A NOTE ON INTEREST RATE FUTURE

MISC/011
IBS Center for Management Research
A Note on Interest Rate Futures

This case was written by Sumit Arora, under the direction of Vivek Gupta, IBS Center for Management Research. It was
compiled from published sources, and is intended to be used as a basis for class discussion rather than to illustrate either
effective or ineffective handling of a management situation.
 2004, IBS Center for Management Research. All rights reserved.
To order copies, call +91-08417-236667/68 or write to IBS Center for Management Research (ICMR), IFHE Campus, Donthanapally,
Sankarapally Road, Hyderabad 501 504, Andhra Pradesh, India or email: info@icmrindia.org
www.icmrindia.org
License to use for IBS Campuses only. Sem IV, Class of 2012-14
MISC/011
ABSTRACT:
The note covers in detail the applications of interest rate futures including T-Bill futures,
Eurodollar futures and T-bond futures. It explains how an investor can use these instruments to
obtain either a predictable cost of funds or a predictable return on assets. The note also explains
how an investor can use T-Bill futures for arbitraging. In addition, the note gives a detailed
explanation of the pricing of T-bond futures and explains how one can determine cheapest to
deliver bond. The objective of this note is to help the reader understand the concept and
applications of interest rate futures better.
INTRODUCTION
An interest rate futures contract is “an agreement to buy or sell a package of debt instruments at a
specified future date at a price that is fixed today.”1 The underlying assets of an interest rate
futures contract are different interest bearing instruments like T-Notes, T-Bills, T-Bonds, deposits
and so on.
Interest rate futures contracts were first traded on October 20, 1975, in the Chicago Board of
Trade. Such contracts can have short-term (less than one year) and long-term (more than one year)
interest bearing instruments as the underlying asset. In the US, short-term interest rate futures like
90-day T-Bill and 3 month Eurodollar time deposits are more popular (See Exhibit I for actively
traded short-term interest rate futures). Long-term interest rate futures include the 10-year treasury
note futures contract, the treasury bond futures contract and more (See Exhibit II for actively
traded long-term interest rate futures).
DEFINING THE TERMS
To study and understand interest rate futures contracts, one must be familiar with a number of
terms. Let us review some of the more commonly used terms. Treasury bill futures are futures
contracts on 90-day treasury bills. Eurodollar refers to any dollar-denominated account outside
the US. The Eurodollar futures contract is a contract on the 3-month LIBOR (London Inter-Bank
Offer Rate). LIBOR is the rate of interest at which banks borrow funds from other banks in the
London interbank market. The risk less return realized from buying the underlying asset and
simultaneously selling a futures contract against the asset is known as the implied repo rate.
Accrued interest refers to the interest that has been earned since the last interest payment date. In
a treasury bond or treasury note futures contract, the underlying financial instrument that is most
beneficial to the seller to deliver is called cheapest to deliver bond. Add-on-yield is equal to the
ratio of the discount to the price, multiplied by the ratio of 360 to the number of days to maturity.
1
As posted on www.hmconsulting.net.
HEDGING INTEREST RATES RISK WITH INTEREST RATE FUTURES
In futures hedging, an investor enters into a transaction in the futures market today, which he will
transact in the cash market in future (Refer Table I). Assume an investor expects a cash inflow
after six months and wishes to invest the same in long-term bonds when the cash becomes
available. He is worried that interest rates may fall and hence would like to hedge the interest rate
risk. He can hedge by buying bonds in the futures market today.
Interest rate futures can be used to protect against an increase in interest rates as well as a decline
in interest rates. By selling interest rate futures, also known as short hedging, an investor can
protect himself against an increase in interest rates; and by buying interest rate futures, also known
as long hedging, an investor can protect himself against a decline in interest rates.
Table I
Transactions Involving Hedging
EXPECTED TRANSACTION IN CASH IN FUTURES MARKET (NOW)
MARKET
Borrow short-terms funds Sell/Short LIBOR Futures
Lend short-terms funds Buy/Long LIBOR Futures
Source: http://www.jaring.my/mme/htm/ba.htm#Hedgin
SHORT TERM HEDGING (HEDGING THE RISK OF A RISE IN INTEREST

