Bond Futures Research Articles

Pricing of the Korean Treasury Bond Futures Using the Term Structure of Interest Rates

This paper shows the limitation of the cost-of-carry model which is used for pricing the theoretical value of the KTB futures, and proposes an alternative pricing model based on the term structure of interest rates. Under the assumption of 1-factor term structure, this paper treats the theoretical price of KTB futures price as a risk-neutral expectation of payoff function at maturity and derives the approximated formula for pricing the KTB futures. As compared with our price of KTB futures using the term structure of interest rates, the conventional KOFEX price based on the cost-of-carry model tends to be overvalued as the time to maturity increases. This result is due to the difference between the futures and forward prices which is caused by treating the futures contract as the forward contract in the conventional KOFEX pricing model. In particular, this discrepancy becomes more significant when the price of underlying asset and the interest rates are negatively correlated and the time to maturity is longer. The bond futures contract is a typical example of financial instrument whose price has a negative correlation with interest rates

Shock effects on stocks, bonds, and exchange rates

Tick data and newswire searches are used to find events that led to large and rapid price changes in a stock future, a bond future, and three exchange rate futures. Knowledge of these events may be useful in future work. They have the advantages that they are truly surprises and that the sign of their effect on each financial instrument is known. The events are used in this study to analyze the effects of three types of events (monetary, price, and real) on the five instruments.

Options on bond futures: Isolating the risk premium

AbstractThe introduction of unspanned sources of risk (and frictions) implies that option prices include a risk premium. Prima facie evidence of the existence of risk premia in option prices is contained in the implied volatility smile patterns reported in the literature. This article isolates the risk premium (defined as the simple difference between estimated and observed option prices) on options on U.K. Gilts, German Bunds, and U.S. Treasury bond futures using models that include price jumps and stochastic volatility. This study finds that single and multi‐factor stochastic volatility models with jumps may explain the empirical regularities observed in bond futures. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:169–215, 2003

Intra-day periodicity and long-run volatility in short sterling futures

Research examining high-frequency financial data has suggested that volatility dynamics may be confounded by the existence of both a periodic pattern and long-memory volatility. Using five-minute sampled UK short sterling bond futures, this paper seeks to confirm the joint presence of such components. Our results provide evidence for both a U-shaped intra-day pattern and long-run dependence in volatility. Estimation of a component-Garch model confirms the presence of both long-run and short-run volatility dynamics, with half-life decay to a shock in the long-run component of 19 hours and short-run half-life decay of 37 minutes. Finally, our results suggest that taking both components into account improves the accuracy of volatility forecasts.

News Releases, Market Integration, and Market Leadership

AbstractUsing intraday data we examine the response of futures on the British Long Gilt (Gilt), the German Government Bond (Bund), the U.S. Treasury Bond (Bond), the Japanese Government Bond (JGB), and the Italian Government Bond (IGB) to the release of U.S. macroeconomic news. Bond, Gilt, and Bund futures respond strongly to the news releases. The response of JGB futures is less pronounced, and IGB futures display weak responses at best. The instruments take time to adjust to news in the announcements. Following the announcements, Bond futures exert a high degree of market leadership. Evidence of increasing market integration is also noted.

Market Quality and Trader Behavior in a Manipulated Market: Anatomy of a Squeeze

This paper investigates the trading behavior of major participants - both dealers and customers - during the six-month period of a well-publicized manipulation episode: an attempted delivery squeeze in a bond futures contract traded in London. The analyses are based on a rich dataset on the spot and futures trades and inventories reported to the chief governmental regulator by different individual dealers and the Exchange. This simultaneous investigation of price distortions and trading positions of participants are of significant interest to both academics and regulators. From an academic perspective, this paper provides, inter-alia, empirical evidence on how learning takes place in the place and on the strategic behavior of major participants, both dealers and public traders, in a manipulation setting. It also shows that prices respond selectively to the trading actions of only the group of selected participants that are relevant at that time. From a regulatory perspective, this paper has several messages. First, regulators and exchanges need to be very concerned about ensuring that squeezes do not take place since they are accompanied by severe price distortions and significant erosion of depth. Second, exchanges should mark to market the specifications of their contracts more frequently, so that the term structure which underlies the calculation of conversion factors does not become dramatically different from the prevailing term structure. Third, regulatory reporting should ask for flagging of possession oriented trades like forward term repos: these trades can currently go un-noticed since they require virtually no regulatory capital. Fourth, and very importantly, delivery non-performance penalties in bond futures markets should be changed to conform to the cash and the repo conventions for settlement nonperformance.

