Interest Rate Portfolio

Bond futures and options

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omissions contained in this publication. This publication is for information only and does not constitute an offer, solicitation or recommendation
to acquire or dispose of any investment or to engage in any other transaction. All information, descriptions, examples and calculations contained
in this publication are for guidance purposes only and should not be treated as definitive.
Those wishing either to trade futures and options contracts on Exchanges within the Euronext Group, or to offer and sell them to others should
establish the regulatory position in the relevant jurisdiction before doing so.
Euronext.liffe refers to the combined derivatives operations of Euronext and LIFFE. It comprises:
l Euronext Amsterdam Derivative Markets, which is a regulated market under Dutch Law;
l Euronext Brussels Derivatives Market, which is a regulated market under Belgian Law;
l Euronext Lisbon Futures and Options Market, which is a regulated market under Portuguese Law;
l LIFFE Administration and Management, which is a Recognised Investment Exchange under English Law;
l MATIF and MONEP, which are regulated markets under French Law.
All are regulated markets under the European Unions Investment Services Directive.
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The Netherlands
Tel +31 (0)20 550 4444
For more information about Euronext.liffes Bond products please contact:
Interest Rate Derivatives:
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Email: bonds@liffe.com
Web: www.euronext.com
Further information
Introduction 1
Contract specifications 4
Long Gilt futures 4
Option on Long Gilt futures 6
Japanese Government Bond (JGB) futures 7
Pricing Bond futures 8
Principle of forward pricing 8
The price (conversion) factor 8
Invoice amount formula 8
Cash and carry arbitrage 9
Implied repo rate calculation 9
Basis analysis example 10
Option pricing 12
Option value determination 12
Types of volatility 14
Option sensitivities 15
Summary 18
Trading Gilt futures and options 19
Spread trading 22
Hedging 22
Sell futures 23
Buy puts 23
Sell calls 24
Using futures in asset allocation 25
Accessing futures and options on the Euronext.liffe market 27
LIFFE CONNECT

27
Wholesale trading facilities 30
Euronext.liffes block trading facility 30
Euronext.liffes basis trading facility 31
Contents
Margining 33
The role of the clearing house 33
SPAN

margining requirements 34
Appendix A
Long Gilt futures contract price factor 36
Appendix B
Quote vendor contract codes 39
Appendix C
Further reading 40
Further information Inside back cover
Volatility and uncertainty are ever present in todays financial markets, not least in the interest rate
markets. In the face of this type of uncertainty, traders, treasurers and fund managers are increasingly
advised to consider methods of managing their exposure to sharp movements in financial markets.
Futures and options were conceived for the purpose of managing risk, which in turn can be translated
into the protection of prices. Futures and options, through their versatility, offer significant advantages
as strategic financial instruments. They help reduce costs, enhance returns, and manage interest rate
risk with greater certainty, precision and economy.
Additionally, market participants, when using futures, can benefit from less restrictive regulatory
constraints pertaining to capital requirements, facilitating more efficient use of available capital.
This publication provides the reader with a full overview of the Bond Futures and Options available
for trading on LIFFE CONNECT

