Treasury bond is a marketable, fixed coupon, short-term to long-term investments. In the United States, the maturity of the treasury bonds is typically more than ten years. During this period, the treasury holder is entitled to a semi-annual payment. They offer security as the government of the United States can issue them.
By what amount will the market value of a Treasury bond futures contract change if interest rates rise from 5 to 5.25 percent? The underlying Treasury bond has a duration of 10.48 years, and the Treasury bond futures contract is currently being quoted at 113-06.
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For one to determine the change that takes place in the Treasury bond contract's market value when the interest rate is changed, the following computation will be employed.
For our case, the change in the interest rate is from 5 to 5.25%.
| The change in the market value of the Treasury bond contract= 10.48 years multiplied by $113,187.50= $1,186,205 |
| x + 0.0025 = (0.00238) $1,186,205 multiplied by 0.00238 = -$2,823.17 |
| 1 x (1 + 0.05) |
Morning View National Bank reports that its assets have duration of 7 years, and its liabilities average 1.75 years in duration. To hedge this duration gap, management plans to employ Treasury bond futures, which are currently quoted at 112-170 and have duration of 10.36 years. Morning View’s latest financial report shows total assets of $100 million and liabilities of $88 million. Approximately how many futures contracts will the bank needs to cover its overall exposure?
The duration gap is a word that is used by financial institutions such as pension funds and banks to assess the risk as a result of fluctuations in interest rates. The variations come as a result of asset-liability inconsistency
N = (7 years – 88 million x 1.75 years) x 100 million = Number of contracts
100 million
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10.36 x 112,531.25
(7 - .88 x 1.75 = 5.46) x 100 million = $546,000,000 = 468 Contracts
10.36 x 112,531.25 = $1,165,823.75
Morning View National Bank has a duration gap of +5.46 years. The bank is at risk of interest rate upward move. To prevent this, Morning View will be obliged to apply a short-hedge. The bank will require 468 of the future bonds to take care of the risk. They will cash in 468 of the future contracts.
The morning view National Bank scenario implies bond prices have an inverse correlation to the interest rate. If the rate of the interest rate increases, there will be a subsequent decrease in the market value of the bond, and the vice versa is true.
Future of Treasury Bonds
The future of the treasury bonds is aimed at helping the investors who are risk-averse with the opportunity of managing the possible risks which likely to occur in their investment activities. The virtual price of a future treasury bond relates to the spot value and the cost of carry. On the other hand, the cost of carry equals the cost used in financing less the value of the security. The future of treasury bonds can be predicted via a yield curve; that is the correlation between the rate of short-term financing and the current outcome on the contract. An upward-sloping curve depicts a positive carry on the bond, and the vise-versa is true. A positive carry means that short-term financing is lower than the current yield on the contract. Low bond yields mean that the returns are lower due to low income and increased interest rates; high rates put the organization at risk of capital losses. Therefore, for maximum gains, lower interest rates are the only way for bond yields.
As asserted by Labuszewski, Kamradt, and Gibbs (2013), the effective use of the contracts requires a better understanding of the hedging techniques. It should be noted however, that the Treasury bond futures (TBF) are mainly purchased incrementally from tow to thirty years on bonds and notes with a face value of $100 to $200 thousand ( Rose & Hudgins, 2013b) . This solely depends on the duration of the contract. Therefore, the longer the contract, the higher the interest rates and vice versa. Essentially, the contracts start on quarterly cycles, with each having three months. For instance, the signing months for the contract cycles could be March, June, September or December. It should be noted that the treasury binds can be traded to the last date of the calendar month, and all the transactions are delivered via the federal reserve wire transfer system ( Bidabad, 2019) .
While there are regulations that govern the setting of the interest rates and the contract duration, the treasury futures allow a significant number of participants in the global financial market to make adjustments on how they can get exposed to the interest. Moreover, they benefit from the volatility of interest through a selection of the futures contracts, which are in line with their desired interest rates. In this case, the liquid assets provide an important hedging ability, adjustment of the duration, enrichment of income, spread-trading activities, and analysis of the speculative interest rates ( Rose & Hudgins, 2013a) . The move has widely been used by the investors to arrive at the desired interest rates. This reduces the risk of their investment through a multifaceted security system, which explains the reasons why most of these contracts are electronically traded rather than manually daily. It means that it provides peace of mind to the investors owing to the volatility of the economy because it ensures that the yields are consistent and attractive to the investors.
The main characteristics of the interest rate futures include the following:
It provides insurance against the movement of prices but instead provides flexibility to offer benefits to the favorable progress of the costs.
The right to buy or sell a particular commodity at a specific price for a given period;
The option sellers get a fixed premium upfront is required to either buy or sell the item under consideration at a given price in the event the option is undertaken against the writer.
Considering the characteristics, the interest rate can, therefore, rate the future work. It means, thus, that the commodity under consideration is identified. Since the exchange-traded interest rate futures are standardized and known, the exercise duration is determined, the strike price is determined, and the price premium is determined based on the exchange floor. It should be noted that whoever buys the options, the option can be exercised a day before its expiration after giving notice to the exchange. Then, the notice will then be assigned to a random seller. Essentially, the majority of the options are closed instead of exercise.
References
Bidabad, B. (2019). Interest-Free Treasury Bonds (IFTB). International Journal of Shari'ah and Corporate Governance Research , 2 (2), 13-21.
Labuszewski, J. W., Kamradt, M., & Gibbs, D. (2013). Interest Rates: Understanding Treasury Futures. Retrieved May 15, 2020, from https://www.cmegroup.com/education/files/understanding-treasury-futures.pdf
Rose, P. S., & Hudgins, S. C., (2013a). Basis risk with long hedge. Bank management & financial services(9 thed., international ed.) (p 265-6). New York, NY: McGraw Hill.
Rose, P. S., & Hudgins, S. C., (2013b). Number of futures contracts needed. Bank management & financial services(9 thed., international ed.) (pp268-9). New York, NY: McGraw Hill. 4
