Professional Documents
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=
CTD CTD
t t T
P D
P D D ) (
Conversion Factor of CTD Bond
D
T
= Target duration of portfolio
Dt = Initial duration of portfolio
Pt = Initial market value of portfolio
D
CTD
= The duration of cheapest to deliver bond
P
CTD
= The value of cheapest to deliver Bond (Price * contract multiplier)
Arbitraging between cash and futures market
Arbitrage is the price difference between the bonds prices in underlying bond market and IRF
contract without any view about the interest rate movement.
One can earn the risk-less profit from realizing arbitrage opportunity and entering into the
IRF contract traded on NSE by initiating cash and carry trade involving the following steps:
Purchase the cheapest to deliver bond
Take short position in IRF contract
Finance the bond purchase at the current borrowing rate from the market.
Give the intention of delivery to the exchange
Deliver the bond and receive the invoice price.
Repay the cash amount borrowed to purchase the bond.
Detailed example is explained in case study 4.
Page 20
Case Studies
Case study 1: Directional trading
A trader expects a long term interest rate to rise. He decides to sell Interest Rate Futures
contracts as he shall benefit from falling future prices.
Trade Date- 5
th
Oct 09
Futures Delivery date 1st Dec 2009
Current Futures Price- Rs. 93.50
Futures Yield- 7.36%
Trader sell 250 contracts of the Dec 09 10 Year futures contract on NSE on 5
th
Oct 2009 at
Rs. 93.50
Daily MTM due to change in futures price is as tabulated below
Date
Daily Settlement Price*
(Rs.)
Calculation MTM (Rs)
5-Oct-09 93.6925 250*2000*(93.5000-93.6925) -96250.00
6-Oct-09 93.4625 250*2000*(93.6925-93.4625) 115000.00
7-Oct-09 93.4575 250*2000*(93.4625-93.4575) 2500.00
8-Oct-09 93.1275 250*2000*(93.4575-93.1275) 165000.00
Net MTM gain as on 8
th
Oct 09 is Rs. 1,86,250 (I)
* Daily Settlement price shall be the weighted average price of the trades in the last hour of
trading.
Closing out the Position
9
th
Oct 2009- Futures market Price Rs. 93.1125
Trader buys 250 contracts of Dec 09 at Rs. 93.1125 and squares off his position
Therefore total profit for trader 250*2000*(93.1275-93.1125) is Rs.7,500 (II)
Total Profit on the trade = INR 1,93,750 (I & II)
Page 21
Case Study 2: Hedging
A bank has a large portfolio of GOI securities worth Rs. 25 crores. Banks portfolio consists of
bonds with different coupons and different maturities.
In view of rising interest rates in the near term, the treasury head is concerned about the negative
effect this will have on the banks portfolio. The treasury head wants to hold his entire portfolio and
at the same time doesnt want to suffer losses on account of fall in bond prices.
Should the bank go short or long on the futures contracts to establish the correct hedge?
The treasury head decides to hedge the interest rate risk by taking a short position in the Interest Rate
Futures on NSE.
Example :
Date: 05-Oct-2009
Spot price of GOI Security: Rs 98.0575
Futures price of IRF Contract: Rs 93.7925
On 05-Oct-2009 XYZ bought 2000 GOI securities from spot market at Rs 98.0575. He anticipates
that the interest rate will rise in near future. Therefore to hedge the exposure in underlying market he
may sell Dec 09 Interest Rate Futures contracts at Rs 93.7925
On 16-Nov-2009 due to increase in interest rate:
Spot price of GOI Security: Rs 97.2500
Futures Price of IRF Contract: Rs 93.1500
Loss in underlying market will be (97.2500 - 98.0575)*2000 = Rs 1615
Profit in the Futures market will be (93.7925 93.1500)*2000 = Rs 1285
Page 22
Case Study 3: Calendar Spread Trading
A long & short position in different futures contracts on the same underlying is called as a calendar
spread.
If a Long position in a Dec 09 IRF contract versus a Short position in the Mar 10 IRF contract on
NSE is considered a calendar spread.
Since a calendar spread entails only the basis risk, the bank runs little risk on the positions.
Example:
Trade Date : 5
th
Oct 09
Dec 09 Futures (Rs.) : 93.3600 93.3800
Mar 10 Futures (Rs.) : 91.9700 92.0200
The difference between the Dec 09 & Mar 10 contracts is currently Rs. 1.41 (after considering bid-
ask). If the trader believes that this spread is very high, he would execute a calendar spread by
Selling the Mar 10 futures at 91.9700
Buying the Dec 09 futures at 93.3800
10 days later
Trade Date : 15
th
Oct 09
Dec 09 Futures (Rs.) : 93.0050 93.0250
Mar 10 Futures (Rs.) : 91.3000 91.3700
The difference between the Dec 09 & Mar 10 contracts is now Rs. 1.6350 (after considering bid-
ask).
The trader may decide to liquidate his calendar spread trade by
Buying the Mar 10 futures at 91.3700 (Profit 0.60)
Selling the Dec 09 futures at 93.0050 (Loss 0.38)
Net profit of Rs. 0.22 without running any interest rate risk
Page 23
Case Study 4: Arbitrage
The price differential in the underlying bond market and the future market can also provide
opportunities to arbitragers. If the futures are expensive compared to the underlying,, then the
arbitrager can make profit by taking long position in underlying market by borrowing funds and
taking short positions in the future market. This is explained with following example.
On 15
th
Oct, 09 buy 6.35% GOI 20 at the current market price of Rs. 97.2550 and conversion factor
is 0.9815
Step 1 - Short the Dec 09 futures at the current price of Rs. 100.00 (7.00% Yield)
Step 2 - Fund the bond by borrowing up to the delivery period (assuming borrowing rate is 4.25%)
Step 3 - On 1st Dec 09, give a notice of delivery to the exchange
Assuming the futures settlement price of Rs. 100.00, the invoice price would be
= 100 * 0.9815
= Rs. 98.15
Under the strategy, the bank has earned a return of
= (98.1500 97.2550) / 97.2550 * 365 / 49
= 6.86 % (implied repo rate)
(Note: For simplicity accrued interest is not considered for calculation)
Against its funding cost of 4.25% (borrowing rate), thereby earning risk free arbitrage
The bond with the highest implied repo rate would be the cheapest to deliver (CTD) bond.
The arbitrager would identify the bond with the highest implied repo rate or the CTD bond and
execute the strategy with the same bond, depending on its availability in the secondary market.
Page 24
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