Advanced Fixed Income

Course Objectives

Understand different variations Construct these hypothetical Fit yield curves based on a series
of yield curves (e.g., Par, Spot, and yield curves using bootstrapping of yield observations
Forward yield curves)

Learn how to tell if a bond is rich Understand bond futures and

or cheap using Cheap-Rich how to determine which bond is
Analysis the most economical to deliver

Corporate Finance Institute®

Constructing Yield Curves
 Yield Curves

Yield curves capture the current yields of an issuer

One Different Existing Security

Issuer Yield Currency Maturities Trading

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 Yield Curves

Current
Funding
Cost

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 Yield Curves

Yield curves help inform our understanding of

General Shape Performance Comparison

Normal Flat

Historical Absolute and Relative

Inverted Humped

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 Yield Curves

Yield Curve Over Time Different Credit Ratings

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 Bond Yields

Drawbacks of using curves in all situations

01 Linear interpolations between points

without statistical curve-fitting 02 Yield-to-maturity yield curve

Bond Z
Issuer Curve
Bond Y
YTM

‘Theoretical 7-yr Bond’

Interpolation of Bonds Y and Z

Bond X
Maturity
(years)
1 5 10

Corporate Finance Institute®

 Bond Yields

Yield-to-
One constant rate % that each bond coupon is re-invested at
Maturity

CPN CPN CPN CPN P + CPN

PV = + + + + …+
0.5 1 1.5 2 20
1+YTM 1+YTM 1+YTM 1+YTM 1+YTM

YTM
Reinvestment 10
Risk year
1
S.A. 2%

All 20 Semi- Reinvested Prevent Value

Annual Coupons at 2% of Bond

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 Zero-Coupon Yield Curve

Hypothetical curve comprised Zero-coupon, Zero,

of zero-coupon instruments or Spot Curve
Zero-coupon
yield curve
10 1 20 zero-coupon
year S.A. Instruments

Most accurate way of

YTM (%)
discounting cash flows

Unique rate for each time

period vs. one constate rate $101 for
(e.g., YTM) $1 semi-annually for Year 10
each year 1 to 9.5
Maturity
(Years)
10 20

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 Zero-Coupon Yield Curve

US Zero / Spot Value Risk-

Treasuries Curve Free Cashflow

Zeros STRIPS

Constructing a curve from another set of rates is called Bootstrapping.

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 Other Yield Curves

01 Par Yield
Curves
Plots YTM against tenor for bonds trading at, or very close to, par

Rare to find a complex of

bonds trading at par
E.g., BDL Corp. Par bonds
Bonds priced
Term Coupon Price YTM
at par Bootstrap non-par yields
1 0.10% $100.00 0.10% into zero-coupon yield
3 0.20% $100.00 0.20% curves

5 0.40% $100.00 0.40%

7 0.65% $100.00 0.65% Hypothetical Par Yield
Curve
Coupon = YTM 10 0.90% $100.00 0.90%
20 1.45% $100.00 1.45%
Used by the debt-capital
markets

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 Other Yield Curves

02 Coupon Yield
Curves
Plot of YTMs against term-to-maturity for a group of bonds
with the same coupon
YTM (%)

Similar
coupons

Finding a group of bonds with the same coupon

along the entire term structure is rare.

Maturity
(years)
10 20

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 Significance of Hypothetical Curve

01 Pricing Spread
Products
Referenced relative to the US Treasury curve

US Treasuries • Priced over a benchmark US Treasury

• Sometimes quoted on a Z-spread basis
• Risk-free Spread
• Cash instrument Products
• Little to no
counterparty risk

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 Significance of Hypothetical Curve

02 Pricing and Valuing Interest

Rate Derivatives
E.g., Spot Curve

• Initial rate at start of • After trade monitoring

transaction • Mark-to-market (MTM)
• Initial value is zero
Pricing Valuing

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 Significance of Hypothetical Curve

02 Pricing and Valuing Interest

Rate Derivatives
USSW<GO>

Fixed-to-Floating Interest Rate

Swap

Pay Receive
Fixed Fixed
Receive Pay
Floating Floating

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 Significance of Hypothetical Curve