Temporal aggregation, volatility components and volume in high frequency UK bond futures

This paper examines volatility in UK Long Gilt and Short Sterling futures over several intra-day frequencies. Initial GARCH model estimates are found to exhibit remaining residual structure and to be inconsistent with theoretical temporal aggregation results for all frequencies other than the full day. Further estimates suggest that intra-day volatility is more adequately characterized by a component model which decomposes volatility into short-run effects which dominate intra-day periods and long-run effects which dominate inter-day horizons, and that such components are associated with the arrival of information flows as proxied by volume. This component volatility model is also able to account for all dependence in Long Gilt futures at frequencies of 15 minutes and lower, and in Short Sterling futures at 1 hour and lower.

Modelling the Implied Volatility of Options on Long Gilt Futures

This paper investigates the properties of implied volatility series calculated from options on Treasury bond futures, traded on LIFFE. We demonstrate that the use of near‐maturity at the money options to calculate implied volatilities causes less mis‐pricing and is therefore superior to, a weighted average measure encompassing all relevant options. We demonstrate that, whilst a set of macroeconomic variables has some predictive power for implied volatilities, we are not able to earn excess returns by trading on the basis of these predictions once we allow for typical investor transactions costs.

Does Implied Volatility Imply Volatility—in Bonds?

The authors investigate the relationship between the implied volatility derived from option contracts on U.S. Treasury bond futures and the actual volatility observed in these securities. Research has suggested that implied volatility in stock options correctly forecasts realized volatility in stock prices; the authors find the same is true in bonds. Evidence on implied volatility in 25 options written on futures contracts on U.S. Treasury long bonds over 1993–1999 indicates a statistically significant relationship between implied and realized volatility. Further, implied volatility predicts realized volatility in an unbiased fashion.

Affine Models, Credit Spreads and the Delivery Option of a Multi-Issuer Bond Future

The contribution of this paper is two-fold: Firstly we use the intensity-based framework of Duffie/Singleton (1999) to analyse empirically the credit spread between Italian and German government bonds in an affine model framework. Secondly we value the delivery option of a multi-issuer bond-future contract. This contract allows the short to deliver bonds of different issuers and, therefore, depends on the credit spread between these bonds. The empirical part studies the valuation of German and Italian bonds using two-factor affine models. Similar to Pearson/Sun (1994) we combine cross-sectional and time-series information to estimate the process parameters with maximum likelihood. From our results we conclude that two-factor models produce about the same pricing errors for German and Italian bonds. However, both models explain only imperfectly the observed convex shape and the volatility smile of the default-spread structure. In the second part we analyse the delivery option of a bond future that is similar to the German Bund Future but allows additionally to deliver Italian government bonds. In contrast to our results for the valuation of coupon bonds we find that the option values in both models differ considerably. Our results provide useful insights for empirical work concerning affine intensity based models for the valuation of default-risky bonds and options that depend on a credit spread.