in addition to a firm understanding of the basic principles behind

the use of the contracts.
Bonds and their characteristics
In laymans terms, a bond can be thought of as an IOU exchanged between two parties. It is also an
IOU designed to be easily transferred in the secondary market. Technically it is defined as a debt
security. Bonds are issued by a number of different types of institutions, such as Governments, Public
Corporations and Supranational agencies. These institutions are known as issuers and they typically
issue a bond in order to raise money to invest in long-term capital projects.
When you buy a bond at issue in the primary market, you are lending money to the issuer. In return,
the issuer will pay you, the lender, a specified rate of interest, known as the coupon, on the amount
you lend over the lifetime of the bond and repay the principal amount upon maturity of the bond.
When you sell on the bond in the secondary market the rights to coupon payments and principal
repayment are transferred to the new owner of the bond. Depending on the issuer, coupon payment
is usually either semi-annual or annual.
Bonds are priced based on a nominal value of 100 percent. Prices may fluctuate above or below 100
throughout the lifetime of the bond. This is due mainly to the interest rates prevailing in the secondary
market relative to the value of the bonds coupon payments. As the price of the bond fluctuates above
or below 100, the coupon payment is not exactly the return on investment. The return you receive is
known as the yield and the calculation is based on the coupon rate, time to maturity and market price.
The prices normally quoted for bonds are referred to as clean prices, meaning they do not include
the interest which has accrued on the bond since the last coupon payment. When the bond actually
changes hands, the actual amount paid will be the dirty price, which includes accrued interest.
The UK Government Bond market
Bonds issued by the UK Government are commonly known as Gilts. They are issued to the
marketplace entirely through an auction process which is held by the Debt Management Office
(DMO), a division of the UK Treasury. The UK Debt Management Office was created in April 1998 as
an executive agency of Her Majestys Treasury, with the brief of minimising the governments financing
costs. Gilts are issued to finance the Central Governments Net Cash Requirements and to refinance
maturing debt. Gilt auction dates are published up to a year in advance.
1
Introduction
Gilts have a wide range of maturities, and are categorised as shorts (1-7 years) mediums (7-15 years)
and longs (over 15 years). Almost all Gilts pay interest, also known as a dividend or coupon, on a six-
monthly basis.
Gilts are priced in decimals and quoted per 100 of principal. Seven business days before the coupon
payment date, Gilts begin to trade ex-dividend or ex-div. If the Gilt is bought whilst it is ex-div, the
buyer gives up the right to receive the following dividend payment and is compensated by the seller
accordingly. Therefore, from the ex-dividend date until the coupon payment date, the accrued interest
will be negative.
There is an established group of firms in the market known as Gilt-Edged Market Makers (GEMMs).
GEMMs are primary gilt dealers who participate in all DMO issuance auctions and also provide
continuous 2-way prices to the secondary market. They may deal with each other as well as
customers. To preserve pre-trade anonymity, GEMMs often use inter-dealer brokers (IDBs) as
intermediaries to their trades.
The German Government Bond market
The issuance of German Government Bonds is the responsibility of the German Finance Agency,
known as Bundesrepublik Deutschland Finanzagentur, on behalf of the German Government. Bonds
with lifetimes, or maturities, of 2, 5, 10 and 30 years are issued. Interest payment for these bonds is
annual and maturities are fixed. The 2, 5, 10 and 30 year German issues are known respectively as
Federal Treasury notes (Bundesschatzanweisungen or Schtze), Five-year Federal notes
(Bundesobligationen or Bobls) and Federal bonds (Bundesanleihen or Bunds). Bunds, Bobls and
Schtze are brought to the market through an auction process.
The Japanese Government Bond market
The Japanese Government Bond (JGB) market is the worlds largest. The 10 year sector of the market
is by far the largest in terms of issuance. Euronext.liffes JGB future is based on this segment of the
market. JGBs are issued through a US style Dutch Auction and offered to an underwriting syndicate.
Interest payments on JGBs are semi-annual.
International bond market conventions
The following table provides an overview of the key features and relevant information relating to the
underlying bond markets covered by Euronext.liffe contracts.
2
Country Coupon Day Count Settlement Relevant web sites
United Kingdom Semi-annual Actual/Actual Usually T + 1 www.hm-treasury.gov.uk
www.dmo.gov.uk
www.bankofengland.co.uk
Germany Annual Actual/Actual Usually T + 2 www.deutsche-finanzagentur.de
www.bundesbank.de
Japan Semi-annual Actual/365 Usually T + 3 www.mof.go.jp
www.boj.or.jp
Bond futures and options
Futures:
A deliverable futures contract is a legally binding obligation to make or take delivery of a specified
instrument at a fixed date in the future, at a price agreed at the time of dealing. In addition all futures
contracts are exchange traded securities. In the case of bond futures, the seller must deliver to the
buyer an agreed amount of an eligible bond from a list of deliverable bonds at the agreed price.
The buyer of the futures contract will take delivery from the seller. These two parties are known
as holders of Long and Short positions respectively.
Options:
An option contract is a legally binding agreement which bestows upon the buyer a right, but not an
obligation, to take (call) or make (put) delivery of a specified instrument at a fixed date in the future,
at a price agreed at the time of dealing. The specified instrument which must be called or put by the
buyer or seller of a Euronext.liffe Bond Option, is the relevant Bond futures contract.
Euronext.liffe Bond futures and options
Euronext.liffe offers a number of Bond futures and options contracts that provide exposure to the
British and Japanese Government Bond markets.
The table below presents an overview of the available contracts
3
Contract Currency Futures Options
Long Gilt Sterling Yes Yes
JGB Japanese Yen Yes No
The contract specifications provided below are correct as of February 2006. Please refer to the
Euronext.liffe website (www.euronext.com/derivatives) for the most up to date versions.
Long Gilt futures
Unit of trading 100,000 nominal value notional Gilt with 6% coupon
Delivery months March, June, September, December, such that the nearest three delivery months
are available for trading
Quotation Per 100 nominal
Minimum price movement 0.01 (10)
(Tick size and value)
First notice day Two business days prior to the first day of the delivery month
Last notice day First business day after the last trading day
Last trading day 11.00
Two business days prior to the last business day in the delivery month
Delivery day Any business day in delivery month (at sellers choice)
Trading hours 08.00 18.00 London Time
Trading platform:
l LIFFE CONNECT

Trading Host for futures and options.

l Algorithm: Central order book applies price-time priority trading algorithm.
l Wholesale trading facilities: Asset allocation, block trading, basis trading.
Exchange delivery settlement price (EDSP): The LIFFE market price at 11.00 on the second
business day prior to the Delivery Day. The invoicing amount in respect of each Deliverable Gilt is to
be calculated by the price factor system. Adjustment will be made for full coupon interest accruing as
at Settlement Day.
Contract standard: Delivery may be made of any gilts on the List of Deliverable Gilts in respect of
a delivery month, as published by the Exchange on or before the tenth business day prior to the First
Notice Day of such delivery month. Holders of long positions on any day within the Notice Period
may be delivered against during the delivery month. All gilt issues included in the List will have the
following characteristics:
l having terms as to redemption such as provide for redemption of the entire gilt issue in a single
installment on the maturity date falling not earlier than 8.75 years from, and not later than 13 years
from, the first day of the relevant delivery month;
l having no terms permitting or requiring early redemption;
l bearing interest at a single fixed rate throughout the term of the issue payable in arrears semi-
annually (except in the case of the first interest payment period which may be more or less than
six months);
l being denominated and payable as to the principal and interest only in pounds and pence;
l being fully paid or, in the event that the gilt issue is in its first period and is partly paid, being
anticipated by the Board to be fully paid on or before the Last Notice Day of the relevant
delivery month;
l not being convertible;
l not being in bearer form;
l having being admitted to the Official List of the London Stock Exchange;
4
Contract specifications
l being anticipated by the Board to have on one or more days in the delivery month an aggregate
principal amount outstanding of not less than 1.5 billion which, by its terms and conditions, if
issued in more than one tranche or tap or issue, is fungible.
5
Option on Long Gilt futures
Unit of trading One Long Gilt futures contract
Expiry months March, June, September, December (nearest two available for trading) plus two
additional serial months, such that four expiry months are available for trading,
which include the nearest three consecutive calendar months
Quotation Multiples of 0.01
Minimum price movement 0.01 (10)
(Tick size and value)
Exercise day Exercise by 17.00 on any business day, brought forward to 10.45 on the last
trading day
Last trading day 10.00
Six business days prior to the first day of the expiry month
Expiry Exercise by 10.45 on the last trading day
Delivery day Delivery on the first business day after the exercise day
Trading hours 08.02 16.18 London Time
Trading platform:
l LIFFE CONNECT

trading host for futures and options.

