In the previous chapter our focus was on the application of derivatives to the management of an equity portfolio. In this chapter, we look at how fixed income portfolio managers can use interest rate derivatives (Treasury futures, Treasury futures options, and interest rate swaps) to control interest rate risk and how credit derivatives (in particular credit default swaps) can be used to control credit risk.
18.1 Controlling Interest Rate Risk Using Treasury Futures
There are several interest rate futures contracts that are available to portfolio managers. The contracts commonly used to control the interest rate risk of bond portfolios are Treasury bond and note futures contracts. We describe these contracts here, their pricing in terms of deviations from the basic futures pricing model in Chapter 16, and how they are used.
The Treasury bond and note futures contracts are traded on the Chicago Mercantile Exchange (CME). The underlying instrument for the bond futures contract is $100,000 par value of a hypothetical 20-year, 6% coupon bond. This hypothetical bond's coupon rate is called the notional coupon. There is also an ultra-Treasury-bond futures contract. An acceptable deliverable for the ultra-Treasury-bond futures contract is a bond with a maturity of at least 25 years, allowing bond portfolio managers to better manage the longer end of the yield curve. The Treasury bond futures contract is effectively a ...