RATES FOR OBTAINING A PREDICTABLE COST OF FUNDS)
The risk of an increase in interest rates can be hedged by selling interest rate futures.
Example:
On January 6, 2003, a firm comes to know about a funds requirement of $10 million on March 15,
2003, for a 3-month period. A bank is ready to provide the loan of $10 million for a 3-month
LIBOR rate prevailing on March 15, 2003. Since the firm is concerned about an increase in the
LIBOR rate, it decides to go short on March Eurodollar futures contract to protect itself from any
increase in the interest rate between January 6 and March 15.
The firm will have to enter into ten contracts because the size of one Eurodollar futures contract is
$1 million. Assume that on January 6, the March Eurodollar futures price is 92.86 and the implied
three-month Eurodollar rate is 7.14% (See Exhibit III Treasury Bill Futures and Eurodollar
Futures) while the 3-month LIBOR in January is 7.24%. Since LIBOR rates are always quoted for
one year, 7.14% implies 7.14% per annum. Assume that the tick size is 25.
The firm can lock a 3-month Eurodollar future rate of 7.14% and thus limit its borrowing cost to:
= $100,00,000 X (7.14/100) X 3/12
= $178,500
To limit the borrowing cost, the firm will have to sell 10 March Eurodollar futures contract on
January 6, because if the interest rates rise, the price of the contract will go down and the firm can
settle the contract by purchasing it at a lower price and thereby gaining in the futures market.
Case I
The 3-month LIBOR rises to 8.5% by March 15 (thus the March futures will be priced at 91.5,
since the Eurodollar futures price is quoted as 100 – LIBOR)
Interest Expense = (Principal) X (Annual Rate) X 3/12
= $100,00,000 X 8.5% X 3/12

= $212,500
Less: Futures Gain = (Price Change) X ($25/BP) X 10
= (92.86 – 91.5) X 100 X 25 X 10
= $34000
Net borrowing cost = $(212,500 – 34,000)
= $178,500
Case II
The 3-month LIBOR falls to 6.5% by March 15
Interest Expense = (Principal) X (Annual Rate) X 3/12
= $100,00,000 X 6.5% X 3/12
= $162,500
Less: Futures Loss = (Price Change) X ($25/BP) X 10
= (92.86 – 93.5) X 100 X 25 X 10
= $16,000
Net borrowing cost = $(162,500 + 16,000)
= $178,500
In both the above cases, the firm has locked its cost of borrowing at $178,500. In the first case, a
rise in interest expenses is compensated by a gain on the short futures position. In the second case,
loss on the futures position is compensated by a reduction in the borrowing cost.
LONG-TERM HEDGING (HEDGING THE RISK OF A FALL IN INTEREST
RATES FOR AN INVESTMENT)
This form of hedging is used to protect returns on investments made. Assume an investor is
expecting a cash inflow and plans to invest the cash when it is received. He is worried about the
rate at which the investments will be made and would like to hedge the risk of a fall in interest
rates. He can hedge by buying T-Bills or Eurodollar futures in the futures market today.
Example:
On January 6, 2003, a firm comes to know that it would receive $10 million on March 15, 2003,
from its foreign subsidiary. The firm wishes to invest the amount in T-Bills. On January 6, 2003,
the discount yield on a 3-month T-Bill is 7.24% while the current implied discount yield on March
T-Bill futures is 7.14%. Since the firm is concerned about a decline in LIBOR rate, it decides to go
long on March T-Bill futures contract to protect itself from any decline in interest rates. The firm
buys 10 March 2003 T-Bill futures contracts on January 6 at a price of $92.86, locking in the
discount yield of 7.14%. The following two illustrations provide a better explanation of this
transaction:
Case I
The 3-month discount yield on T-Bills falls to 6.5% by March 15 (thus March futures will be
priced at 93.5).
Price of Cash T- bill = $100,00,000 X (1 – 0.065 X 3/12)
= $98,37,500
Less: Gain on Futures = (Price Change) X ($25/BP) X 10