l Algorithm: Central order book applies a pro-rata trading algorithm, but with priority given to
the first order at the best price subject to a minimum order volume and limited to maximum
volume cap.
l Wholesale trading facilities: block trading, basis trading.
Contract standard: Assignment of one Long Gilt futures contract for the expiry month at the
exercise price. The futures delivery month associated with each option expiry month shall be:
March in respect of January, February and March expiry months;
June in respect of April, May and June expiry months;
September in respect of July, August and September expiry months;
December in respect of October, November and December expiry months.
Exercise price intervals: 0.50 eg 102.00, 102.50 etc.
Introduction of new exercise prices: Thirteen exercise prices will be listed for each new series.
Additional exercise prices will be listed when the Long Gilt futures contract settlement price is within
0.25 of the sixth highest or lowest existing exercise price, or as deemed necessary by the Exchange.
Option premium: The contract price is not paid at the time of purchase. Option positions, as with
futures positions, are marked-to-market daily giving rise to positive or negative variation margin flows.
If an option is exercised by the Buyer, the Buyer is required to pay the original contract price to
the Clearing House and the Clearing House will pay the original option price to the Seller on the
following business day. Such payments will be netted against the variation margin balances of Buyer
and Seller by the Clearing House.
.
6
Japanese Government Bond (JGB) futures
Unit of trading 100,000,000 nominal value notional long term Japanese government bond with
6% coupon
Delivery months March, June, September, December, such that three delivery months are available
for trading
Quotation Per 100 face value
Minimum price movement 0.01 (10,000)
(Tick size and value)
Last trading day 16.00
One business day prior to Tokyo Stock Exchange last trading day
Delivery day Next business day*
Trading hours 07.00
1
16.00 London Time
Trading platform:
l LIFFE CONNECT

trading host for futures and options.

l Algorithm: Central order book applies price/time priority trading algorithm.
l Wholesale Trading Facilities: Asset Allocation, Block Trading, Basis Trading.
Contract standard: *All open positions on Euronext.liffe at the close of a business day will be
closed out automatically at the first subsequent opening price on the Tokyo Stock Exchange for the
same delivery month, and cash settlement made accordingly through variation margin. Unless deferred
as a result of there being no TSE opening price (eg in the event of a TSE holiday), settlement will be on
the next business day.
Price limit: (1) 2.00 from Tokyo Stock Exchange closing price. If limit is hit, price limits are removed
one hour later for the remainder of the day. (2) No limit during the last hour of trading on each day.
1
The JGB Contract opens at 08.00 on Tokyo Stock Exchange Holidays.
7
The prices at which futures contracts trade is fundamentally related to the prices which prevail for
bonds in the underlying bond market. This connection is accomplished through the potential for
arbitrage between the cash bond and futures market.
Principle of forward pricing
Futures pricing is the result of an analysis of the value of owning an asset today, and having available a
known price at which the asset might be sold on some future date. For example, if one were to be in
possession of an ounce of gold or a barrel of oil it would be rational to consider the value that might
be acquired from the sale of that asset in todays cash market, compared to the value to be acquired
from the sale of that asset at some different price at some future date. As a cash bond/futures arbitrage
calculation, this analysis takes the form of looking at the possibility of purchasing the asset in the bond
market today and then selling that asset forward through the futures delivery and clearing process.
This relationship can be expressed as:
= +
Delivery basket
Underlying bond futures, and unlike various other types of futures such as stock futures and
commodity futures, there is a list of different bonds which can be delivered when the contract expires.
This list is commonly known as a basket. The basket contains different bonds which vary in their
characteristics but match a set of criteria specified by the Exchange. Most often the bond will differ
in its coupon and time to maturity. The specified criteria for the Bond futures contract listed by
Euronext.liffe can be found in the Contract Specifications.
The price (conversion) factor
Due to the non-homogeneous nature of the bonds contained within the deliverable basket, each bond
is assigned a factor which is applied to the final invoice price calculation.
This price factor is the mechanism which brings the maturity and coupon differences of the
deliverable bonds onto a common base and is intended to make all of the bonds equally attractive
for delivery. In essence, a bonds price factor is the price, per 1 nominal, at which the deliverable
bond would yield the notional coupon on the delivery day, or the first day of the delivery month in
the case of Long Gilt futures.
Invoice amount formula
The process of delivery established by the Exchange provides the facility for a trader holding a short
futures position, to deliver any bond from the list of deliverable bonds, via LCH.Clearnet on the
contracts delivery date. The proceeds of that delivery are determined by the final Exchange Delivery
Settlement Price (EDSP) multiplied by the delivered bonds price factor and adjusted for accumulated
accrued interest at delivery. The proceeds of the sale resulting from a single contract varies with bond
the holder of the short position elects to deliver, and is called the invoice amount
Invoice amount = (EDSP x scaling factor x price factor) + accrued interest
The EDSP is quoted per 100 nominal. The scaling factor adjusts for the nominal value size of the
futures contract. In the case of the Long Gilt (100,000), the scaling factor is 1,000.
income
from cash
bond sale
cost of
financing
Cash
bond
price
Futures
Price
8
Pricing Bond futures
Cash and carry arbitrage
A curious trader would naturally want to see how the price of a bond at delivery (EDSP) might
compare to the current market price of those bonds. Specifically, the trader might wish to know if
there might be a profit to be made from buying a bond from the deliverable basket today, then holding
it for a specific period of time, whilst simultaneously fixing a selling price for the same bond forward
via the futures market.
This process of buying a bond and locking in a forward selling price is akin to achieving a lending rate.
The term associated with this action is known as a cash and carry analysis. The rate achieved is called
the implied repo rate. Alternatively the trader may decide to short a cash bond today and buy it back
via the futures market. This action would be akin to achieving a borrowing rate, and is known as a
reverse repo.
Implied repo rate calculation
The following formula may be used to calculate the implied lending rate:
where = Clean cash price of bond at delivery (futures price x price factor)
= Current clean market price of bond
= Accrued interest of bond at delivery per 100 principal
= Accrued interest of bond for current settlement per 100 principal
= Intervening coupon
= Actual number of days from settlement to delivery
Example:
Trade date: 26 Jan 04
Settlement date: 27 Jan 04
Delivery date: 31 March 04
Holding period: 64 days
Bond: 8% 27 Sep 2013
Current bond price 124.74
Accrued interest at settlement 2.6813
Actual repo rate ~4%
Current futures price 108.56
Price factor 1.1439664
Bond price at delivery 108.56 x 1.1439664 = 124.188992
Accrued interest at delivery 0.086957
Intervening coupon 4
d
CP
s
CP
d
AI
s
AI
IC
s d
Days

d
CP
s
CP
d
AI
s
AI
IC
s d
Days

d
CP
s
CP
d
AI
s
AI
IC
s d
Days

d
CP
s
CP
d
AI
s
AI
IC
s d
Days

d
CP
s
CP
d
AI
s
AI
IC
s d
Days

d
CP
s
CP
d
AI
s
AI
IC
s d
Days

( ) ( )
( )
s d s s
s s d d
Days
x
AI CP
AI CP IC AI CP

+
+ + + 365
9
(124.74 + 2.6813)
x 3.83% implied repo rate
64
365 (124.188992 + 0.086957 + 4) (124.74 + 2.6813)