02 Pricing and Valuing Interest

Rate Derivatives
USSW<GO>

Fixed-to-Floating Interest Rate

Swap

Pay Receive
Fixed Fixed
Receive Pay
Floating Floating

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 Significance of Hypothetical Curve

02 Pricing and Valuing Interest

Rate Derivatives
SWPM<GO>

1 Based on swap curve

2 Defining floating rate every 3 months

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 Significance of Hypothetical Curve

02 Pricing and Valuing Interest

Rate Derivatives

Rate Comparison

Annuity Calculation

Present Value Calculation

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 Significance of Hypothetical Curve

03 Infer Forward Curves

Varying Notional Delayed

Amounts Start Dates

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 Bootstrapping

Constructing a zero-coupon curve from a series of coupon-bearing products

Bootstrapping

Input for… Input for…

In theory Calculation A Calculation B Calculation C

In practice Seldom straightforward

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 Bootstrapping Example – 1-Year Discount Note

Formula:

1
PV = FV x
(1 + i ) n
Term: 1 year

Par Value: $100.00 1

99.875 = 100.00 x
(1 + i ) 1
Current Price: $99.875

Yield (YTM): ?
100.00
i = YTM = −1 = 0.0012516 = 12.516bps
99.875

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 Bootstrapping Example – 1-Year Discount Note

Investment
Yearn Returns in Yearn YTM Discount Factor
Today
1 $99.875 $100.00 0.12516% ?

Formula:

1
PV = FV x
(1 + i ) n

1 Discount factor =
99.875 = 100.00 x
(1 + i ) 1 0.99875

Corporate Finance Institute®

 Bootstrapping Example – 2-Year Bond

Cash Discount Zero

Today Year
Flow Rate Rate

$100.15 0 -$100.15

$0.2497 1 +$0.25 0.99875 0.12516%

Term: 2 years $99.9003 2 +$100.25 0.99651 0.17487%

Par Value: $100.00

Formula:
Current Price: $100.15

Coupon Rate: 0.25% Coupon Principal + Coupon

PV = +
(1 + Z1) 1 (1 + Z2) 2
Zero Rate 2: ?

0.25 100 + 0.25

100.15 = +
(1 + 0.12516%) 1 (1 + Z2) 2

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 Bootstrapping a Swap Curve

Interest Rate Swap (IRS) Hypothetical Spot Curve Reference Index

Rates

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 Bootstrapping a Swap Curve

Swap Rate
Discount
Tenor (Quarterly Pay, Bootstrapped Rate Forward Rate
Factor
30/360 Day Count)

3 months 0.200% 0.200%

6 months 0.443% Spot0x6

9 months 0.659% Spot0x9

12 months 0.865% Spot0x12

15 months 1.076% Spot0x15

18 months 1.299% Spot0x18

21 months 1.458% Spot0x21

24 months 1.545% Spot0x24

Corporate Finance Institute®

 Bootstrapping a Swap Curve

Swap Rate
Discount
Tenor (Quarterly Pay, Bootstrapped Rate Forward Rate
Factor
30/360 Day Count)
Current
3M LIBOR 3 months 0.200% 0.200%

6 months 0.443% Spot0x6

9 months 0.659% Spot0x9

12 months 0.865% Spot0x12

15 months 1.076% Spot0x15

18 months 1.299% Spot0x18

21 months 1.458% Spot0x21

24 months 1.545% Spot0x24

Corporate Finance Institute®

 Bootstrapping a Swap Curve

Swap Rate
Discount
Tenor (Quarterly Pay, Bootstrapped Rate Forward Rate
Factor
30/360 Day Count)

3 months 0.200% 0.200%

6 months 0.443% Spot0x6

9 months 0.659% Spot0x9

At-market
IRS rates 12 months 0.865% Spot0x12

15 months 1.076% Spot0x15

18 months 1.299% Spot0x18

21 months 1.458% Spot0x21

24 months 1.545% Spot0x24

Corporate Finance Institute®

 Bootstrapping a Swap Curve

Swap Rate
Discount
Tenor (Quarterly Pay, Bootstrapped Rate Forward Rate
Factor
30/360 Day Count)

3 months 0.200% 0.200%

6 months 0.443% Spot0x6 ?