= $(93.5 – 92.86) X 100 X 25 X 10
= $16,000
Effective Purchase price = $ 98,21,500
Annualized discount yield
= (100,00,000 – 98,21,500/100,00,000) X 12/3 X 100
= (178500/100,00,000) X 4 X 100
= 7.14%
Case II
The 3-month discount yield on T-Bills rises to 8.5% by March 15 (thus March futures will be
priced at 91.5).
Price of Cash T- bill = $100,00,000 X (1 – 0.085 X 3/12)
= $97,87,500
Add Loss on Futures = (Price Change) X ($25/BP) X 10
= (92.86 – 91.5) X 100 X 25 X 10
= $34,000
Effective Purchase Price = $98,21,500
Annualized discount yield
= [(100,00,000 – 98,21,500)/100,00,000] X 12/3 X 100
= 7.14%
In both cases, the firm has locked in the investment yield at 7.14%. In the first case, there was a
gain on the long futures position of $16000, because of a decline in the interest rate. In the second
case, loss on the futures position of $34000 was due to an increase in the interest rate.
ARBITRAGE WITH T-BILL FUTURES

T-Bill future prices are worked out after considering the implication of cost of carry. The cost of
carry is the net cost of carrying the commodity forward at a future date. Thus, the futures price can
be depicted as:
F1 = S0 (1 + Cc0,1)
Where, F1 = Futures price at time 1
Cc0,1 = Cost of carry from time 0 to 1
S0 = Spot commodity price
Carrying cost helps investors establish the relationship between the futures price and the spot
price. In interest rate futures, the quotes for both the spot price as well futures price of the T-Bill
are given. These values can be used to determine the cost of carry and the resultant, also known as
the implied repo2 rate. In the absence of any arbitrage, this rate would be prevalent between two
dates.
2
Repo is short for repurchase agreement. In this type of contract, one party sells a security and also
promises to buy it back at a predetermined price on some future date.
Example:
Assume a mutual fund owns T-Bills that have a face value3 of $5 million and a current market
value of $49,43,727. Faced by the demand for money by the fund participants, the fund enters into
a repurchase agreement with a financial institution. The institution provides the advance equal to
the current market value with a promise from the fund to repurchase the bills at $49,45,460 after
four days. The repo rate works out to be
$ 49,45,460 - 49,43,727 X 365 = 3.20%
$ 49,43,727 4
There is an opportunity for arbitrage if the T-Bill itself yields more than the institution’s repo rate
(3.20%). The fund can make arbitrage benefit by borrowing from the institution at this rate and
investing more in T-Bills.
Example:
Assume the following quotes are available in a T-Bill futures market:
INSTRUMENT MATURITY PRICING INFO

T-Bill futures market 120 days IMM Index = 94.80
T-Bill 120 days Discount yield = 4.65 %
T-Bill 210 days Discount yield = 4.85 %
Buying the futures contract is equivalent to buying the 120-day bill followed by a 90-day T-Bill
when the 120-day T-Bill matures. This is because on the date of expiration of the futures contract,
the longer maturity T-Bill will have 90 days to maturity and hence will be deliverable against the
futures. Therefore, buying the futures contract today is equivalent to buying the 210-day T-Bill.
The person long on the futures will receive a 90-day T-Bill in 120-days. With the data for 120 and
210-day T-Bill provided, the price of the futures contract can be worked out to find whether any
opportunity for arbitrage exists.
D = (100 –P)/100 X 360/t
P120 = 100 – 100 X .0465 X (120/360) = 98.45
Unannualized yield for 120 days = (100 – 98.45)/98.45 = 0.01574
Annualized yield = 0.01574 X 360/120 = 0.04722 or 4.72%
P210 = 100 – 100 X .0485 X (210/360) = 97.1708
Unannualized yield for 210 days = (100 – 97.1708)/97.1708 = 0.0291
Annualized yield = 0.0291 X 360/210 = 0.04988 or 4.99%
Futures Contract
(1.0291) = (1.01574) (1 + R120, 210)
R120, 210 = 0.01315 (R120, 210 stands for the forward interest rate from day 120 to day 210)
Futures Price = 100/1.01315 = 98.70
Futures discount yield = (100 – 98.70)/100 X 360/90 = 0.052 or 5.20%
IMM Index = 100 – 5.20 = 94.80
Since the IMM Index is the same as that in the table, no arbitrage opportunity exists.
3
The stated principal amount of an instrument.
Opportunities for arbitrage exist when the futures price deviates from the theoretical price.
Suppose instead of selling for 94.80, T-Bill futures sell for 95.02, the appropriate strategy would
be to borrow for 120 days, buy 210 day T-Bills and sell futures due in 120-days. An arbitrageur
can borrow at a 120-day repo rate of 4.85%. The IMM index of 95.02 translates into a price of
$9,87,875.
Discount yield = 100 – 95.02 = 4.98%
Futures price = 10,00,000 (1 – Discount yield X 90/360)
= $9,87,875
The following transactions would yield an arbitrage profit,
TODAY
Buy 210-day T-Bill ($9,71,708)
Borrow $9,71,708 @ 4.85% for 120 days ($9,71,708)
Sell one futures contract @ 95.02 --
Net cash requirement $0
120 Days Later
Deliver T-Bill on futures contract; collect $9,87,875