Using the implied repo formula:

The cheapest to deliver
The calculation of return on investment tells the trader the return associated with buying a bond
and holding it to delivery. The bond with the highest implied repo rate offers the greatest profit
(or smallest loss) as a percentage of funds invested of all the bonds available for arbitrage. This bond
is referred to as the cheapest to deliver (CTD) bond. By comparing the implied repo rate for each
bond with a comparative borrowing rate for the same duration (actual repo), a trader is able to see
if any arbitrage potential exists. In other words, if the implied repo rate (synthetic lending rate) is
greater than a corresponding actual repo rate (borrowing rate) then there is an arbitrage profit to
be had. Typically, as the above example shows, there is no arbitrage to be had, as the actual repo
rate was around 4% in this case.
Considering the cost of funds
A trader acting as a pure arbitrageur is unlikely to be operating with a large pool of money. Instead the
trader will be looking to borrow funds to execute the transaction. The cost of these funds will impact
the profitability of the arbitrage and the trader will require a calculation of the profit incorporating the
cost of funds.
Financing costs and carry return
The cost associated with holding a bond to delivery is the financing cost. This cost is the result of
both the interest rate charged in the transaction as well as the holding period. This financing cost is
compared to the coupon income that is earned. The difference between coupon income and the
financing cost is called carry basis. If the bonds coupon income is greater than the cost of financing,
the position is said to have positive carry, if not then it has negative carry.
Basis analysis example
The cost of financing a cash and carry position is a simple money market calculation and is given by
the following formula:
Amount financed = CP + AI
Financing rate = Actual Repo Rate
Days to delivery = Days
Using the trade information from the previous example we can calculate the financing cost for the
cash bond 8% 27 Sep 2013.
Cost of finance = (124.74 + 2.6813) x 4.01% x 64/365 = 0.895929
Coupon income is the amount of interest earned from settlement to delivery date.
Coupon income = 1.406593
365
days to delivery
x Financing rate x financed Amount
10
Carry basis
Carry basis is the difference between coupon income and financing costs. Typically carry basis is
positive, reflecting the fact that the return from holding the bond (coupon income) will be greater
than the financing costs (actual repo rate) for normal (positively sloped) yield curves.
Carry basis = coupon income financing costs
= 1.406593 0.895929
= 0.5107
Gross basis is the difference between the cash bond price and the futures adjusted price.
Gross basis = cash bond price (futures price x price factor)
= 124.74 (108.56 x 1.1439664)
= 0.5510076
An arbitrageur given the above equations is now able to calculate the all in costs of a cash and
carry analysis.
Net basis = Gross basis coupon income + financing cost
= Gross basis carry basis
= 0.5510076 0.5107
= 0.04 or 4 ticks
Net basis
The difference between the cost of borrowing (cost of funds) and the lending rate (implied repo)
achieved through the cash and carry is known as net basis (value basis). Under normal conditions, net
basis is negative, and there is thus no single bond arbitrage to be made (it is convention to show this
loss however as a positive number). In this example the potential arbitrageur would lose 4 ticks if he
were to perform the cash and carry transaction delivering the example bond into the futures short
position. Part of the explanation for the net basis being negative is the optionality contained within
the bond futures delivery process and hence reflected in the bond futures price.
Delivery option
In a simple world, gross basis should equal carry basis, in other words the net difference (basis)
between the price of the cash bond today and the futures adjusted price should be zero. Typically
the actual futures price will trade at a price slightly below its fair value. One reason for this is that
the seller of the futures contract has certain rights, such as choice of bond to deliver and the day
in the delivery month on which to deliver. This right to choose is sometimes valuable and is called
the delivery option.
The value of the delivery option principally arises from the possibility of a change in the cheapest
to deliver, which can happen if overall yield levels in the cash market move significantly. A futures long
has given away the delivery option to the short at the time of trade, so the buyer of the futures
contract has to be compensated. This compensation takes the form of a reduced futures price.
Thus we can say that the net basis reflects a series of in-built options which are subject to change
over the life of the futures contract.
11
Option value determination
An option bestows upon the buyer a right to buy (call) or sell (put) the underlying futures contract at
a pre-determined price on or before (American style) a final expiry date. Buyers of options have rights
and sellers have obligations.
Price distribution
The pay-off characteristic of an option depends not so much upon the price of the underlying futures
contract today, but rather, what the pattern of future price distributions is likely to be between now
and option expiry. It is this distribution of future prices that dictates the likelihood that the option will
be in-the-money, and by what extent at expiry.
The theory of option pricing centres on the concept that the fair option price is based upon a value
which will allow a hedger to precisely offset any exposure they may have in the underlying market.
Many option pricing models prevail in the market today, encompassing very detailed calculations.
What follows is a succinct explanation, in general terms, of how an option premium is derived.
Option value
The price or premium (value) on an option is determined by the following parameters which are
entered into an option pricing model
1
.
The first three inputs into the model are easily observable in the market place and can be said to
be objective. The fourth input into the option pricing equation, volatility, is subjective. This is the
individual traders view on what the distribution of the future prices will be between now and
expiry of the option.
12
Option pricing
1
Euronext.liffe options on bond futures operate on a delayed payment of premium basis. This means that there is no need to
incorporate an interest rate element into the pricing model.
Exercise price
Known
Current futures price
Known
Time to expiry
Known
Expected volatility
Unknown
Option pricing
model
Option
premium
Determining the future price distribution
The illustration below shows in simple terms how an options price may be calculated over a single
time period. The following method is based upon the binomial pricing concept.
100 call option value single time period
105 (5)
100
(2.5)
95 (0)
In this example the futures price is conditioned to move up or down in steps of 5 points and has a
50% chance of either being in-the-money or out-the-money at expiry. The value of the 100 call option
under the above scenario equates to 2.5. This is the sum of the two possible outcomes. That is, if the
