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Interest Rate Futures

6 important questions on Interest Rate Futures

What day count conventions do we have?

Day count defines the way in which interest accrues over time. Generally the time between coupon payments on a bond. X/Y convention.
- Actual/Actual (in period), like UST.
- 30/360, like municipal and corporate in USD.
- Actual/360, money market.

What about wild card play?

Basically the short can decide to deliver later than when prices are available (2:00 PM), this means that he could look whether the market has turned favorable to him. Of course this results in a lower future price.

How to determine the futures price?

Due to timing choice and bond choice this can be hard. However, if known/assumed. F0 = (S0- I)*e^r*T
In which I is the present value of the coupons during the life of the futures contract.

What about a convexity adjustment?

To account for the difference between forward and future rates.
Forward rate = Futures rate - 1/2 * Variance(change in short-term rate in 1 year)*T1*T2.
T1 is the time to maturity of the futures contract
T2 is the time to the maturity of the rate underlying the futures contract
The size of the adjustment increases with the time to maturity, double maturity the adjustment quadrupples.

What about extending the LIBOR zero-curve?

The LIBOR zero curve is determined by 1M, 3M, 6M and 12M LIBOR rates. Once the convexity adjustment is done, the rates can be used to extend the zero curve by a bootstrap procedure.

R(i+1) = (Fi(Ti+1 - Ti) + Ri*Ti) / Ti+1

Hedging portfolios of assets and liabilities?

Banks try to assure that the average duration of their assets equals the average duration of their liabilities, called duration matching or portfolio immunization. This means that the bank is protected against small parallel shifts.

In practice however, short-term rates are usually more volatile and not perfectly related to long-term rates. Duration matching is therefore only a first step. Second can be GAP management, by dividing the portfolio into segments/buckets of different tenors. ALM can then investigate the effect of changing one bucket while leaving the others the same. Based on this it can adjust accordingly.

The question on the page originate from the summary of the following study material:

Part 3: Financial Market and Products

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