Predictability and the Dynamics of Long Forward Rates

Distantly maturing forward rates represent the markets long term (risk neutral) expectations about interest rates. As such, they are the fundamental ingredient of the pricing kernel. In most equilibrium models, interest rates mean revert, and so long forward rates are asymptotically constant. However, from US Treasury STRIPs data, forward rates slope increasingly downwards, and do not attenuate in volatility, as maturity increases beyond about 13 years. This has recently been documented formally by Brown and Schaefer (Working Paper, London Business School, 1999), though it also seems to well known to finance practitioners. Our aim is to build and test an equilibrium model, which incorporates this behavior. The key to our analysis, is first to show that most of the volatility in long forward rates comes from a predictable factor which is mean reverting on a time scale of a few weeks. Our techniques for this are first to apply the Variance Ratio test of Lo and MaKinlay (Review of Financial Studies, Vol 1, Number 1, pp 41 - 66, 1988), and then to implement the filtering procedure of Lo and Wang (Journal of Finance, Vol 50, pp 87 - 129, 1995), which extracts a second, non-predictable, factor from the forward rate time series, to which the forward rates mean revert. To reinforce our results, we also apply these procedures to the returns of US Treasury Bond futures, and extract essentially the same predictable component. Then, we show that the mean reverting aspect of the forward rates, is absent when we transform to risk neutral probabilities. This is natural, otherwise the market would obviate the predictability. We also establish this directly, by analyzing our T Bond futures data, and noting that for futures, the risk neutral dynamic can be extracted directly, since its drift is just minus the initial slope of the futures term structure, and we see that it does not have this predictability. Armed with these insights, we formulate our equilibrium model, which is based on the classical Vasicek Model, and has a single predictable factor. This model applies to forward rates with maturity beyond 13 years, and any interest rates with earlier maturity are irrelevant to the model. In our model, the forward rates mean revert with respect to the objectively realized probabilities, but not with respect to the risk neutral probabilities, and so the consequences of mean reversion are absent in the cross sectional shape, and the volatility term structure, of these forward rates.

Minute-by-minute dynamics of the Australian bond futures market in response to new macroeconomic information

This paper investigates the response efficiency of the 10 year Australian Commonwealth bond futures market to the news content of the Australian scheduled information release from January 1993 to July 1997. Using Money Market Services market expectations data to generate the news component of announcements, we find that the futures price falls in response to higher than expected current account deficit, inflation, GDP and retail sales announcements, whereas an unexpected rise in unemployment raised it. In addition to the price response, there is strong evidence of elevated volatility of the price and of trading volumes following all five news announcements. More importantly, most of the market adjustments (of price and volatility) to new information were completed during the first minute following each news announcement suggesting market efficiency of the Australian futures market. The trading volumes, on the other hand, continue to respond to news for 1 h following the news release. This suggests that, after the new equilibrium price has been quickly established and its volatility dispersed, volume trading persists for the purposes of portfolio re-balancing by liquidity traders and for establishing a complete consensus amongst traders.

The Dynamics of the Forward Interest Rate Curve with Stochastic String Shocks

This article offers a new class of models for the term structure of forward interest rates. We allow each instantaneous forward rate to be driven by a different stochastic shock, but constrain the shocks so that the forward rate curve is kept continuous. We term the shocks to the forward curve “stochastic string shocks,” and construct then as solutions to stochastic partial differential equations. This article offers a variety of parameterizations that can produce, with parsimony, any correlation pattern among forward rates of different maturities. We derive the no-arbitrage condition on the drift of forward rates shocked by stochastic strings and show how to price interest rate derivatives. Although derivatives can be easily priced, they can be perfectly hedged only by trading in an infinite number of bonds of all maturities. We show that the strings model is consistent with any panel dataset of bond prices, and does not require the addition of error terms in econometric models. Finally, we empirically calibrate some versions of the model and price the delivery option embedded in long bond futures. We show that the delivery option is much more valuable in string models than in a similar one-factor model. This is due to the greater variety of shapes of the term structure that string models can produce, which induces more changes in the cheapest-todeliver bond. In this article we develop a new class of bond pricing models. Our model is as parsimonious and tractable as the traditional Heath, Jarrow, and Morton (1992; hereafter HJM) model, but is capable of generating a much richer class of dynamics and shapes of the term structure of interest rates. Our main innovation consists in having each instantaneous forward rate driven by its own shock, while constraining these shocks in such a way as to keep the forward

Shock Effects on Stocks, Bonds, and Exchange Rates

Tick data and newswire searches are used to find events that led to large and rapid changes in a stock future, a bond future, and three exchange rate futures. Knowledge of these events may be useful in future work. They have the advantages that they are truly surprises and that the sign of their effect on each financial market is known. The events are used in this study to analyze the effects of three types of shocks on the five variables.

