Chapter 4: Interest Rate Derivatives

4.1 Interest Rate Futures and Convexity Adjustment

Interest Rate Models
Damir Filipovic

4.1 Interest Rate Futures and Convexity Adjustment

Recap interest rate futures

Derive futures rate formula
Calculate convexity adjustment for
Gaussian HJM models
Example: Vasicek model

Interest Rate Models

Recap: Interest Rate Futures

Similar to a FRA, an interest rate futures contract allows to manage the

exposure to the simple spot rate L(T0 , T1 ) prevailing over a future period
[T0 , T1 ] with length = T1 T0 .
In contrast to FRAs, interest rate futures are daily marked to market (resettled).

Interest Rate Models

Recap: Marking to Market

Marking to market works as follows:
At t T0 : the futures price is quoted as
Pfutures (t, T0 , T1 ) = 100 (1 Rfutures (t, T0 , T1 ))
where Rfutures (t, T0 , T1 ) is the futures rate prevailing at t
At t + t: cash flow to holder of futures contract
Pfutures (t + t) := Pfutures (t + t, T0 , T1 ) Pfutures (t, T0 , T1 )

Interest Rate Models

Futures Rates

The futures rate is chosen such that

At t = T0 (delivery): Rfutures (T0 , T0 , T1 ) = L(T0 , T1 )
At t < T0 : the present value of cash flow Pfutures (t + t) from holding the
futures contract is zero, for small t:
h R t+t
i
t
r (s)ds
0 = EQ
e
P
(t
+
t)
e r (t)t EQ
futures
t
t [Pfutures (t + t)]
Consequence: futures price process Pfutures (t, T0 , T1 ) is a Q-martingale.
Interest Rate Models

Futures Rates Formula

Consequence: futures rate process Rfutures (t, T0 , T1 ) is a Q-martingale,
Rfutures (t, T0 , T1 ) = EQ
t [L(T0 , T1 )] .
Recap: forward rate process F (t, T0 , T1 ) is a QT1 -martingale,
T

1
F (t, T0 , T1 ) = EQ
[L(T0 , T1 )] .
t

The difference
(t, T0 , T1 ) = Rfutures (t, T0 , T1 ) F (t, T0 , T1 )
is called convexity adjustment. It is a model dependent value.
Interest Rate Models

Convexity Adjustment in Gaussian HJM Models

Consider a Gaussian HJM model with deterministic forward rate volatility (t, T ).
RT
Denote T -bond volatility v (t, T ) = t (t, u)du.
Some stochastic calculus shows
R
 Rt
>
t
P(t,T0 )
P(0,T0 )

1 )v (s,T0 )) ds
= P(0,T1 ) E 0 (v (s, T0 ) v (s, T1 ))dW (s) |e 0 v (s,T1 )(v (s,T
P(t,T1 )
{z
}.
|
{z
}
deterministic
Q-martingale

Hence
EQ
t

1
P(T0 ,T1 )

P(t,T0 )
e
P(t,T1 )

RT
t

v (s,T1 )(v (s,T1 )v (s,T0 ))> ds

Interest Rate Models

Convexity Adjustment in Gaussian HJM Models

The convexity adjustment is

(t, T0 , T1 ) = EQ
t

h 
1

1
P(T0 ,T1 )

RT


i

0)
1 1 P(t,T

1
.
P(t,T1 )

Hence
(t, T0 , T1 ) =

1 P(t,T0 )
P(t,T1 )

RT
s

R

T
(s,u)du ) T 1 (s,v )> dv ds
0


1 .

The convexity adjustment (t, T0 , T1 ) 0 if (s, u)(s, v )> 0 for all s, u, v .

Interest Rate Models

Convexity Adjustment in the Vasiek Model

Vasicek short rate model is Gaussian HJM model with (t, T ) = e (T t) .

0.8

0.7

0.7

0.6

Convexity adjustment (bps)

Convexity adjustment (bps)

Parameters: = 0.86, = 0.08, = 0.01, r (0) = 0.06, T0 t =

0.6
0.5
0.4
0.3
0.2
0.1
0
0

2
3
Time to maturity T0 t

1
2

and = 41 :

0.5
0.4
0.3
0.2
0.1
0
0

0.5

1
Volatility (%)

1.5

Interest Rate Models