9 months 0.659% Spot0x9

12 months 0.865% Spot0x12

15 months 1.076% Spot0x15

18 months 1.299% Spot0x18

21 months 1.458% Spot0x21

24 months 1.545% Spot0x24

3-month LIBOR rate as a Swap rate curve can also be called

hypothetical coupon a par yield curve

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 Bootstrapping a Swap Curve - Spot 0x6

Coupon Principal + Coupon

PV = +
1 2
1 + Z1 1 + Z2

0.443 0.443
100 +
100.00 = 4 + 4
0.0020 1 Spot0x6
2
1+ 1+
4 4

Corporate Finance Institute®

 Bootstrapping a Swap Curve - Spot 0x6

Coupon Principal + Coupon

PV = +
1 2
1 + Z1 1 + Z2

0.443 0.443
100 +
100.00 = 4 + 4
Spot 0x6 = 0.443%
0.0020 1 Spot0x6
2
1+ 1+
4 4

Corporate Finance Institute®

 Bootstrapping a Swap Curve - Spot 0x9

Swap Rate
Discount
Tenor (Quarterly Pay, Bootstrapped Rate Forward Rate
Factor
30/360 Day Count)

3 months 0.200% 0.200%

6 months 0.443% Spot0x6 0.443%

9 months 0.659% Spot0x9 ?

12 months 0.865% Spot0x12

15 months 1.076% Spot0x15

18 months 1.299% Spot0x18

21 months 1.458% Spot0x21

24 months 1.545% Spot0x24

Corporate Finance Institute®

 Bootstrapping a Swap Curve - Spot 0x9

Coupon Coupon Principal + Coupon

PV = + +
1 + Z1 1 1 + Z2 2 1 + Z3 3

0.659 0.659 100 + 0.659

100.00 = 4 + 4 + 4 Spot 0x9 = 0.659%
1 2 3
1+ 0.0020 1+ 0.00443 Spot
4 4 1+ 0x9
4

Corporate Finance Institute®

 Bootstrapping a Swap Curve - Spot 0x12

Swap Rate
Discount
Tenor (Quarterly Pay, Bootstrapped Rate Forward Rate
Factor
30/360 Day Count)

3 months 0.200% 0.200%

6 months 0.443% Spot0x6 0.443%

9 months 0.659% Spot0x9 0.659%

12 months 0.865% Spot0x12 ?

15 months 1.076% Spot0x15

18 months 1.299% Spot0x18

21 months 1.458% Spot0x21

24 months 1.545% Spot0x24

Corporate Finance Institute®

 Bootstrapping a Swap Curve - Spot 0x12

Coupon Coupon Coupon Principal + Coupon

PV = + + +
1 + Z1 1 1 + Z2 2 1 + Z3 3 1 + Z4 4

0.865 0.865 0.865 100 + 0.865

100.00 = 4 + 4 + 4 + 4 Spot 0x12 = 0.866%
1 2 3 4
1+ 0.0020 1+ 0.00443 1+ 0.00659 Spot
4 4 4 1+ 0x12
4

Corporate Finance Institute®

 Bootstrapping a Swap Curve

Swap Rate
Discount
Tenor (Quarterly Pay, Bootstrapped Rate Forward Rate
Factor
30/360 Day Count)

3 months 0.200% 0.200%

6 months 0.443% Spot0x6 0.443%

9 months 0.659% Spot0x9 0.659%

12 months 0.865% Spot0x12 0.866%

15 months 1.076% Spot0x15 1.078%

18 months 1.299% Spot0x18 1.303%

21 months 1.458% Spot0x21 1.464%

24 months 1.545% Spot0x24 1.552%

Corporate Finance Institute®

 Discount Factors

1 1
The 0x3 Month DF0X3 = = = 0.999500
1
Spot0X3 0.002 1
Discount Factor 1+ 1+
4 4

1 1
The 0x6 Month DF0X6 = = = 0.997788
2
Discount Factor Spot0X6 0.00443 2
1+ 1+
4 4

1 1
The 0x9 Month DF0X9 = = = 0.995070
3
Discount Factor Spot0X9 0.00659 3
1+ 1+
4 4

