European bond futures contracts

Questions such as the uses to which European bond futures can be put, contract specifications and trading volumes are discussed with illustrative examples. Technical issues, which surround the use of bond futures, are also examined and presented with numerical examples. The issues include the calculation of gross and net basis, identifying the cheapest-to-deliver (CTD) cash market bond, different approaches to measuring relative volatility, calculating hedge ratios, and portfolio duration adjustment. Bloomberg screen output is used to provide a real world flavour to the topics covered. 

The Bund future was launched on 29 September 1988. With the introduction of the German government bond futures contract LIFFE was now trading bond contracts in the US Treasury bond, the Japanese government bond, the Italian government bond and UK gilts. It was the first financial futures exchange to have achieved this position. The contract specifications on the UK and European bond futures offered at that time appear in Exhibit 16.1. 

For descriptions and analyses of bond futures contracts, basis, implied repo, and the cheapest-to-deliver bond, see Burghardt et al. (1994). Fiona (1996) is a readable treatment of the European government bond basis. 

The above examples have focused on the use of the Euro-Bund future as a vehicle for achieving a particular bond portfolio exposure. As indicated earlier, there are several other futures contracts available in the European arena and these could be used in the same way as described above. The futures contracts could also be used to alter the maturity characteristics of the portfolio by using, for example, futures contracts constructed around shorter or longer dated instruments than those currently held in the portfolio. The fact that the contracts can be bought or sold on margin, that the major contracts are liquid and span the European markets, and their flexibility of use make them essential financial market instruments. 

Bonds are traded generally over the counter. Futures contracts on bonds may be more liquid and may remove some of the modelling difficulties generated by the known value at maturity of the bonds. Hedging may be more efficient in this context using the futures contracts on pure discount bonds (provided they are liquid) rather than the bonds themselves. Chen provides closed-form solutions for futures and European futures options on pure discount bonds, under the Vasicek model. 

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