An Introduction to International Capital Markets: Products, Strategies, Participants, Second Edition

12

Bond Futures

12.1 CHAPTER OVERVIEW

The previous chapter looked at futures contracts on short-term interest rates. Exchange-traded futures are also available on a range of major government bonds. The present chapter explores the structure and application of bond futures taking contracts on US Treasuries, UK gilts, and German bunds as examples. It explains contract specifications and basic trading strategies. These contracts have a physical delivery mechanism although they are based on notional bonds. The chapter explains how the delivery and settlement procedures operate and how the exchanges calculate the conversion factors that are designed to adjust for the relative values of the actual bonds that can be delivered. It looks at how bond forward and futures contracts are priced and explains concepts such as basis, basis risk, the implied repo rate, and the cheapest to deliver bond. It considers the limitations of the conversion factors and the behaviour of the cheapest to deliver bond. Finally, the chapter explores some practical applications of bond futures in hedging positions in underlying bonds and in implementing asset allocation decisions.

12.2 DEFINITIONS

A financial futures contract is an agreement to buy or to sell on an organized exchange:

• a standard amount of a specified financial instrument;

• at a specified date in the future (or within a range of dates);

• at an agreed price.

As illustrated in Chapter 11, a buyer or seller of futures contracts has to pledge ...