Corporate Finance Institute®

 Discount Factors

Swap Rate
(Quarterly
Tenor Bootstrapped Rate Discount Factor Forward Rate
Pay, 30/360
Day Count)

3 months 0.200% 0.200% DF0x3 0.999500

6 months 0.443% Spot0x6 0.443% DF0x6 0.997788

9 months 0.659% Spot0x9 0.659% DF0x9 0.995070

12 months 0.865% Spot0x12 0.866%

15 months 1.076% Spot0x15 1.078%

18 months 1.299% Spot0x18 1.303%

21 months 1.458% Spot0x21 1.464%

24 months 1.545% Spot0x24 1.552%

Corporate Finance Institute®

 Discount Factors

Swap Rate
(Quarterly pay,
Tenor Bootstrapped Rate Discount Factor Forward Rate
30/360 day
count)

3 months 0.200% 0.200% DF0x3 0.999500

1
6 monthsQuick way of discounting
0.443% Spot0x6 cash0.443%
flow DF0x6 0.997788

9 months 0.659% Spot0x9 0.659% DF0x9 0.995070

2 Calculating
12 months forwardSpot
0.865% yield
0x12 curves
0.866% DF0x12 0.991385

15 months 1.076% Spot0x15 1.078% DF0x15 0.986630

18 months 1.299% Spot0x18 1.303% DF0x18 0.980674

21 months 1.458% Spot0x21 1.464% DF0x21 0.974755

24 months 1.545% Spot0x24 1.552% DF0x24 0.969504

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 Forward Yield Curve

ED Future contracts ≠ LIBOR forward curve

Different
01 02 03
Convexities Settlement Mark-to-market

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 Naming Convention

Constructing forward curve from bootstrapped spot rates or discount factors

Spot Rate 0X12

Spot Rate 0X9

Forward Rate 9X12

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 Forward Rate

Spot0X6
1+
4
2
1 + 0.00443 2
4
= −1 X4= − 1 X 4 = 0.686%
1+
Spot0X3 1 1 + 0.00200 1
4 4
The 3x6 Month Implied
Forward Rate Formula

DF0x3 0.99950
= −1 X4 = − 1 X 4 = 0.686%
DF0x6 0.997788

Corporate Finance Institute®

 Finding Forward Rates

Swap Rate
(Quarterly
Tenor Bootstrapped Rate Discount Factor Forward Rate
Pay, 30/360
Day Count)

3 months 0.200% 0.200% DF0x3 0.999500

6 months 0.443% Spot0x6 0.443% DF0x6 0.997788 FR3x6 0.686%

9 months 0.659% Spot0x9 0.659% DF0x9 0.995070 FR6x9 1.093%

12 months 0.865% Spot0x12 0.866% DF0x12 0.991385 FR9x12 1.487%

15 months 1.076% Spot0x15 1.078% DF0x15 0.986630 FR12x15 1.928%

18 months 1.299% Spot0x18 1.303% DF0x18 0.980674 FR15x18 2.429%

21 months 1.458% Spot0x21 1.464% DF0x21 0.974755 FR18x21 2.429%

24 months 1.545% Spot0x24 1.552% DF0x24 0.969504 FR21x24 2.166%

Corporate Finance Institute®

 Proving Spot vs. Spot and Forward

T=0 T=2

Investing money for 2 years at the

spot 2-year rate

≠ Arbitrage
Opportunities
T=0 T=1 T=2

Investing money Entering into a

at the spot 1-year 1x2 forward
rate

Corporate Finance Institute®

 Proving Spot vs. Spot and Forward

1
0.443% 1 100.1107 × 1 +
0.443%
=
Interest = 100 × =
4 4
00.1107 = 11.07 cents 100.2217

T=0 T = 3 months T = 6 months

Investing $100 at the six-month spot rate

(Spot0x6)

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 Proving Spot vs. Spot and Forward

1
0.200% 1 100.05 × 1 +
0.686%
=
Interest = 100 × =
4 4
00.5 = 5 cents 100.2217

T=0 T = 3 months T = 6 months

Investing money at 3- Entering into a 3x6

month spot rate forward

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 Curves Graphing

Forward Curve
Spot Curve
Par Curve
Par Curve
Spot Curve
Forward Curve

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 Using the Forward Curve to Value Derivatives

