Determine the current underlying value of this T-note futures contract.

Case Problem 15.1 T. J.’s Fast-Track Investments: Interest Rate Futures

T. J. Patrick is a young, successful industrial designer in Portland, Oregon, who enjoys the excitement of commodities speculation. T. J. has been dabbling in commodities since he was a teenager—he was introduced to this market by his dad, who is a grain buyer for one of the leading food processors. T. J. recognizes the enormous risks involved in commodities speculating but feels that because he’s young, he can afford to take a few chances. As a principal in a thriving industrial design firm, T. J. earns more than $150,000 a year. He follows a well-disciplined investment program and annually adds $15,000 to $20,000 to his portfolio.

Recently, T. J. has started playing with financial futures—interest rate futures, to be exact. He admits he is no expert in interest rates, but he likes the price action these investments offer. This all started several months ago, when T. J. met Vinnie Banano, a broker who specializes in financial futures, at a party. T. J. liked what Vinnie had to say (mostly how you couldn’t go wrong with interest rate futures) and soon set up a trading account with Vinnie’s firm, Banano’s of Portland.

The other day, Vinnie called T. J. and suggested he get into five-year Treasury note futures. He reasoned that with the Fed pushing up interest rates so aggressively, the short to intermediate sectors of the term structure would probably respond the most—with the biggest jump in yields. Accordingly, Vinnie recommended that T. J. short sell some five-year T-note contracts. In particular, Vinnie thinks that rates on these T-notes should go up by a full point (moving from about 5.5% to around 6.5%) and that T. J. should short four contracts. This would be a $5,400 investment because each contract requires an initial margin deposit of $1,350.

Questions

a. Assume T-note futures ($100,000/contract; 32’s of 1%) are now being quoted at 103’16.

1. Determine the current underlying value of this T-note futures contract.

2. What would this futures contract be quoted at if Vinnie is right and the yield does go up by one percentage point, to 6.5%, on the date of expiration? (Hint: It’ll be quoted at the same price as its underlying security, which in this case is assumed to be a five-year, 6% semiannual-pay U.S. Treasury note.)

b. How much profit will T. J. make if he shorts four contracts at 103’16 and then covers when five-year T-note contracts are quoted at 98’00? Also, calculate the return on invested capital from this transaction.

c. What happens if rates go down? For example, how much will T. J. make if the yield on T-note futures goes down by just 3/4 of 1%, in which case these contracts would be trading at 105’8?

d. What risks do you see in the recommended short-sale transaction? What is your assessment of T. J.’s new interest in financial futures? How do you think it compares to his established commodities investment program?

 

(a)   (1) The current underlying value is 103% & 16/32% or 103.5% of the face value. With a face value of $100,000, the T-notes are being priced at $103,500.

(2) The new quote would be computed using the following inputs:

10N, 3.25I/Y, $3,000 PMT, $100,000 FV

Compute PV = $91,889

Hence, the quote would be 91-28.

(b)   (1.035 – 0.98) $100,000 ´ 4 = $5,500 ´ 4 = $22,000 gain

$22,000/$4,000 = 550%

According to the Table 16.2, the initial margin is $3,000 per contract, which would reduce the rate of return on invested capital to 183% ($22,000/$12,000).

(c)   (1.035 – 1.0525)$100,000 ´ 4 = –$1,750 ´ 4 = –$7,000 loss

–$7,000/$4,000 = –175%

It is possible to loss more than 100 percent, if T.J. Patrick continues to make maintenance margin deposits, as the rising value of the T-note exhausts his deposit. Also note that according to the Table 16.2, the initial margin is $3,000 per contract, which would reduce the rate of return on invested capital to –58.3%.

 

(d)

T.J has made a profit on the futures contract market. If TJ was to invest more in the furtures contract market based on his annual savings ( $15000 to $20000), he could have a good return on his investment. Since TJ is young, he can take the risk associated with the futures contract market.