/(350x500) = 342.857, or 343 contracts. 16