$100 million USD notional quarterly settled fixed-to-floating interest rate swap

2%

Swap Payer 0.865% Swap Receiver

2.0% − 0.865%
Cash difference of quarterly payments = × $100,000,000 = $283,750.00
4

$283,750 $283,750 $283,750 $283,750

MTM value = + + + = $1,130,390.45
1 2 3 4
1 + 0.00200 1 + 0.00443 1 + 0.00659 1 + 0.00866
4 4 4 4

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 Valuing Derivatives

MTM value ≠ Unwind Price

Including all the necessary consideration for counterparty

credit. e.g., type of documentation or funding cost

• Moving away from LIBOR and towards other benchmarks.

e.g., using OIS (overnight index swaps)
• Same bootstrapping process regardless of rate index

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Fitting Yield Curves &
Cheap-Rich Analysis
 Fitting

Yield curve Dots plot that represents the market yields of a group of similar bonds

Fitting Zero error

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 Polynomial vs. Spline Fitting

• Y = aX + b, a first-degree polynomial

• Y = X2 , a second-degree polynomial (parabola)

• Cubic polynomial, a third-degree polynomial
Polynomial • N degree means N-1 turning points.
fitting • Polynomial wiggle is the drawback.

• Curve fit
• Bette interpolation
• Extrapolate beyond the end
Spline fitting • Cubic spline

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 Purpose of Fitted Curve

Pricing & Forecasting Central Bank Taking

Valuation Data Point Advantage of
Mispricing

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 Relative Value –Cheap/Rich Analysis

Construct a curve from current and off-the-run securities

Finding Relative
Giving an implied yield
Value

Estimating rich or cheap bonds

+ : cheap

Residual = Traded yield – Modeled yield

− : rich

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 Relative Value –Cheap/Rich Analysis

Statistical interpretation of the data using a Z-score and the concept of mean reversion

Modeled Yield
Greater Residual
Traded Yield

More attractive bond

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 Relative Value –Cheap/Rich Analysis

Statistical interpretation of the data using a Z-score and the concept of mean reversion

Modeled Yield
Greater Residual
Traded Yield

Buy over +1.5 & sell under

-1.5 standardized residuals

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 Relative Value –Cheap/Rich Analysis

Statistical interpretation of the data using a Z-score and the concept of mean reversion

Modeled Yield
Cheap/Rich Model
Traded Yield

Warning: Idiosyncratic risk

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 Bloomberg GOVY Screen

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 Bloomberg GOVY Screen

Current, old and,

double-old US
Treasuries

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 Bloomberg GOVY Screen

Spline fitting technique

Sorted by maturity over

a 3-month observation
period

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 Bloomberg GOVY Screen

Cubic spline yield fitting

model

Sorted by the highest z-

score

30-year Treasury bond is

the cheapest security

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 Bloomberg GOVY Screen

Cubic spline yield fitting

model

Sorted by the highest z-

score

30-year Treasury bond is

the cheapest security

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 Relative Value –Cheap/Rich Analysis

Cheap-rich analysis of the front end of the curve (2–3-year sector at the time of the report)

Source: TD Securities
As of May 16th , 2017

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 Relative Value –Cheap/Rich Analysis

Sell

Buy Butterfly Strategy

Sell
Source: TD Securities
As of May 16th , 2017

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 Limitations

01 Trading OTC products depends on the inventory or appetite for the bond.

02 Not easy or cheap to borrow

03 Impacts of new issuance

04 Technicals become more exaggerated further down the credit curve.

05 Based on mean-reversion

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 Bond Futures &
The Cheapest-to-Deliver
 Government Bond Futures Contract

CBOT Treasury Futures Contract Details

Cheapest-to-deliver
(CTD)

Government bond
futures

US Treasury market is
the most liquid

Source: CME group

Corporate Finance Institute®

 Government Bond Futures Contract

CBOT Treasury Futures Contract Details

Cheapest-to-deliver
(CTD)

