Treasury bond futures: impact of contract specifications on price sensitivity and hedging
Toles, John Holland
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Recent studies of the Chicago Board of Trade Treasury bond futures contract have indicated that the conversion factor system results in long duration bonds being cheapest-to- deliver when interest rates are above 8 percent, while short duration bonds are cheapest-to-deliver when rates are below 8 percent. This dissertation uses a duration framework to show that the conversion factor system should affect the futures price sensitivity with respect to changes in interest rates. Specifically, it is theorized that the futures contract should exhibit greater (lesser) price sensitivity when rates are above (below) 8 percent. Using a sample that spans 1985 through June 1988, regression analysis provides results that are consistent with this hypothesis. The futures/interest rate relationship exhibited a structural shift below versus above 8 percent, as evidenced using various tests of linear restrictions in a weighted least squares analysis. Mean differences between log prices of a long duration cash bond and the futures contract exhibited a substantial increase when rates fell below 8 percent, providing additional evidence of a shift in Treasury bond futures price sensitivity at rates below 8 percent. The second part of this study compares the hedging effectiveness of two widely used hedging methodologies: (1) the price sensitivity hedge ratio; and (2) the regression hedge ratio, with that of a new hedging approach that employs an estimated futures price sensitivity. Using a holdout sample spanning July 1988 through December 1989, the hedging effectiveness of these approaches was compared in 5-day and 20-day hedging horizons. Empirical results indicate a decline in hedging effectiveness in the 20-day horizon when interest rates are below 8.75 percent, and fluctuating above and below 8 percent, relative to hedging effectiveness when rates were above 8.75 percent. The 5-day horizon results indicate an increase in hedging effectiveness in the price sensitivity hedge ratios when rates were below 8.75 percent. The results suggest that hedgers may wish to incorporate the possibility of changing futures price sensitivity into their hedging methodology when interest rates are fluctuating above and below 8 percent.