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Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 2
Lab: Constructing the Short End
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 3
Lab: Constructing the Short End
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 4
Solution: Short End
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 5
Futures Libor Rates
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 6
Futures & Forwards
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 7
Convexity
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 8
Convexity: Future vs Swap
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 9
Pricing Convexity Differences
¾ If not priced
9Short swap/short futures buys positive convexity
for free
• Significant for longer tenor securities 5+ years
• Arbitrage gains with rate increases/declines
¾ If priced
9Forward rates implied by FRA’s or swaps differ
from forward rates implied by futures
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 10
Lab: FRA-Futures Convexity
¾ Sell $100 81 v 84M IMM dated FRA @ 5.00%
¾ Hedge by Selling Futures @ 95.00
¾ Yield curve is flat at 5%
¾ Work out:
9 Equivalent futures position
9 Gain or loss on FRA and equivalent Futures position for
parallel shifts +/- 4%
¾ Worksheet: FRA-Futures
9 See cell notes for help
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 11
Solution: FRA - Futures
¾ D81 = 0.7150
¾ FRA Value for 1bp change in YC = $1,788
¾ Therefore equivalent position is:
9 $1,788/ $25 = Long 72 Futures
9(or if hedging, sell 72 futures contracts)
¾ Examine changes in position value due to
shifts in spot & forward rates
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 12
Chart: FRA-Futures Convexity
1,200,000 Short FRA
Difference
800,000
600,000
400,000
200,000
-
1% 2% 3% 4% 5% 6% 7% 8% 9%
Spot & Forw ard Rates
-200,000
-400,000
-600,000
-800,000
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 13
Convexity
¾ Short FRA has positive convexity
¾ Futures have zero convexity
¾ Difference must be paid for:
9Forward rate is lower than implied by futures price
9(100 - futures price) is greater than forward rate
9Need adjustment factor to take account of the
volatility of the two rates and their correlation
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 14
Convexity Adjustment Factor
¾ Depends on term structure dynamics
¾ Rule of thumb (Burghardt & Hoskins)
¾ Change in spread between forward rate and
futures:
∆S = σf x σzcb x σf,zcb
σf = standard deviation of change in forward rate
σzcb = standard deviation of zero coupon bond return
σf,zcb = correlation of forward rate change and zero
coupon bond returns
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 15
Convexity Adjustment Factor
¾ Futures and forwards are the same at expiry
¾ Rule gives change in difference over time
¾ Calculate the change for each three month period
¾ Standard deviation of returns on ZCB:
9 Duration (Maturity) * SD of Yield (Spot Rate) changes
• Standard deviations and correlations will be slightly different for each
period
• Derived from historical data or option prices
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 16
Adjustment Factor Example
¾ Assume:
• Annualized SD of changes in all futures prices = 1%
• Annualized SD of change in ZCB yields = 1%
• Correlation = 0.99
¾ First contract has 3 months to expiry:
∆S0-3 = [0.01 x 0.01 x (4.5 / 12) x 0.99] / 4 = 0.09375 bp
Average maturity of deposit period
¾ Second Contract:
∆S3-6 = [0.01 x 0.01 x (7.5 / 12) x 0.99] / 4 = 0.15625 bp
¾ Adjustment for 6 months = ∆S0-3 + ∆S3-6 = 0.25bp
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 17
Adjustment Factors: Typical Values
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 18
Building the Curve
Today F1 Start 90 days F2 Start
90 days
10-May 18-Jun 16-Sep 17-Sep
¾ CASH FUTURES
1w: 5.50 - 5.38 (17-May)
1m: 5.60 - 5.48 (10-Jun) Jun: 94.00 (18-Jun)
2m: 5.71 - 5.59 (10-Jul) Sep: 94.83 (16-Sep)
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 19
Building the Curve Using Futures
¾ Find spot rate to expiry of first futures contract
9Interpolate from cash rates
¾ Calculate 90-day forward rate from expiry
9100-futures price less adjustment factor
¾ Combine to give spot rate to 90 days from expiry
¾ Extrapolate to expiry of next futures contract
¾ Repeat steps above for successive futures
contracts
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 20
Extending the Curve Using Swaps
Today Year 1 Year 2 Year 3
C1 C2 C3
Bond Price
9Cash flows are known from the swap coupon
9The curve has already been built out to 2 years using
futures
9D1 and D2 are known, calculate D3 by bootstrapping
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 21
Bootstrap Method with Swaps
¾ Example:
9Three year swap rate = 5%
9D1 = 0.9655 D2 = 0.9259
9100 = 0.9655 x 5 + 0.9259 x 5 + 105 x D3
9D3 = (100 - 4.8275 - 4.6295) / 105 = 0.8623
¾ Repeat with 4, 5, . . . year swaps to
complete the curve
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 22
Lab: Delmar Capital
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 23
Delmar Capital: Yield Curves
5.4%
5.3%
5.2%
5.1%
5.0%
4.9%
4.8%
4.7%
4.6%
4.5%
0 500 1000 1500 2000
Futures Sw aps Adjusted Futures
Copyright © 1996-2006 Investment Analytics Yield Curve Building with Futures & Swaps Slide: 24