Repay Repo Loan ($9,71,708)
Pay Repo Interest
0.0485 X 9,71,708 X 120/360 ($15709.28)
Net cash receipt $457.72

To avoid any opportunities for arbitrage, given the repo rate of 4.85%, the futures price should be
94.97. At this price, the inflow from short sale of the futures would be very close to the cost of
borrowing for buying 210-day T-Bill (See Exhibit IV).
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 @ 93.00
Day 15 Sell 15 TB @ 94.50 Buy 15 ED @ 92.87
Gain 0.05 Gain 0.13
5
= 15 X $25/tick 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.
Therefore, the prices at which the underlying bonds trade varies. Because of the variation in prices,
futures contracts specify a conversion factor 6 (announced by the exchange prior to commencement
of trading in a particular contract for all bonds eligible for delivery) to make the delivery of one
among many possible bonds consequential. The conversion factors are used to standardize all
deliverable bonds to bonds yielding 6%. To work out the conversion factor, the maturity period
and times to coupon payment dates of a bond are approximated to the nearest three months. If after
rounding, the bond lasts for an exact number of half-years, the first coupon is assumed to be paid
in 6 months. If after rounding, the bond does not last for an exact number of half-years (i.e. there is
an extra 3 months), the coupon is assumed to be paid after 3 months and accrued interest is
subtracted. The examples given below illustrate the calculation of the conversion factor.
Example:
Consider an 8.5% coupon bond with 20 years and two months to maturity. The coupon payments
are made semi-annually. Assume that the first coupon payment is to be made after six months. The
discount rate is 6% per annum with semi-annual compounding. The value of a $100 face value
bond is then,
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.
6
The conversion factor is the factor used to adjust the invoice price so that a higher amount is paid for the
delivery of a bond with a higher coupon.
40
4.25 100
 t
  128.89
t 1 1.03 1.03 40
The conversion factor is the value divided by its face value = 128.89/100 = 1.2889
Example:
Consider a 9% coupon bond with 15 years and four months to maturity. In this case, the period of
the bond to maturity is assumed to be 15 years and three months. Discounting all the cash flows
back to a point in time three months from today gives:
30
4.50 100
 4.5   1.03
t 1
t

1.0330
133.9
The next logical step is to calculate the interest rate for a 3-month period is (1.03 – 1) X 100 =
1.4889% and discount back the value of 133.39 to the present date i.e. 133.9/1.014889 = 131.94.
Accrued interest = 2.25. Therefore, the conversion factor is (131.94 - 2.25)/100 = 1.2969. The
conversion factor computed is used to determine the amount received by the party with the short
position, when he/she delivers the bond. It is computed for each $100 face value of the bond
deliverable, using the following formula:
Cash Received = Quoted Futures Price X Conversion Factor + Accrued Interest since Last Coupon
Date
PRICING OF T-BOND FUTURES CONTRACTS
For T-bond futures, it is up to the seller to decide which bond to deliver. Therefore he/she
identifies the cheapest to deliver bond (Refer Exhibit VI). This is done by computing the cost of
delivery for each deliverable bond as follows:
Cost = (Quoted Price + Accrued Interest) – (Quoted Futures Price X Conversion Factor + Accrued
Interest).
Quotes for Treasury Bonds
The prices of Treasury bonds are quoted in terms of dollars and 32nds of a dollar. Therefore, a
quote of 94-22 means that the price of a bond with a face value is $100,000 is $94,687.5 (since the
quote is in terms of a bond with a face value of $100). However, the price paid by the purchaser is
not the quoted price7 but the cash price8. The relationship between the two is:
Cash Price = Quoted Price + Accrued Interest since last Coupon Date.
Example:
Assume that on April 8, 2003, a fund manager is holding US Treasury bonds maturing on July 8,
2020, carrying a coupon rate of 12%. The bond is quoting at 93-08 (or $93.25). The interest is paid
semi-annually on January 8 and July 8 every year. As per the day count convention, the interest on
the government bond accrues on an actual basis. The last coupon payment date in this case was
January 8, 2003.
Therefore, the accrued interest between January 8 and April 8, 2003 is,
= (90/181) X $6 = $2.98
Where the number of days between Jan 8 and April 8 is 90
Number of days between Jan 8 and July 8 is 181
7
Quoted price is sometimes referred to as the clean price.
8
Cash price is sometimes referred to as the dirty price.
And $6 is the coupon payment on January 8 and July 8

