The late 1970s and 1980s saw a dramatic increase in the volatility of interest rates, leading to investor desire to hedge returns on fixed-income securities against changes in interest rates. As one example, thrift institutions that had loaned money on home mortgages before 1975 suffered substantial capital losses on those loans when interest rates later increased. An interest rate futures contract could have protected banks against such large swings in yields. The significance of these losses has spurred trading in interest rate futures.
The major U.S. interest rate contracts currently traded are on Eurodollars, Treasury bills, Treasury notes, and Treasury bonds. The range of these securities provides an opportunity to hedge against a wide spectrum of maturities from very short (T-bills) to long term (T-bonds). In addition, futures contracts tied to interest rates in Europe (euro-denominated), Japan, the United Kingdom, and several other countries trade and are listed in The Wall Street Journal. Figure 16.2 shows listings of some of these contracts in The Wall Street Journal.
The Treasury contracts call for delivery of a Treasury bond, bill, or note. Should interest rates rise, the market value of the security at delivery will be less than the original futures price, and the deliverer will profit. Hence, the short position in the interest rate futures contract gains when interest rates rise and bond prices fall.
Similarly, Treasury bond futures can be useful hedging vehicles for bond dealers or underwriters. We saw earlier, for example, how the T-bond contract could be used by an investor to hedge the value of a T-bond portfolio or by a pension fund manager who anticipates the purchase of a Treasury bond.
An episode that occurred in October 1979 illustrates the potential hedging value offered by T-bond contracts. Salomon Brothers, Merrill Lynch, and other underwriters brought out a $1 billion issue of IBM bonds. As is typical, the underwriting syndicate quoted an interest rate at which it guaranteed the bonds could be sold. This underwriting arrangement is called a "firm commitment," and is discussed in more detail in Chapter 3. (In essence, the syndicate buys the company's bonds at an agreed-upon price and then takes the responsibility of reselling them in the open market. If interest rates increase before the bonds can be sold to the public, the syndicate, not the issuer, bears the capital loss from the fall in the value of the bonds.)
In this case, the syndicate led by Salomon Brothers and Merrill Lynch brought out the IBM debt to sell at yields of 9.62% for $500 million of 7-year notes and 9.41% for $500 million of 25-year bonds. These yields were only about four basis points above comparable maturity U.S. government bond yields, reflecting IBM's excellent credit rating. The debt issue was brought to market on Thursday, October 4, when the underwriters began placing the bonds with customers. Interest rates, however, rose slightly that Thursday, making the IBM yields less attractive, and only about 70% of the issue had been placed by Friday afternoon, leaving the syndicate still holding between $250 million and $300 million of bonds.
Then on Saturday, October 6, the Federal Reserve Board announced a major credit-tightening policy. Interest rates jumped by almost a full percentage point. The underwriting syndicate realized the balance of the IBM bonds could not be placed to its regular customers at the original offering price and decided to sell them in the open bond market. By that time, the bonds had fallen nearly 5% in value, so that the underwriter's loss was about $12 million on the unsold bonds. The net loss on the underwriting operation came to about $7 million, after the profit of $5 million that had been realized on the bonds that were placed.
As the major underwriter with the lion's share of the bonds, Salomon lost about $3.5 million on the bond issue. Yet, while most of the other underwriters were vulnerable to the interest rate movement, Salomon had hedged its bond holdings by shorting about $100 million in Government National Mortgage Association (GNMA) and Treasury bond futures. Holding a short position, Salomon Brothers realized profits on the contract when interest rates increased.
The profits on the short futures position resulted because the value of the bonds required to be delivered to satisfy the contract decreased when interest rates rose. Salomon Brothers probably about broke even on the entire transaction, making estimated gains on the futures position of about $3.5 million, which largely offset the capital loss on the bonds it was holding.
How could Salomon Brothers have constructed the proper hedge ratio, that is, the proper number of futures contracts per bond held in its inventory? The T-bond futures contract nominally called for delivery of an 8% coupon, 20-year maturity government bond in return for the futures price. (In practice, other bonds may be substituted for this standard bond to settle the contract, but we will use the 8% bond for illustration.) Suppose the market interest rate is 10% and Salomon is holding $100 million worth of bonds, with a coupon rate of 10% and 20 years to maturity. The bonds currently sell at 100% of par value. If the interest rate were to jump to 11%, the bonds would fall in value to a market value of $91.98 per $100 of par value, a loss of $8.02 million. (We use semiannual compounding in this calculation.)
To hedge this risk, Salomon would need to short enough futures so that the profits on the futures position would offset the loss on the bonds. The 8%, 20-year bond of the futures contract would sell for $82.84 at an interest rate of 10%. If the interest rate were to jump to 11%, the bond price would fall to $75.93, and the fall in the price of the 8% bond, $6.91, would approximately equal the profit on the short futures position per $100 par value.7 Because each contract calls for delivery of $100,000 par value of bonds, the gain on each short position would equal $6,910. Thus, to offset the $8.02 million loss on the value of the bonds, Salomon theoretically would need to hold $8.02 million/$6,910 = 1,161 contracts short. The total gain on the contracts would offset the loss on the bonds and leave Salomon unaffected by interest rate swings.
The actual hedging problem is more difficult for several reasons, most of which are due to the fact that this is really a cross-hedge: Salomon is hedging its IBM bonds by selling contracts on Treasury bonds and, to a lesser extent, GNMA bonds. Some of the complications in this hedging strategy are: (1) Salomon probably would hold more than one issue of bonds in its inventory; (2) interest rates on government and corporate bonds will not be equal and need not move in lockstep; (3) the T-bond contract may be settled with any of several bonds instead of the 8% benchmark bond; and (4) taxes could complicate the picture. Nevertheless, the principles illustrated here underlie all hedging activity.
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