futures price at expiry is 105, the 100 call option is worth 5, but as there is only a 50% probability of
this occurring, the value is calculated as 5 x 50% = 2.5. The value of the 100 call option is zero if the
final futures price is at, or below 100.
Applying the same conditions as before, we now increase the time period to three, this has the effect
of increasing the distribution of probable outcomes, thus increasing the value of the starting 100 call
options price from 2.5 to 3.75. This is intuitively correct as there has been an increase in the chances
of the option being in-the-money at expiry.
100 call option value three time periods
The value of the 100 call option under the revised three time period scenario is now 3.75. In order to
calculate this premium the model requires you to work backwards to asses the value of the option at
each branch of the lattice tree. For example at t3 (expiry) with the futures price at 115, the value of the
100 call is worth 15, this is simply the difference between the futures price and the option exercise
price (115 -100 = 15).With the future at 105 the option is worth 105 100 = 5 at expiry etc.
115
(15)
110
(10)
105 105
(6.25) (5)
Future 100
100 (2.5)
(3.75) 95 95
(1.25) (0)
90
(0)
85
(0)
t0 t1 t2 t3
13
The premium of an option that is in-the-money at expiry (t3) will comprise solely of intrinsic value.
Options that are at or out-the-money at expiry have zero value. This is illustrated above. Prior to
expiry in-the-money options may contain both intrinsic and time value. At and out-the-money options
prior to expiry will contain only time value ie no intrinsic value.
At t2 (one period before expiry), if the futures price is trading at 110 we can calculate the 100 call
option value as being 10. That is the sum of the two possible outcomes for the futures price (115 or
105). We already know the value of the option prices at 115 (15) and 105 (5) Therefore, the value of
the 100 call option can be calculated {(15x50%=7.5) + (5x50%=2.5)} = 10.
The process is repeated throughout the lattice so at each stage it is possible to value the option over
time. Just to complete the picture, at t1 with the future at 105, the option value will be {(10x50%=5) +
(2.5x50%=1.25)} = 6.25. And finally at t0 the value of the 100 call is calculated as {(6.25x50%=3.125) +
(1.25x50%=0.625) = 3.75.
We can conclude that an increase in time has the effect of increasing the range of possible future
price outcomes. In other words, time and future price distributions are inexorably linked. The longer
the time remaining to maturity of an option, the greater the likelihood of the option being in-the-
money at expiry. As a consequence of increased time to expiry, the option premium is higher (for
calls and puts) which reflects the compensation offered to the seller of the option for the increased
risk of being exercised.
Types of volatility
The likelihood of an option being profitable at expiry depends largely upon the time and the expected
future price distribution or volatility.Volatility is the term used by option traders to describe the
propensity of the futures price to move (either up or down) over a period of time.Volatility is one of
the most important elements to be considered when trading options. This is explained by its highly
significant influence on the options price. A large number of option trading strategies are centred
on volatility expectations. Option volatility can be described using different measures:
Historic volatility
Historic volatility is simply the observed futures price movements over a period of time. Although the
price movements are objective, the assimilation of the data can lead to subjective results. For example,
in order to value a 3 month option, a trader may wish to review historic prices for the last 2 years and
weight the findings according to his chosen preference.
Expected volatility
Using historic volatility and taking into consideration events that may or may not occur in the future
allows the trader to derive an expected volatility which is clearly subjective. Expected volatility is
therefore what the trader believes the futures price distribution will be between now and option
expiry. Each trader will have their own interpretation of expected volatility.
Implied volatility
Implied volatility is the volatility needed in the option pricing equation to generate a given option
value. The given option price, which can be observed in the options market, represents a consensus
view of volatility. The difference between implied volatility and expected volatility is what influences
the decision to trade options for many participants.
14
We can appreciate now that an increase in expected volatility and time has the effect of increasing
option premiums for both calls and puts. A fall in volatility and time has the opposite effect.
Option sensitivities
The option pricing model is not only useful for calculating an options price for today, but can be
used to generate a series of option sensitivities (the Greeks). These sensitivities help inform a trader
as to the likely change in an options value given a change in one or more of the various inputs into
the model.
Delta
The delta of an option indicates how sensitive the option price is to a change in the price of the
underlying future. Knowing the delta of an option is useful for both hedging and trading purposes.
The range of deltas for calls, puts and futures is shown below.
in-the- at-the- out-of-the-
money money money
Calls +1 +0.5 0
Puts -1 -0.5 0
Long future +1
Short future -1
Example of delta use estimating a new options value
Futures price 100
98 Call option price 0.25
Delta 0.65
A trader is interested in knowing what the estimated new price of the option will be, should the
futures price move up by 1 full point (100 ticks).
To calculate the new option price we simply multiply the futures price movement by delta ie 100 ticks
x 0.65 = 65 ticks. Therefore the estimated new option price is 0.25 + 0.65 = 0.90.
Example of delta use hedging with options
A trader is long a Long Gilt futures contract and wishes to hedge his position using options.
How many at-the-money puts does he need to buy, in order to create a delta neutral position?
A long futures position has a delta of +1, so two at-the-money puts (-0.5) are required to create a
delta neutral hedge.
Delta is very useful for estimating the change in the option value for a change in the price of the
underlying future. However, delta has its limitations. In an environment where the futures price moves
by a considerable amount, delta will either, under or over estimate the real change in the value of the
options position.
15
In particular, holders of long positions (puts/calls) would achieve greater than expected gains and
lower than expected losses when the market moves significantly up or down. Conversely, holders of
short positions would achieve lower than expected gains and higher than expected losses (as shown
in the table below). This is because the option delta changes over time and as the option moves more
or less in or out-the-money (convexity effect). Gamma is a measure of the expected change in delta
for one unit change in the underlying futures price.
Delta impact on option prices for large movements
Futures up Futures down
Long call under estimate profit over estimate loss