Therefore, the cash price per $100 face value for a July 8, 2003 bond is
= $93.25 + $2.98 = $96.23
QUOTED FUTURES PRICE

A futures contract on a security that provides the holder with a known income is known as a
Treasury bond futures contract. The assumption underlying the contract is that both the cheapest to
deliver bond and the delivery date are known. Then the relationship of the futures price to the spot
price is determined by the following formula:
F0 = (S0 – I)ert
Where,
F0 = Cash Future Price
S0 = Cash bond price
I = Present value of coupons during the life of the futures contract
r = Risk free interest rate
t = The time difference between the maturity of the futures contract and the current time.
The logical step to calculate the quoted futures price is shown in Table III.
Table III
Steps to Calculate Quoted Futures Price
Step 1: Calculate the cash price of the cheapest-to-deliver bond from the quoted price.
Step 2: Calculate the cash futures price from the cash bond price using the above equation.
Step 3: Calculate the quoted futures price from the cash futures price.
Step 4: Divide the quoted futures price by the conversion factor.
Source: Hull C. John, “Options, Futures and Other Derivatives”
Example:
Assume that in a T-bond futures contract, the cheapest to deliver bond is a 14% coupon bond with
a conversion factor of 1.37. Delivery will take place after 280 days. The term structure is flat and
the rate of interest is 10% per annum. Assume that the current quoted bond price is $120 with
semi-annual coupons. The last coupon date was 45 days ago, the next coupon date will be 137
days from the present date, and the next to next coupon date will be in 320 days from the present.
The diagrammatic representation would be:
Coupon
Coupon Current Maturity of Coupon
Payment
Payment Date Future Contract Payment
45 137 days 143 days 40

days days
Given the current quoted bond price of $120, the cash price would be the quoted price plus the
accrued interest,
= 120 + [45/(45+137) X 7] = $121.73
The present value of the coupon payment of $7 to be received after 137 days (0.3753 year) is,
= 7e-0.3753 X 0.1 = 6.742
The futures contract last for 280 days (= 0.7671 year). The cash futures price of a 14% bond would
therefore be:
(121.73 – 6.742)e 0.7671 X 0.1
= 124.155
At the point of delivery, the accrued interest would be for 143 days. This has to be deducted from
the cash futures price to calculate the quoted futures price,
124.155 – 7 X [143/(143+40)] = 118.685
The contract is written on a standard 6% bond, and 1.37 standard bonds are considered to be
equivalent to each 14% bond. Therefore, the quoted futures price would be,
118.685/1.37 = 86.63
CONCLUSION
Futures are among the oldest financial instruments. This concept note attempts to help readers
understand the applications of interest rate futures. Interest rate futures are used for hedging,
spreading and arbitraging purposes. Corporates can use these instruments to hedge fixed income
assets against the risk of interest rate volatility. By understanding how interest rate futures
contracts work and how prices are quoted, an investor can create a hedge against the exposure to
interest rates.
10
Exhibit I
List of Actively Traded Short Term Interest Rate Futures
US Exchanges
a) 3-month Eurodollar (Chicago Mercantile Exchange)
b) 90-day T-Bill (CME)
c) 1-month LIBOR (CME)
Foreign Exchanges
a) 3-month Euroyen SIMEX, Singapore
b) 3-month Eurodollar LIFFE, UK
c) 3-month KLIBOR (Kuala Lumpur Interbank Offered Rate), MME
d) 3-month HIBOR Hong Kong Future Exchange
Source: Financial Risk Management, IBS Center for Management Research Textbook.
Exhibit II
List of Actively Traded Long Term Interest Rate Futures
US Exchanges
a) T-Bonds (15 years) Chicago Board of Trade (CBOT)
b) T-Notes (10 years) CBOT
c) T-Notes (5 years) CBOT
Foreign Exchanges
a) Japanese Government Bonds (10 years)
b) UK Government Bonds
c) Australian T-Bonds
Source: Financial Risk Management, IBS Center for Management Research Textbook.
11
Exhibit III
T-Bill Futures and Eurodollar Futures
The 90 day T-Bill was the first short term interest rate futures contract traded on the
International Monetary Market (IMM) in 1976. A Treasury bill does not pay any coupon and the
investor receives the face value at maturity. U.S. T-Bills sell at a discount form their par value or
face value, The underlying asset of a Treasury Bill futures contract is a 90-day Treasury bill. A
T-Bill futures contract is for a delivery of $1 million face value of T-Bills with 13 weeks to
maturity at the time of futures expiration. In general, the T-Bills to be delivered can have
maturities of 90, 91 or 92 days. The prices of T-Bills and T-Bills futures prices are
conventionally quoted in terms of bank discount yield.
The Eurodollar futures contract at the Chicago Mercantile Exchange is perhaps the most actively
traded futures contract. The Eurodollar futures contract is a contract on the 3-month LIBOR
(London Inter-Bank Offered Rates). This contract is settled in cash. Following are the basic
contract characteristics of two short term futures:
Specification 13-week US Treasury Bill 3-month Eurodollar time