Government bond
futures

US Treasury market as
the most liquid

Source: CME group

Corporate Finance Institute®

 Government Bond Futures Contract

CBOT Treasury Futures Contract Details

Cheapest-to-deliver
(CTD)

Government bond
futures

US Treasury market as
the most liquid

Source: CME group

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 Government Bond Futures Contract

Corporate Finance Institute®

 Government Bond Futures Contract

Contract size

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 Government Bond Futures Contract

Tick value

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 Government Bond Futures Contract

Contract listing
month

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 Government Bond Futures Contract

Maturity

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 Government Bond Futures Contract

Delivery Date Liquidity Physical Delivery

First day of the month Most liquidity is in the first Deliverable basket
few contracts

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 Delivery

Treasury Future Contract Summary

Source: CME group

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 Delivery

Treasury Future Contract Summary

Source: CME group

Corporate Finance Institute®

 Delivery

Treasury Future Contract Summary

Source: CME group

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 Delivery

Physical Bond
Choosing among deliverable bonds

Short Position Long Position

Specified Invoice Price

Cheapest-to-deliver Selecting most cost-efficient bonds in the deliverable basket

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 Delivery

01 Imaginary 6% Notional Bond Coupon on delivered bond Conversion factor

02
>6% >1
Conversion Factor
6% =1

03 Cheapest-to-Deliver <6% <1

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 Conversion Factor

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 Conversion Factor

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 Conversion Factor

August 2027 note value ~ 80% of 6%, 10-year note value

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 Conversion Factor

Coupon
Conversion Factor = α × +c+d −b
2

Remaining maturity of the note

Dec 01, Aug 15,
2020 2027
2021 2022 2023 2024 2025 2026

6 years, 8 months,
and 14 days

Corporate Finance Institute®

 Conversion Factor

Ywhole: The number of whole years from the first day of the delivery month to the
maturity (or call) date of the bond or note

Remaining maturity of the note

Dec 01, Aug 15,
2020 2027
2021 2022 2023 2024 2025 2026

Ywhole = 6 6 years, 8 months,

and 14 days

Corporate Finance Institute®

 Conversion Factor

Ywhole: The number of whole years from the first day of the delivery month to the
maturity (or call) date of the bond or note

10-year/ 30-year bond futures: rounded down to the nearest quarter

Mwhole:
2/3/5-year contracts: rounded to the nearest month

Remaining maturity of the note

Dec 01, Aug 15,
2020 2027
2021 2022 2023 2024 2025 2026

6 years, 8 months, Mwhole = 6

and 14 days

Corporate Finance Institute®

 Conversion Factor

Ywhole: The number of whole years from the first day of the delivery month to the
maturity (or call) date of the bond or note

10-year/ 30-year bond futures: rounded down to the nearest quarter

Mwhole:
2/3/5-year contracts: rounded to the nearest month

Mwhole: if Mwhole < 7

V: 3: if Mwhole ≥ 7 (for TY, US, and UB)

Mwhole – 6: if Mwhole ≥ 7 (for TU, 3YR, and FV)

Remaining maturity of the note

Dec 01, Aug 15,
2020 2027
2021 2022 2023 2024 2025 2026

6 years, 8 months,
and 14 days

Corporate Finance Institute®

 Conversion Factor

2 × Ywhole
1
= 0.701380
1.03
Coupon
Conversion Factor = α × +c+d −b
2

V
1 6
= 0.970874 Coupon of Our Actual Bond 6−V
1.03 × =0
2 6

Actual Coupon
× 1 − C = 0.111983
0.06

Corporate Finance Institute®

 Conversion Factor

Coupon
Conversion Factor = α × +c+d −b
2

= 0.8006

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 Conversion Factor

[Link]/trading/interest-rates/us-treasury-futures-
[Link]

Market data provider: e.g., Bloomberg or EIKON

Trade Date Settlement Date Delivery Date

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 Invoice Amount

Principal Invoice Amount = Futures Price x Conversion Factor (CF) x Futures Notional

(e.g., $1,000 or $2,000

depending on contract)

Corporate Finance Institute®

 Calculating Invoice Amounts

T2.25% 08/15/2027

Principal Invoice Amount = Futures Price x Conversion Factor (CF) x Futures Notional