Short call under estimate loss over estimate profit
Long put over estimate loss under estimate profit
Short put over estimate profit under estimate loss
The diagram illustrates a large fall in the
futures price from f1 to f2. Using delta alone
as represented by the tangent, the fall in the
long call premium would be shown as od1 to od2.
In fact the true fall is less, ie a fall from od1 to o2.
Gamma
The gamma of an option can be used to adjust for the inaccuracies of delta. In the above illustration,
gamma will account for the discrepancy in estimated option price movements between od
1
od
2
and od
1
o
2
.
Gamma can be used to estimate the new option delta as a result of a change in the underlying futures
price. Gamma is expressed in deltas gained or lost for a full point move in the underlying price. For
example, as the underlying price rises, an at-the-money call with a delta of 0.50 will now move in-the-
money. If the gamma of the option is 0.2962, a trader can estimate the new delta for his option by
simply adding the gamma to his original delta.
option
price
od
1
o
2
od
2
f
2
f
1
futures
price
16
Example
Futures price change +1.00
Call delta 0.50
Gamma 0.2962
The new option delta would be
0.50 + 0.2962 = 0.7962.
For a long put at the same exercise price, the change in the option delta would be -0.50 + 0.2962 =
0.2038 as a result of a rise in the futures price of one point. Long options have a positive gamma
position and short options have a negative gamma position.
From the above example we can appreciate that, as the underlying price changes the delta of an option
will also change. Gamma can help an options trader to assess how quickly his option delta position
may change. For example, an option trader may have a portfolio of options which collectively results
in a near zero delta position. If however, the portfolio has a large gamma position, gamma is telling
the trader that for even a small change in the futures price the net delta position could change
dramatically generating huge gains or losses. If the position is to remain delta neutral the trader
will need to rebalance his position over time. Either options or futures may be used.
Theta
Theta is a measure of the change in the options price for a change in time. For example, an out-of-the-
money call with a premium of 0.20 and 30 days remaining until expiry will exhibit decay in its value
with all else remaining equal, simply through the passage of time.
If the theta of the option is 0.005670, then for each day that passes the option value will erode by
0.005670. For example, a call worth 0.20 today will be worth 0.19433 tomorrow (20 ticks 0.005670)
and so on.
Theta works against both long call and put positions, but works in the favour of holders of short
options. Time value decay is the greatest for at-the-money options.
Vega
Vega is a measure of change in an options price for a change in volatility. It is usually represented as a
change in option value given a full point change in volatility. For example, an option has a value of 2.19
and a vega of 0.1652. If the volatility changes by 1% from 16% to 17% then the new option price will
be 2.36 (2.19 + 0.1652).
An increase in volatility is beneficial for long option positions but detrimental for short positions,
whereas a fall in volatility is detrimental for long positions but beneficial for short positions.
17
Summary
The table below shows the direction of movement for various option and futures positions as a result
of a change in future price, time and volatility.
18
Position delta gamma theta vega
Long future + n/a n/a n/a
Short future - n/a n/a n/a
Long call + + - +
Short call - - + -
Long put - + - +
Short put + - + -
Futures and options can be used in numerous ways either to generate profits or minimise losses when
prices change. A number of applications for bond futures and options are outlined below.
Speculative trading
An investor who wishes to take an outright position in futures based on his view of the direction of
yields, can do so by buying or selling futures, depending on whether he expects yields at this part of
the curve to rise or fall. As yields rise, prices fall and vice versa.
View Bullish
Futures position Long
Investors expecting the price of the futures to rise can enter into a long futures position which will
profit if the value of the futures at expiry is above the price paid now. If the price rises during the
lifetime of the contract then the investor can close out (sell) his long position for a profit. The payoff
profile below shows how the profit increases as the price of the futures rises. If the futures price falls,
the position begins to make a loss.
Option position Long Call
By buying a call option investors can limit the loss on his position if prices fall, to the amount of
premium paid. The upside is unlimited. The payoff profile, below, illustrates this.
Example:
Day1
Option Premium 0.35
Option Strike 108.00
Futures Price 107.89
Day 2
Futures Price 109.21
Profit/Loss 109.21-108.00-0.35 = 0.86
Price
0
Profit/
Loss
Price
0
Profit/
Loss
Trading Gilt futures and options
19
Scenario 2 A trader expects yields on 10 year gilts to rise and thus prices to fall.
View Bearish
Futures position Short future
A short futures position will profit when prices fall and make a loss if prices rise. The payoff profile
below illustrates this.
Option position Long put
Alternatively investors can buy a put option which will limit the maximum possible loss to the cost of
the option. The upside is potentially unlimited.
Example:
Day 1
Option Premium 0.15
Option Strike 108.55
Futures Price 108.86
Day 2
Futures Price 107.00
Profit/Loss 108.55-107.00-0.15 = 1.4
Price
0
Profit/
Loss
Price
0
Profit/
Loss
20
View Neutral
Option position Short call
Investors expecting yields to remain unchanged, or to rise slightly and thus the price to remain
unchanged or fall slightly will sell a call option. If the prediction comes true, the option will expire out-
the-money and thus not be exercised. The seller of the call profits from the premium earned. However
if the price rises, the potential loss is unlimited. The payoff profile, below, illustrates this.
Example:
Day 1
Option Premium 0.35
Option Strike 108.00
Futures Price 107.89
Day 2
Futures Price 107.79
Profit/Loss The buyer of the option will not exercise the option and it will expire worthless.
The profit for the seller will be the premium.
Option position Short put
Investors expecting yields to remain unchanged, or to fall slightly and thus the price to remain
unchanged or rise slightly will sell a Put option. If the prediction comes true, the option will expire
out-the-money and thus not be exercised. The seller of the put profits from the premium earned.
However if the price falls, the potential loss is unlimited. The payoff profile, below, illustrates this.
Example:
Day 1
Option Premium 0.15
Option Strike 108.55
Futures Price 108.86
Price
0
Profit/
Loss
Price
0
Profit/
Loss
21
Day 2
Futures Price 108.88
Profit/Loss The buyer of the option will not exercise the option and it will expire worthless.
The profit for the seller will be the premium.
Spread trading
Spread trading involves taking opposing positions in more than one futures contract. The spread
can be intra-commodity (between futures contracts with the same underlying instrument), or