deposit
Size $ 10,00,000 $ 10,00,000
Negotiable Transferable Non transferable
Settlement Settled by delivery Cash settlement
Yields Discount Add on
Trading months March, June, September, March, June, September,
December December
Minimum change in price .01 (1 basis point) .01 (1 basis point)
Symbol TB ED
T-Bill prices are typically quoted on a discount basis, and the year is considered to be of 360
days and each month of 30 days. The discount yield on T-Bills is calculated as follows:
Par Value – Market Price 360

Discount Yield = _____________________ X ______
Par Value Days
Adapted from Strong A. Robert, Derivatives An Introduction, Hull C. John, Options, Futures and Other Derivatives,
Financial Risk Management, IBS Center for Management Research Textbook, www.cba.uiuc.edu.
12
Exhibit III (Continued)

T-Bill Futures and Eurodollar Futures
Assume an investor bought T-Bills worth $10,000 in an auction for which he paid 97.563% of
par, or $9756.30. Substituting the values we get the discount rate of:
= (10000 – 9756.30)/10000 * 360/91 = 9.64%
The prices for T-Bill futures contracts are quoted both as a discount from par and as a percentage
of par value. For example, the settlement price of 95.65 for the June contract represents a discount
rate of 100 – 95.65 = 4.35% of par, or 95.65% of 100. But generally, T-Bill futures contracts are
quoted in terms of the IMM index, which is defined as
IMM Index = 100 – D, therefore if the IMM index is 94, then the implied discount yield is 6%.
The minimum price change allowed per futures contract is one basis point (.01%), which works
out to be ($ 10,00,000 X .0001 X 3/12) = $ 25.
The Eurodollar futures prices on the IMM division of CME are quoted as 100 – LIBOR, where
LIBOR is an annualized three-month rate. For example, the settlement price of 96.67 on a
September 03 contract corresponds to an annualized LIBOR rate of 3.33%. Unlike T-Bills, the
yield on Eurodollar futures is quoted in terms of add-on or simple interest rate. It is determined
by:
Discount 360
Add –on – yield = X
Price Days to Maturity
Substituting,
.0333 = (Discount/$ 10,00,000 – Discount) X 360/91
Discount = $ 8347.24
If a T-Bill of $ 1 million is sold at a discount of $ 8347.24, the discount yield would be:
= ($8347.24/$ 10,00,000) X 360/91 = 3.30%
Therefore, it can be inferred that for a give discount, the discount yield will be less than the add-
on yield.
13
Exhibit IV
No Arbitrage Futures Price
At any time, if the cash requirement at point 0 is nil and at point 1, if an investor ends up with
cash in hand, then there is some problem in the financial system. Either the repo rate is too low
or
the futures price is too high. If the investor can borrow at a lower rate than the implied financing
rate from the T-Bill futures market, the investor should borrow for 120 days, buy 210 day T-
Bills and sell futures due in 120 days. But, if the borrowing rate is more than the implied
financing rate, than the investor should be to borrow for 210 days, buy 120 day T-Bills, and buy
futures due in 120 days.
Given the repo rate of 4.85%, the price at which there will be no arbitrage is $94.97.
Total cost of borrowing = $9,71,708 + $15,709.28 = $987417.28
Discount yield on futures = 100 – 94.97 = 5.03%
Price = $10,00,000 (1 – discount yield X 90/360)
= $9,87,425
Source: Strong A. Robert, Derivatives an Introduction.
Exhibit V
Characteristics of T-Note and T-Bonds
5-year US T-Note 10-year US T-Note US T-Bond