= 138.656250 x 0.8006 x $1000

= $111,008.19

Corporate Finance Institute®

 Calculating Invoice Amounts

T0.625% 05/15/2030

Principal Invoice Amount = Futures Price x Conversion Factor (CF) x Futures Notional

= 138.656250 x 0.6226 x $1000

= $86,327.38

Corporate Finance Institute®

 Comparing Principal Invoice Amounts

Treasury Note T 2.25% Aug 15, 2027 T 0.625% May 15, 2030
Futures Price 138-21 138-21
CF 0.8006 0.6226
Futures Notional X$1,000 X$1,000
Principal Invoice Amount $111,008.19 $86,327.38
Cash Price of Treasury Note 111-11+ 98-19¼
Cash Amount ($100k Notional) ($111,359.38) ($98,601.56)
Delivery Gain or (Loss) ($351.18) ($12,274.18)

Corporate Finance Institute®

 Comparing Principal Invoice Amounts

Treasury Note T 2.25% Aug 15, 2027 T 0.625% May 15, 2030
Futures Price 138-21 138-21
CF 0.8006 0.6226
Futures Notional X$1,000 X$1,000
Principal Invoice Amount $111,008.19 $86,327.38
Cash Price of Treasury Note 111-11+ 98-19¼
Cash Amount ($100k Notional) ($111,359.38) ($98,601.56)
Delivery Gain or (Loss) ($351.18) ($12,274.18)

Corporate Finance Institute®

 Comparing Principal Invoice Amounts

Treasury Note T 2.25% Aug 15, 2027 T 0.625% May 15, 2030
Futures Price 138-21 138-21
CF 0.8006 0.6226
Futures Notional X$1,000 X$1,000
Principal Invoice Amount $111,008.19 $86,327.38
Cash Price of Treasury Note 111-11+ 98-19¼
Cash Amount ($100k Notional) ($111,359.38) ($98,601.56)
Delivery Gain or (Loss) ($351.18) ($12,274.18)

Corporate Finance Institute®

 Comparing Principal Invoice Amounts

Treasury Note T 2.25% Aug 15, 2027 T 0.625% May 15, 2030
Futures Price 138-21 138-21
CF 0.8006 0.6226
Futures Notional X$1,000 X$1,000
Principal Invoice Amount $111,008.19 $86,327.38
Cash Price of Treasury Note 111-11+ 98-19¼
Cash Amount ($100k Notional) ($111,359.38) ($98,601.56)
Delivery Gain or (Loss) ($351.18) ($12,274.18)

Corporate Finance Institute®

 Comparing Principal Invoice Amounts

Treasury Note T 2.25% Aug 15, 2027 T 0.625% May 15, 2030
Futures Price 138-21 138-21
CF 0.8006 0.6226
Futures Notional X$1,000 X$1,000
Principal Invoice Amount $111,008.19 $86,327.38
Cash Price of Treasury Note 111-11+ 98-19¼
Cash Amount ($100k Notional) ($111,359.38) ($98,601.56)
Delivery Gain or (Loss) ($351.18) ($12,274.18)

Corporate Finance Institute®

 Comparing Principal Invoice Amounts

Treasury Note T 2.25% Aug 15, 2027 T 0.625% May 15, 2030
Futures Price 138-21 138-21
CF 0.8006 0.6226
Futures Notional X$1,000 X$1,000
Principal Invoice Amount $111,008.19 $86,327.38
Cash Price of Treasury Note 111-11+ 98-19¼
Cash Amount ($100k Notional) ($111,359.38) ($98,601.56)
Delivery Gain or (Loss) ($351.18) ($12,274.18)

Corporate Finance Institute®

 Futures/Cash Basis

Gross Basis = Cash Price − Adjusted Futures Price

Adjusted Futures Price = Futures Price × Conversion Factor

Treasury Note T 2.25% Aug 15, 2027 T 0.625% May 15, 2030
Cash Price of Treasury Note $111-11+ $98-19¼
Futures Price $138-21 $138-21
CF 0.8006 0.6226
Adjusted Futures Price $111.0081938 or ~$111-00¼ $86.32738125 or ~$86-10+
Gross Basis (32nds) ~11¼ ~12-8¾ or ~392¾

