Government bonds futures

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. 

In this section we address the following questions regarding government bond futures ... 

Inside the Eurozone, the Spanish exchange MEFF Renta Fija in Barcelona offers a notional 10-year, 4% coupon Spanish government bond future and covers the 7.5-10.5-year cash market bond maturity range. It has a March, June, September, and December expiry cycle, a nominal contract value of 100,000, and a tick size of 1 basis point with a value of 10. The average open interest over the period 1 November 2002-29 November 2002 was relatively small at approximately 1,260. 

Consider the opposite scenario, bond yields are expected to fall substantially and in the near future. In this case, the fund manager will be seeking to extend the maturity or duration of the bond portfolio. However, instead of adopting a physical bond-switching strategy government bond futures will be used. Here is such a scenario ... 

As explained in Chapters 19 and 16, swaps and futures contracts represent one of the easiest and most effective methods of managing a portfolio s duration exposure. Government bond futures is a frequently traded and extremely liquid contract in Europe, and investors can buy futures to increase duration, and sell futures to reduce the duration of their portfolio incurring minimal transaction costs. 

Central banks and market practitioners use interest rates prevailing in the government bond market to extract certain information, the most important of which is implied forward rates. These are an estimate of the market s expectations about the future directirMi of short-term interest rates. They are important because they signify the market s expectafirMis about the future path of interest rates however, they are also used in derivative pricing and to create synthetic bond prices from the extent of credit spreads of corporate bonds. 

In a conventional positive yield curve environment, it is common for the 30-year government bond to yield say 10-20 basis points above the tlO-year bond. This might indicate to investors that a 100-year bond should yield approximately 20-25 basis points more than the 30-year bond. Is this accurate As we noted in the previous section, such an assumption would not be theoretically valid. Marshall and Dybvig have shown that such a yield spread would indicate an undervaluation of the very long-dated bond and that should such yields be available an investor, unless he or she has extreme views on future interest rates, should hold the 100-year bond. 

Government bond markets are closely related to other fixed income assets and interest rate and bond futures. This market is also increasingly related to the interest rate swap market. 

So, we have argued, the economics of supply and demand make the risk premium a slippery concept. Bond mathematics now makes matters worse. This new aspect centres on the issue of convexity. We know that a forward curve of implied future short-term nominal rates can be derived from the nominal government bond curve. In principle, a forward curve of implied future short-term real rates can be similarly derived from the inflation-linked bond real yield curve. These two curves, taken together, should imply a future path of inflation, if we can set aside the risk premium for the moment. Unfortunately, that is not the case. 

To answer these questions it is first necessary to take a step back and ask why are futures contracts on government bonds needed at all and, indeed, why do governments issue bonds in the first place ... 

A variation on these futures contracts based on German Government paper is offered by Euronext Paris—MATIF. Both the Euro Notional Future, which covers the 8.5-10.5 year section of the yield curve and the 30-year E-Bond Future which covers the 25-35 year segment, allow delivery of either French or German Government bonds into the contract on settlement. 

From the discussion above it is clear that the introduction of futures contracts on government bonds was strongly motivated by the need to hedge against increased market volatility. This remains one of the main functions of these instruments. The existence of bond futures, though, attract other desirable, indeed essential players, into the market place ... 

The contract specification of the Euro-Bund bond future introduces a concept of a notional bond. This is also true for all other bond futures contracts. For example, in the case of the UK gilt, the description of the futures contract bond is a 10-year gilt with a 7% coupon for the Euro-Bund future it is a 10-year German government bond with a 6% coupon the Spanish bond (bonos) future is a Spanish Government bond with a 4% coupon, and so on. 

Options on Euro-BOBL futures (OGBM). The BOBL future is exactly like the BUND, except that the remaining maturity of the German Government bond is between 4.5 and 5.5 years, and is therefore a medium-term contract. 

Althongh an option into a future sounds somewhat esoteric, each contract is effectively an option on 100,000 of German government bonds carrying a 6% coupon of the appropriate maturity. 

A rise in interest rates increases the value of most call options. For stock options, this is because the equity markets view a rate increase as a sign that share price growth will accelerate. Generally, the relationship is the same for bond options. Not always, however, since in the bond market, rising rates tend to depress prices, because they lower the present value of future cash flows. A rise in interest rates has the opposite effect on put options, causing their value to drop. The risk-free interest rate applicable to a bond option with a term to expiry of, say, three months is a three-month government rate—commonly the government bond repo rate for bond options, usually the T-bill rate for other types. 

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. 

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