To employ futures contracts to increase the duration of a bond portfolio, we could:
A ) sell interest rate futures to increase portfolio duration
B ) buy interest rate futures to increase portfolio duration
C ) buy interest rate futures to decrease portfolio duration
My answer was A, but the correct answer is B.
Why does buying an interest rate future increase porfolio duration? In the case of rising rates, wouldn’t the profit on the future contract offset the loss on the bonds, thereby reducing duration?
when rate rises - without the futures contract - the portfolio would have shrunk in value. that would reduce duration of the portfolio. buying the futures contract - will offset loss on the portfolio (just as you have said). so based on that - status quo or close to status quo - no change in duration [when compared to the original portfolio] is achieved. So duration of the portfolio is increased [and this is in comparison to the portfolio without the futures contracts]. does that make sense?
This may be a better way to think about it. When you are long a T-Bond futures contract you own the asset (i.e. underlying cheap to deliver bond) when you short a T-Bond futures contract you own the liability. As a result, you increase the duration of an existing bond portfolio by buying futures (positive duration plus positive duration) or you decrease the duration of an exiting bond portfolio buy selling futures (positive duration plus negative duration). From an active FI approach, if you own the bond portfolio and think the overall level of interest rates will shift higher, you go long the futures contract, which will increase the duration of the overall position (higher sensitive to interest rates) and may earn a higher profit if the shift is realized.
Buying an interest rate futures contract allows the buyer of the contract to lock in a future investment rate; not a borrowing rate as many believe. http://www.mysmp.com/futures/interest-rate-futures.html Definition of Interest Rate Future on page 114 did not make this clear. The underlying instrument that buyer of the interest rate future receives that seller delivers on settlement date is a bond. So, long on interest rate futures contract is long on a bond.
May I ask whether there are two different products in reality with titles: (1) interest rate futures and (2) bond futures? Do they refer the same thing in substance? Which one will be used for risk management of long bonds? pls.
Both exist. The most popular ones are bond futures, used for bond portfolios. Interest rates futures are normally for 3-month interest only, based on Eurodollar, Euribor, normally for risk management of loans. Go to the CME website if you want more info for each products. http://www.cmegroup.com/