Exchange CBOT CBOT CBOT
Symbol FV TY US
Face Value (or $ 100,000 $ 100,000 $ 100,000
contract size)
Price of quotation Points and 1/32 of a Points and 1/32 of a Points and 1/32 of a
point point point
Delivery 7th business day 7th business day 7th business day
preceding the last preceding the last preceding the last
business day of the business day of the business day of the
delivery month delivery month delivery month
Trading months March, June, March, June, March, June,
September, December September, December September, December
Minimum change in 1/32 of a point i.e. 1/32 of a point i.e. 1/32 of a point i.e.
price allowed $31.25 $31.25 $31.25
14
Exhibit VI
Cheapest to Deliver Bond
The seller may choose the bond to deliver from the bonds eligible for delivery. The factors which
affect the bond yield include the bond price, the coupon, and the time until maturity. Therefore,
bonds with coupons of 6% may not yield exactly 6%, but may be more or less than that. Five
percent bonds yielding 6% necessarily sell for less than par, while 7% bonds yielding 6% sell for
more than par. The conversion factor makes all bonds equally attractive for delivery only when
the bonds under consideration yield 6%. If they yield more or less than 6%, one bond will have
the lowest adjusted price, and hence be cheapest to deliver.
Since the party with the short position receives (quoted futures price X Conversion factor) +
accrued interest
And his/her cost of purchasing the bond is quoted price + accrued interest
Therefore, the cheapest to deliver bond is the one for which Quoted price – (quoted futures price
X Conversion factor) is the minimum
Example:
Bond Quoted Price Conversion Factor
1 98.50 1.2082
2 134.50 1.5588
3 128.75 1.3615
Given a quoted futures price of 93.25, the cost of delivering each of the bonds is:
Bond 1: 98.50 - (93.25×1.0182) = 3.55
Bond 2: 134.50 - (93.25×1.4088) = 3.12
Bond 3: 128.75 - (93.25×1.3485) = 3.00
The cheapest to deliver bond is bond 3.
15
Additional Readings & References:
1. John C. Hull., Options, Futures and Other Derivatives.

2. Robert A. Strong, Derivatives An Introduction
3. Financial Risk Management, IBS Center for Management Research Textbook.
4. www.cme.com
5. www.wehner.tamu.edu
6. www.cba.uiuc.edu
7. www.jaring.my/mme/htm
8. www.forbes.com/tools/glossary
16

A NOTE ON INTEREST RATE FUTURE

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A NOTE ON INTEREST RATE FUTURE

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MISC/011

IBS Center for Management Research

A Note on Interest Rate Futures

 2004, IBS Center for Management Research. All rights reserved.

A Note on Interest Rate Futures

DEFINING THE TERMS

HEDGING INTEREST RATES RISK WITH INTEREST RATE FUTURES

SHORT TERM HEDGING (HEDGING THE RISK OF A RISE IN INTEREST

= $100,00,000 X 8.5% X 3/12

Less: Gain on Futures = (Price Change) X ($25/BP) X 10

ARBITRAGE WITH T-BILL FUTURES

INSTRUMENT MATURITY PRICING INFO

Sell one futures contract @ 95.02 --

Net cash requirement $0

120 Days Later

Deliver T-Bill on futures contract; collect $9,87,875

Net cash receipt $457.72

TREASURY BONDS FUTURES

And $6 is the coupon payment on January 8 and July 8

QUOTED FUTURES PRICE

45 137 days 143 days 40

Specification 13-week US Treasury Bill 3-month Eurodollar time

Par Value – Market Price 360

Exhibit III (Continued)

5-year US T-Note 10-year US T-Note US T-Bond

Additional Readings & References:

1. John C. Hull., Options, Futures and Other Derivatives.

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