Intraday data and hedging efficiency in interest spread trading

Three government bond futures contracts and their respective 3-month interest rate futures contracts traded on LIFFE are examined. The data period covers three years of observations, January 1994-December 1996, sampled at half-hourly intervals. Borrowing from the calculation of minimum variance hedge ratios, half-hourly minimum variance spread ratios (the ratio of one contract to another, which provides the minimum variance) are estimated for the above contracts. The hypothesis under examination is whether there is any value-added in estimating minimum spread ratios based on intraday data. Three spread ratios are defined: two ratios calculated from daily data and a third one based on intraday data. Evidence tends to indicate that spread ratios calculated from intraday data exhibit a substantially lower variance than the other two spread ratio speciications. Thus, it is shown that intraday data, in comparison with daily data, allow for lower hedging costs. Moreover, the use of intraday-based spread ratios might be a contributing factor to reducing the maximum cumulative loss potentially incurred while holding a spread position.

Evidence on Risk/Return Patterns in Cash and Futures Markets

Active investment strategies at the asset–class level and at the security level have been criticized for being inconsistent with market efficiency. Futures and options–based systematic commodity trading advisor strategies have been further criticized on the basis that they trade in risky markets that do not offer a 9natural9 return. This article surveys some of the substantial and growing academic literature indicating that market inefficiencies may be a real source of returns to systematic commodity trading advisor investment strategies. Specifically, theory and empirical evidence on calendar effects, trends and reversals, and volatility patterns in returns in the stock, bond, and foreign currency cash and futures markets are discussed.

LEARNING SHORT-OPTION VALUATION IN THE PRESENCE OF RARE EVENTS

We extend the neural-network approach for the valution of financial derivatives developed by Hutchinson et al. [1] to the case of fat-tailed distributions of the underlying asset returns. We use a two-layer perceptron with three inputs, four hidden neurons, and one output. The input parameters of the network are: the simulated price of the underlying asset F divided by the strike price E, the time-to-maturity T, and the ratio |F-E|/T. The latter takes into account the volatility smile, whereas the price F is generated by the method of Gorenflo et al. [2] based on fractional calculus. The output parameter is the call price C over E. The learning-set option price C is computed by means of a formula given by Bouchaud and Potters [3, 4]. Option prices obtained by means of this learning scheme are compared with LIFFE option prices on German treasury bond (BUND) futures.

The Dynamics of the Forward Interest Rate Curve with Stochastic String Shocks

This paper offers a new class of models for the term structure of forward interest rates. We allow each instantaneous forward rate to be driven by a different stochastic shock, but constrain the shocks so that the forward rate curve is kept continuous. We term the shocks to the forward curve ``stochastic string shocks'', and construct them as solutions to stochastic partial differential equations. The paper offers a variety of parameterizations that can produce, with parsimony, any correlation pattern among forward rates of different maturities. We derive the no-arbitrage condition on the drift of forward rates shocked by stochastic strings and show how to price interest rate derivatives. Although derivatives can be easily priced, they can be perfectly hedged only by trading in an infinite number of bonds of all maturities. We show that the strings model is consistent with any panel dataset of bond prices, and does not require the addition of error terms in econometric models. Finally, we empirically calibrate some versions of the model and price the delivery option embedded in long bond futures. We show that the delivery option is much more valuable in string models than in a similar one-factor model. This is due to the greater variety of shapes of the term structure that string models can produce, which induces more changes in the cheapest-to-deliver bond.

Intraday periodicity, long memory volatility, and macroeconomic announcement effects in the US Treasury bond market

In this paper, we provide a detailed characterization of the return volatility in US Treasury bond futures contracts using a sample of 5-min returns from 1994 to 1997. We find that public information in the form of regularly scheduled macroeconomic announcements is an important source of volatility at the intraday level. Among the various announcements, we identify the Humphrey–Hawkins testimony, the employment report, the producer price index (PPI), the employment cost, retail sales, and the NAPM survey as having the greatest impact. Our analysis also uncovers striking long-memory volatility dependencies in the fixed income market, a finding with important implications for the pricing of long-term options and other related instruments.

Efficiency tests in the French derivatives market

The French derivatives market, the Marché à Terme International de France (MATIF) or the French International Futures and Options Exchange is one of the major derivatives markets in the world. The efficiency of four financial contracts traded on the MATIF-CAC40 Index Futures, ECU Bond Futures, National Bond Futures, and PIBOR 3-Month Futures are examined in this paper. Test results from serial correlations, unit root tests, and variance ratio tests provide overwhelming evidence that the random walk hypothesis cannot be rejected for these contracts.