Let's take the following idea:

Your objective is to hedge interest rate risk. You decide between Futures and IRS:

You can sell bund futures (10Y bond equivalent):

  • Price 177.70
  • Theoretical coupon: 6%
  • Your costs should be: ((100/177.70)/10 * (-1)) + (-6% per year) = ~ (-1.63%) p.a.
  • theoretically you will earn 77.70pts due to your short and the pull to par effect

Whereas a 10Y payer IRS would be c.p.:

  • (-0.20%) p.a. payment fix
  • (-0.46%) p.a. on the variable side (3M Euribor) receiving
  • So in sum the costs would be: ~ (-0,26%) p.a.

What do you think about this? Is this the case? Are futures a more expensive way of hedging interest rate risk? What could be wrong about this very simple ceteris paribus experiment?

  • 2
    $\begingroup$ to be honest everything is wrong with this example. A bond future does not pull to par and it does not experience carry. The futures price of the underlying CTD already accounts for the carry to the settlement date of the future. An IRS is priced so that the floating cashflows are expected to offset the fixed cashflows. The fact the pay side might have a net outflow in the first period means the swap just becomes more valuable (positive mtm) the next period. Basically if your object is to hedge interest rates you should be clear which rates to hedge - bond or swap. $\endgroup$ – Attack68 Mar 5 at 11:09

I'll start by saying that if you found a cheaper way to hedge exactly the same risk, that would be arbitrage (assuming transaction costs don't invalidade the opposite position)

Without going into the numbers, although the pull to par effect is not very relevant here, you will always have basis risk so you can't really tell beforehand which is the best option.

For the bund it's less of a problem because its very liquid but check what happens with Italy futures at some delivery dates. Sometimes there is a big squeeze.

Then, the future has an implied repo rate for your initial price and you have margins. For the IRS you would probably have a CSA.

What is your underlying risk? Depending on that you will also have the asset swap to worry about if you choose one instead of the other.

Additionally, when choosing your option you would choose the appropriate dv01 in either case and the appropriate maturity. Futures will be less flexible because you only have a certain number of contracts (Schatz, Bobl, Bund, etc), certain settlement months and you will have to trade a whole number of contracts. Not only can you have the need to trade more than one future to avoid curve risk, you might also have to roll your position which is an additional variable. In this sense, the IRS is more flexible because you can match your risk more closely.

However, it's probably easier to trade futures, because for the IRS you will need an ISDA and CSA, and bid ask will probably be wider.

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The bund, boble and schatz futures can and have been subject to some big squeezes. Certain banks were famous for cornering the supply of the bonds and in some cases might have got into trouble for market manipulation IIRC.

However, when trading IRS you obviously have the relevant credit risk of entering into a long term contract with the counterparty, even if you intend to offset the risk by exiting or offseting the risk with another bank.

You also might have different daily cash flows wrt to variation margin vs collateral calls.

As usual, its one thing to compute therectical arbritrage, but quite another to execute it.

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