Derivatives

CHAPTER 13T-bond Futures

Aims

• To examine contract details for UK Gilt futures and US T-bond futures including the conversion factor, the cheapest-to-deliver bond and wild card play.
• To determine the optimal number of T-bond futures contracts for hedging.
• To determine the fair price of a T-bond futures contract using cash-and-carry arbitrage.
• To analyse speculative strategies using T-bond futures. This includes spread trades and altering the effective duration of a bond portfolio to take advantage of market timing strategies.

Some of the practical details of T-bond futures are quite intricate. A long T-bond futures position allows the holder to take delivery of a long maturity T-bond at expiration of the futures contract. As with all futures contracts, T-bond futures can be used for speculation, arbitrage, and hedging. Hedging allows the investor to eliminate price risk of her bond portfolio.

For example, suppose Ms Bond holds $20m in (cash market) 20-year T-bonds and she fears a rise in long-term yields over the next 6 months. Ms Bond should hedge by shorting (selling) T-bond futures. If long rates do subsequently rise, the price of her cash-market T-bonds will fall but so does the futures price. Hence, she can close out her short futures position at a profit by buying back the T-bond futures at a lower price. The profit from the futures position compensates for the loss in value of her cash market position in T-bonds.

If Ms Bond wants to act as a speculator and she forecasts ...