A Note On Interest Rate Futures

SPREADING WITH INTEREST RATE FUTURES

Traders, who anticipate potential changes in the relative value of two different contracts, may employ a speculative trading strategy known as spread trading. A popular strategy involving the T-Bill futures contract (TB) and the Eurodollar futures contract (ED) is ‘TED spreading.'The TED spread is the difference between the price of the US T-Bill futures contract and the Eurodollar futures contract when both the contracts are due to mature in the same month.

Traders who speculate on this spread anticipate some change in the price relationship between TB/ED. Generally, the yield on Eurodollar futures is always more than the yield on T-Bill futures, and the T-Bill price is always more than the ED price. If traders feel that the gap between the yields of TB and ED will widen over a period, they would buy the spread. When traders buy the TED spread, they buy T-Bill futures and sell the ED futures; but when they sell the spread, they sell T-Bill futures and buy ED futures.

Example:

Assume the settlement price of a June 03, 2003, ED is $93.00, while that of a June TB is $94.45. Therefore, the respective yields on these will be 7% (100-93) for ED and 5.55% (100-94.45) for TB. The current difference between the yields is 145 basis points^[4]. A trader expects this spread to widen and thus buys a fifteen-contract TED spread. After two weeks the spread has widened. Hence, the profit made by the trader on closing out would be, if the prices become 94.50 for the TB and 92.87 for the ED, the new spread therefore will be 163 basis points (Refer Table II).

TABLE II
TRANSACTIONS INVOLVING BUYING THE TED SPREAD

Day 1	Buy	15 TB @	94.45	Sell	15 ED @	93
Day 15	Sell	15 TB @	94.5	Buy	15 ED @	92.87
	Gain		0.05	Gain		0.13
= 15 X $25/tick^[5] X 5 tick = 15 X $25/tick X 13 tick = $1875 gain = $4875 gain Net Gain = $6750

TREASURY BONDS FUTURES

Treasury notes (maturity period of less than 10 years) and Treasury bonds (maturity period of more than 10 years but less than 30 years) form the market for long term interest rate futures (Refer Exhibit V characteristics of T-Notes and T-Bonds). Treasury bonds are similar to corporate bonds. The interest on these bonds is paid semi-annually and these bonds are actively traded in capital markets. The face value of a T-bond futures contract is $1,00,000 and the underlying instrument is a hypothetical 20-year 6% (was 8% until December 1999 contract) coupon bond. Though futures prices are quoted in terms of this hypothetical bond, the party with a short position can choose to deliver any treasury bond that has at least 15 years to first call or maturity.

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PRICING OF T-BOND FUTURES CONTRACTS

QUOTED FUTURES PRICE

TABLE III STEPS TO CALCULATE QUOTED FUTURES PRICE

CONCLUSION

EXHIBIT I LIST OF ACTIVELY TRADED SHORT TERM INTEREST RATE FUTURES

EXHIBIT II LIST OF ACTIVELY TRADED LONG TERM INTEREST RATE FUTURES

EXHIBIT III T-BILL FUTURES AND EURODOLLAR FUTURES

EXHIBIT IV NO ARBITRAGE FUTURES PRICE

EXHIBIT V CHARACTERISTICS OF T-NOTE AND T-BONDS

EXHIBIT VI CHEAPEST TO DELIVER BOND

ADDITIONAL READINGS & REFERENCES

^[4] A basis point is used to express the fractional interest rate,
where 100 basis point is equal to 1%.

^[5] Tick is the minimum allowable price change in a futures position.