Financial Markets Operations Management (10 page)

Closer examination of the contract specifications will show that there is no one particular bond designated as being the deliverable bond. The implication is that there is a choice of one or more bonds which meet the criteria to a certain extent.

In all probability there is no such bond that has a coupon rate as stated and with a maturity that fits within the timeline. The exchange overcomes this problem by publishing a list of bonds that would be suitable for any particular delivery month.

Take, for example, the June 2014 long gilt futures contract, remembering that the contract specifies a 4% coupon with a maturity from 8 years and 9 months out to 13 years. Therefore, for this particular contract, we are looking at an underlying security maturing from March 2023 to June 2027. NYSE LIFFE published its initial list of two deliverable gilts in September 2013,
⁸
with an update in March 2014.
⁹
The list now contains three securities:

• 2.25% Treasury bond due 7 September 2023;
  
• 2.75% Treasury bond due 7 September 2024; and
  
• 5.00% Treasury bond due 7 March 2025.
  

On occasion, there can be up to four or five different deliverable securities.

Questions now arise as to which of these three bonds would be delivered and at what price.

We saw from the contract specification that it is the seller who chooses when to deliver. In the case of the June 2014 contract, the seller can choose one of these three bonds. However, the delivered bond tends to be the one that has been calculated as the cheapest to deliver (CTD). We will look at CTD in the next section on futures pricing. From an Operations point of view, this is an example of a transformation from a derivative product into a cash market product. Normally, users tend to close out their long and short positions before the last date for trading, removing the need to deliver/receive against the contract.

The price at which the delivered bond is traded is dictated by the exchange and this price is known as the
exchange delivery settlement price
(EDSP). We will describe how the EDSP works in practice in Chapter 9: Derivatives Clearing and Settlement.

Futures contracts are priced using the same pricing convention as the underlying bond. At the same time, the underlying deliverable gilts are also similarly priced.

Listed in
Table 2.39
are the closing prices for the June 2014 contract together with the three underlying deliverable gilts.

Prices on futures contracts are regarded as being linear, meaning that if you buy a futures contract and the price goes up, you have an unrealised profit; if the price goes down, you have an unrealised loss (see
Figure 2.2
).

The reverse is true if you have a short futures position. If the price goes up, you lose and if the price goes down, you gain. This is approximately the same economic position as if you had purchased or sold the underlying asset (see
Figure 2.3
).

When you trade in the underlying asset, you are expected to settle the full economic value of the transaction almost straight away (e.g. T+3). Once settled, the legal contract is finalised and the original counterparty risk exposure removed. With derivatives such as a futures contract, the full economic value is not settled straight away. It will only be settled if and when the contract goes to delivery and if that happens, it will be several months away. This creates a counterparty risk exposure that would be unacceptable if it were not for the fact that a clearing house assumes the counterparty risk for the purchaser and for the seller (we refer to this as
novation
).

Until such time as the futures contract is either closed or delivered, both the buyer and the seller will reflect changes in the value of the contracts by a system known as
margin
. If a contract has gone up in value for a counterparty, the clearing house will credit that counterparty's account with the difference. Conversely, if a contract has gone down in value for a counterparty, the clearing house will debit that counterparty's account with the difference.

In effect, a counterparty is taking its profits and paying its losses on a day-by-day basis. This is in contrast with the underlying asset, where the profits or losses are not taken until the asset is either sold (from a long position) or purchased (for a short position).

For the June 2014 contract,
¹⁰
we have seen that there are three bonds that have been selected as deliverable. In order to make these bonds “look like” the 4% gilt, each gilt is given a price factor (PF). These PFs are fixed from the outset and do not change throughout the life of the contract. The PF for a gilt with a coupon less than 4% will be less than 1 and for a gilt with a coupon greater than 4%, the PF will be greater than 1. In the case of the three deliverable gilts, the PFs were stated as:

On exercise, the exchange will announce the exchange delivery settlement price (EDSP) and this is multiplied by the price factor. Accrued interest is then factored into the calculation:

This formula is valid for futures contracts that have one delivery date only; in the case of the long gilt future, the contract is deliverable on any business day in the delivery month. The formula must be adjusted to reflect interest that accrues to the delivery date chosen:

This can be restated as:

If we take the first of the three gilts and the EDSP is 110.66, then the invoicing amount on ten contracts will be GBP 963,901.83 for delivery 14 June 2014 (see
Table 2.40
).