Corporate Finance Institute®

 Futures/Cash Basis

Sell-the-Basis Buy-the-Basis

Yields > 6% ; bias for longer-duration cash securities being CTD

Conversion Factor Biases

Yields < 6% ; bias for shorter-duration instruments to be CTD

Corporate Finance Institute®

 Implied Repo Rate

Corporate Finance Institute®

 Implied Repo Rate

Corporate Finance Institute®

 Implied Repo Rate

Basis alone will not identify which security is cheapest-to-deliver due to the cost of bond delivering

Buying the cash bond on the settlement date

Implied Repo Rate Delivering the cash bond on the last delivery date

Accounting for the accrued interest of the cash bond

Carry is the benefit of a position versus the costs associated with holding
that same position.

Corporate Finance Institute®

 Implied Repo Rate

[Adjusted futures price + AIend + IC – (Cash Price + AIbeg)] X Day Countyear

Implied Repo Rate =
D1 X (Cash Price + AIbeg) – (IC x D2)

• AIbeg: Accrued interest of bond/note at beginning of trade (e.g.,

Settlement date)
• AIend: Accrued interest of bond/note at end of trade (e.g., Delivery
date)
• IC: Interim coupon (any coupon that falls between the settlement
date and the delivery date)
• Day Countyear: The number of days in a year based on bond day
count
• D1: Number of days between settlement and actual delivery
• D2: Number of days between interim coupon and bond delivery

Corporate Finance Institute®

 Implied Repo Rate Example

Corporate Finance Institute®

 Implied Repo Rate Example

Corporate Finance Institute®

 Implied Repo Rate Example

Corporate Finance Institute®

 Implied Repo Rate Example

Treasury Note T 0.625% May 15, 2030

Cash Price of Treasury Note $111-11+
Futures Price $138-21
CF 0.6226
Adjusted Futures Price $86.32738125 or ~86-10+
Gross Basis (32nds) ~392¾ Implied Repo Rate =
AIbeg 0.28023 -68.27595%
AIend 0.07942
IC 0.625/2 = 0.3125
Day Countyear 360
D1 65 days (Oct 27, 2020 to Dec 31, 2020)
D2 46 days (Nov 15, 2020 to Dec 31, 2020)

Corporate Finance Institute®

 Implied Repo Rate Example

Corporate Finance Institute®

 Implied Repo Rate Example

Corporate Finance Institute®

 Net Basis

Gross Basis = Cash Price - Adjusted Futures Price

Net Basis = Gross Basis - Carry

Carry = Coupon Income - Financing Costs

Corporate Finance Institute®

 Net Basis

Gross Basis = Cash Price - Adjusted Futures Price

Net Basis = Gross Basis - Carry

Carry = Coupon Income - Financing Costs

Coupon Income = AIend – AIbeg + IC

Financing Costs = (Cash Price + AIbeg) X Actual Repo Rate X (D1/Day Countyear)

Corporate Finance Institute®

 Net Basis Example

Corporate Finance Institute®

 Net Basis Example

Treasury Note T 0.625% May 15, 2030 Coupon Interest of

Cash Price of Treasury $111-11+ 11.169 cents
Note
Adjusted Futures Price $86.32738125 or ~86-10+
Gross Basis (32nds) ~392¾
Finance Cost of
AIbeg 0.28023
2.178 cents
AIend 0.07942
IC 0.625/2 = 0.3125
Day Countyear 360
D1 65 days (Oct 27, 2020 to Dec Carry Cost or Benefit of
31, 2020) 8.99 cents

Corporate Finance Institute®

 Net Basis Example

Corporate Finance Institute®

 Net Basis Example

3 ticks

Corporate Finance Institute®

 Net Basis Example

Corporate Finance Institute®

 Net Basis Example

Arbitrage Opportunities……

Buying Note
Delivering Futures
Selling Futures

Borrowing Cash Paying Back Loan

Pledging Note Getting Back Collateral

Corporate Finance Institute®

 Basis Optionality

Cash and Futures Mispricing…

Wildcard End-of-Month
Quality Option Timing Option
Option Option

Corporate Finance Institute®