inter-commodity (futures with different underlying instruments).
Intra-commodity spreads, also known as calendar spreads, involve taking a simultaneous long and short
position in futures with the same underlying instrument but in different expiry months. The trader
expects that the price difference between the two contracts will change, either widen or narrow. A
long spread is when the near calendar month is purchased and the far month is sold. The opposite is
the case for a short calendar spread. The risk associated with a spread position is much lower than an
outright position as any loss in one contract may be largely offset by a gain in the opposing position.
Example:
January 2005
Long Gilt March 05 future 108.10
Long Gilt June 05 future 107.66
Buy March 05/June 05 calendar
spread at price 0.44
February 2005
Long Gilt March 05 future 108.25
Long Gilt June 05 future 107.51
Sell March 05/June 05 calendar
spread at price 0.74
Profit/Loss 0.30 (0.74-0.44)
Hedging
Holders of long or short positions in cash bonds will want to protect their investments from adverse
price movements. They can do so by buying or selling futures.
A bond portfolio manager is concerned about the rising trend in yields. To protect the portfolio he
considers the possibility of hedging the fund with either futures or options. Three alternatives are to
sell futures (locking in a single fixed value), buy puts (securing a minimum value), or sell calls (achieving
a maximum value). The diagram below compares the expiry profiles of the three alternatives.
22
Expiry profiles of alternative hedging strategies
The construction and explanations of each of the three expiry profiles are shown below.
Sell futures
The futures hedge leaves the fund manager completely flat. The advantage of this strategy is that there
is no premium outlay, but it does mean that if yields do not rise as expected but fall, the portfolio will
not benefit from this movement.
Buy puts
Buying puts allows the fund manager to protect his downside, but also allows him to profit from a rise
in bond prices if his expectation about increasing rates is incorrect. The disadvantage of this position is
that there is a price to pay for this protection the option premium. Upside potential is unlimited but
is reduced by the extent of the premium.
Profit/Loss
Long put
Long put hedge
Long portfolio
price
Option
premium
Profit/Loss
Futures hedge
Long
portfolio
price
Short
futures
Profit/Loss
Unhedged position
Futures hedge
Long put hedge
price
Short
call hedge
23
Sell calls
If the fund manager believed that rates where only likely to rise a small amount he could consider
selling calls. In this situation we can see that the resultant position allows the fund manager to be in
profit should rates rise or fall within a certain range. However, the disadvantage is that if rates rise or
fall by the extent of the premium taken in from the call sale, then the fund will have a capped upside
and an unprotected downside.
Clearly each alternative has its merits and it is up to the fund manager to decide which the most
appropriate strategy is.
Calculating the hedge ratio
Should he elect to hedge his portfolio with either futures or options an appropriate hedge ratio would
need to be calculated. If the bonds in the portfolio were non deliverable then the modified duration
approach would be applied. In this situation the Basis Point Value (BPV) of the portfolio (ie the BPV of
a bond may be calculated as the dirty price of the bond multiplied by modified duration, then divided
by 100) is found and hedged using the BPV of a futures contract. The appropriate calculations
are shown below.
BPV of futures contract = BPV of CTD/Price factor of the CTD
The full hedge ratio is given as:
or
x
BPV of CTD
BPV of portfolio
x Price factor of CTD
nominal value of futures contract
nominal value of portfolio
No. of futures
BPV of future
BPV of portfolio
x
nominal value of futures contract
nominal value of portfolio
No. of futures contracts
Profit/Loss
Short call
Option premium
Long portfolio
price
Short call
hedge
24
Example
Portfolio nominal value 100,000,000
BPV of portfolio 8.81
Futures nominal value 100,000
BPV of futures CTD 8.82
CTD price factor 1.1439664
Price of CTD Bond 124.31
Futures Price 108.18
= 1,143 contracts
Using futures in asset allocation
A fund manager wishes to alter the duration of his portfolio. By buying futures he can increase the
portfolios duration so that an expected fall in yields will present the fund manager with a greater
exposure to price increase sensitivity. In order to facilitate this process quickly, cheaply and with
reduced execution risk he elects to use Euronext.liffes Block Trading Facility (explained later).
Calculation of portfolio duration
Duration adjustment with futures
In order to adjust the duration (BPV) of the portfolio, the manager seeks to increase his portfolio
BPV from 6.531 to 6.884. The following formula may be applied:
Initial risk = par amount x BPVi = 4,000m x 6.531
Target risk = par amount x BPVd = 4,000m x 6.884
Futures risk = par amount x (BPVd BPVi) = 4,000m x (6.884 6.531)
Where:
BPVi is initial BPV of portfolio
BPVd is desired BPV of portfolio
BPV
CTD
= 6.56
CTD
PF
= 1.073288
1.1439664
8.82
8.81
100,000
100,000,000
No. of futures x x
25
Par Par Accrued Market Modified Basis
Yield Amount Price Interest Value Duration Point
Value
Long Gilt 6.77 2,500m 106.11 4.306 2760.4m 5.920 6.537
Long Gilt 6.68 1,500m 108.10 6.000 1711.5m 5.715 6.521
Total 4,000m 4471.9m
Weighted average 5.842 6.531
To calculate the number of futures required to increase the duration:
No. of futures =
=
=
= 2,310 contracts
Using Euronext.liffes Block Trading Facility the fund manager can efficiently adjust his position, avoid
slippage and make considerable savings when compared with the transaction charges and risks he may
experience if he chose to execute the trade in the underlying cash market.
The same principle can be applied if a fund manager holds a mixed currency portfolio and wishes to
switch from one asset class to another. For example, if the fund manager wished to reduce his Bund
holding and increase his Long Gilt position, by using the same technique as described above, the fund
manager would simply sell an appropriate number of Bund futures and buy the corresponding number
of Long Gilt futures to the desired level. Conducting such a switch in the cash market can be costly
and precarious. An advantage of using futures is that the existing portfolio remains intact until a time
when the fund manager feels it is appropriate to physically unwind his cash position when market
conditions prove favourable.
The Futures Roll
When a futures contract is bought or sold, it is not always with the intention of holding the contract
until expiry and then making or taking delivery of the underlying bond. A considerable proportion
of the market use bond futures as a way of managing the (interest rate) risk of holding a bond. The
futures contract will track the price of the underlying bond until it expires. As a futures contract nears
expiry, the open interest (number of open positions) in the contract begins to decline as positions are
transferred into the next available contract. This is known as the roll.
112 . 6
531 . 6 884 . 6
100
4000
x
k
m
PF CTD
i d
CTD BPV
BPV BPV
x
Notional
Par
/

