Technical Note No.
1*
Options, Futures, and Other Derivatives
John Hull
Convexity Adjustments to Eurodollar Futures
In the Ho-Lee model the risk-neutral process for the short rate in the traditional
risk-neutral world is
dr = θ(t)dt + σ dz
where r is the instantaneous short rate, θ is a function of time, a and σ are constants, and
dz is a Wiener process. Define P (t, T ) as the price of a bond paying $1 at time T as seen
at time t. As explained in the text, the bond price has the form P (t, T ) = A(t, T )e−r(T −t) .
From Itô’s lemma the process for the bond price in a traditional risk-neutral world is
dP (t, T ) = r(t)P (t, T )dt − (T − t)σP (t, T ) dz
Define f (t, T1 , T2 ) as the forward rate (continuously compounded) at time t for the
period between T1 and T2 .
ln[P (t, T1 )] − ln[P (t, T2 )]
f (t, T1 , T2 ) =
T2 − T1
From Ito’s lemma the process followed by f (t, T1 , T2 ) is
σ 2 (T2 − t)2 − σ 2 (T1 − t)2
df (t, T1 , T2 ) = dt + σ dz
2(T2 − T1 )
The expected change in the forward rate between time zero and time T1 is determined by
integrating the coefficient of dt between 0 and T1 . It is σ 2 T1 T2 /2.
The forward rate equals the spot rate at time T1 . The expected value of the forward
rate at time T1 is therefore the expected value of the spot rate at time T1 . It follows that
the forward rate at time zero equals the expected spot rate minus σ 2 T1 T2 /2.
Because we are in the traditional risk-neutral world the expected value of the spot rate
is the same as the futures rate. The futures rate is therefore greater than the forward rate
by σ 2 T1 T2 /2 when both are expressed with continuous compounding. (There is a small
approximation here in that we know that the futures rate with quarterly compounding
equals the expected future spot rate with quarterly compounding. We assume that the
same is true when both both rates are converted continuous compounding.)
When converting the futures rate to the forward rate we should therefore subtract
σ 2 T1 T2 /2 from the futures rate. This is known as a convexity adjustment. As explained
in the text, there are actually two parts to the convexity adjustment:
1. The difference between a futures contract that is settled daily and a similar contract
that is settled entirely at time T1
2. The difference between the contract that is settled at time T1 and a similar contract
that is settled at time T2
To prove a corresponding result for the Hull-White model
dr = [θ(t) − ar] dt + σ dz
* c Copyright John Hull. All Rights Reserved. This note may be reproduced for use in
conjunction with Options, Futures, and Other Derivatives by John C. Hull.
1
we proceed similarly. The process for the bond price is
dP (t, T ) = r(t)P (t, T )dt − B(t, T )σP (t, T ) dz
where
1 − e−a(T −t)
B(t, T ) =
a
The result after crunching through similar but more involved math is that the convexity
adjustment is
B(T1 , T2 ) σ2
[B(T1 , T2 )(1 − e−2aT1 ) + 2aB(0, T1 )2 ]
T2 − T1 4a
This reduces to the earlier result when we take the limit as a tends to zero.