Volume4, fixed income II - page 107 - strategies with FI futures
i am having a hard time understanding why buying a futures ctract will increase pf sensitivity to IR and the pf duration will increase. Same for selling futures with pf duration decreasing.
Can someone explain?
Interest rates go up > Bond price goes down > Futures price goes down
Interest rates go down > Bond price goes up > Futures price goes up
So when you’re long (short) futures, you’re incresing (decreasing) the portfolio’s interest rate sensitivity… which is akin to increasing (decreasing) the portfolio’s duration. This effect is magnified by leveraged positions (as shown in that example on page 107).
A long futures position is essentially the same as buying the underlying asset (except that you don’t have to pay for it today); a short futures position is essentially the same as selling the underlying asset (except that you don’t get paid for it today).
(The primary difference is that the positions in the futures contracts don’t have any interim cash flows (e.g., coupons on bonds, dividends on stocks) that you would have if you bought the underlying or lose if you sold the underlying.)
But cannot a long position increase OR decrease portolio duration, based on the direction of the Interest rates?
Adding to my question above…the book says, buying a futures ctract will increase a portfolio sensitivity to interest rates , and the portoflio’s duration will increase. Isn’t that the duration can increase OR decrease based on where the interest rates go? That is , if int rates rise, duration will decrease, and if int rates decline, duration will increase? So, by buying futures you can lower or raise your portfolio duration. Why does the book says it increases the duration only?
Am I missing fundamental concepts here?
Thanks all who contribute.
duration will increase when you buy futures contracts.
how the portfolio reacts is a obtained by (-1 * New Duration * Change in Rate)
If Rate increases - and you have increased Duration - your Portfolio is MORE Reactive negatively to the rate change.
If rate decreases - you have increased duration - portfolio will react positively.
The above reaction (-1* Duration * Change in Rate) is an approximation for small rate changes. To this you would need to add (Convexity * Change in Rate^2) for larger changes.
No; the duration will increase. The direction of interest rate movements has nothing to do with whether the duration increases or decreases.
The _ value of the portfolio _ will increase or decrease depending on the direction of interest rate movements, and it will increase or decrease more because the duration has increased.
Just an addition to this:
Duration is a measure of sensitivity to Interest rates
So the higher your duration the more the price will move for the same move in Interest Rates. As has been mentioned above this has no relation to the direction of the interest rate movement or the price movement outside of the basic inverse relation
Think of Duration as like an Interest Rate Beta.
So if you swap the example to Equity, going long Euity futures increases your Beta as going Short Equity Futures will reduce it.
it’s the same for the FI version
So, it is essentially owning additional bonds that increases portfolio’s duration?
Thank you much to all who contributed.
Yup. (But at no cost; that’s why the duration increases.)