futures
increase
BPV
BPV
x
Notional
Par
26
LIFFE CONNECT

Euronext.liffes futures and options can be traded either through the central markets or by using
Wholesale Trading Facilities, developed in recognition of the fact that markets need to provide
guaranteed execution to support specific trading strategies.
LIFFE CONNECT

is Euronext.liffes electronic trading platform and is widely recognised as one of

the most advanced derivatives trading platform in the world. It has a unique, flexible design that can
accommodate significant order flow and the transaction volumes associated with highly liquid, large
volume contracts. The combination of an open system design and high performance capacity makes
LIFFE CONNECT

a uniquely powerful and flexible alternative to any existing electronic or floor

based trading platform.
LIFFE CONNECT

utilises an open system architecture that allows access via modern standard PCs,
enabling a true customisation of front-end trading software. LIFFE CONNECT

has been designed to

take advantage of recent advances in software, networking and hardware infrastructure, with a view
to facilitating access from any financial centre or indeed from any PC, around in the world.
To participate in the market, access is available on a subscription basis. To facilitate this process,
Euronext.liffe has, and will continue to establish a series of strategic international hubs, which offer the
opportunity for even more international users to participate directly in the market. Users accessing
the market will require a Trading Application, which links to the Euronext.liffe host via the LIFFE
CONNECT

Application Program Interface (API). These Trading Applications may be free standing or
integrated into a subscribers existing front/back office trading, settlement, risk management and order
routing systems.
Access to LIFFE CONNECT

To gain direct access to LIFFE CONNECT

, your firm can either do so as an exchange member or as

an affiliate of an existing Euronext.liffe member.
LIFFE CONNECT

can be accessed electronically from the worlds major financial centres. Traders
wishing to access LIFFE CONNECT

can do so via one of the many front-end trading applications

which have been developed by Independent Software Vendors (ISVs). These applications are
personalised trading screens that link the user to the LIFFE market via a chosen network.
Customers have considerable flexibility and choice of network via which to access the market, including:
l direct access from London via the LIFFE markets local Exchange Access System (EASy) network
l direct access via Euronext.liffes international network provider
l access through services offered by Value Added Network (VANs) partners
l access via a members own network
Non-members of the LIFFE market may also access the market remotely via a number of indirect
methods which include:
l an order routing service offered to customers by a Euronext.liffe member, allowing a customer to
enter his orders electronically to the member who, in turn, channels the order immediately onto
LIFFE CONNECT

l trading bureaux, which allow independent traders to trade directly on LIFFE CONNECT

under
the umbrella of a Euronext.liffe member
l a broker with access to the LIFFE market
Accessing futures and options
on the Euronext.liffe Market
27
Trading on LIFFE CONNECT

Trading on LIFFE CONNECT

is characterised by two important aspects, the anonymity of the market

and the trade priority matching algorithm. Other key characteristics of LIFFE CONNECT

include its
strategy markets and implied pricing functionality.
Anonymity Trading anonymity is a key aspect of the LIFFE CONNECT

market. Traders in the

market will not be aware of whose orders they are viewing or trading against, in the central order
book, either before or after a trade.
Trade priority matching algorithm Trading takes place through the submission of orders, using
the members trading application, into the LIFFE CONNECT

central order book. Orders may be for

individual contract months, individual option series, or strategies. Once an order has been submitted,
the system then matches orders in the central order book. The criteria for determining trade priority
(ie which orders will trade first against each other) is dependent on the contract being traded. The
Trading Host configuration allows the trade matching algorithm to be set on a product by product
basis. The criteria used for this configuration will be one of the following:
l price and time priority
l price and pro-rata
Trading Algorithm
All of Euronext.liffes Bond futures use the price/time trading algorithm whereas the Bond options
use the price and pro-rata trading algorithm. The price/time trading algorithm has the following
characteristics:
Price: highest bid/lowest offer has priority over orders in the same contract month/strategy
Time: the first order at a price has priority over all other orders at the same price which will,
in turn, trade according to the time they were accepted by the Trading Host
The price and pro-rata trading algorithm has the following characteristics:
Price: highest bid/lowest offer has priority over other orders in the same contract month/strategy
Pro-rata: all orders at a price have the same priority; orders are filled in proportion to their volume
The pro-rata algorithm contains many variations. For Bond options it is Priority Order with
a Minimum Volume Requirement and Volume Cap
The pro-rata algorithm can be adjusted on a product by product basis so that a specific degree of
priority is given to the price maker before pro-rata sharing is applied in respect of any remaining
business. For each side of the market it allows one order in the book to be assigned a priority flag.
Once a new incoming order has traded against the priority flagged order, the pro-rata algorithm will
operate in the normal way. The aim of this mechanism is to encourage market participants to improve
prices by offering a reward of guaranteed volume, through the priority flagging of orders, in return for
the price improvement.
28
An order will gain priority status if it betters the current best price in the order book. Only one order
in a particular market can have priority status, and as a result priority status is removed from any
previous order. In order to gain this priority, the order must satisfy a minimum volume requirement.
In addition, priority for this order will be limited by the imposition of a volume cap.
There will not always be a priority order in the order book.This can occur when the priority order is
fully traded, leaving the other orders at the same or at a worse price, or when no orders which exceed
the minimum volume requirement have been submitted.
The minimum volume threshold
The minimum volume requirement level is configurable by contract. If the first order at a new best
price has a volume at or above the minimum volume threshold, then it will gain priority status. If the
first order does not meet the minimum volume threshold (thus not gaining priority), no subsequent
orders joining at that price will gain priority either, even if they meet the minimum volume threshold.
The following example illustrates the minimum volume threshold:
The Long Gilt option has a minimum volume threshold of 50 lots.
The first order submitted to sell 50 lots at the best price (Order A) would gain priority status.
A subsequent sell order of any size at the same best price (Order B) would not be given trade
priority. If a buy order for 60 lots at that price was then submitted to the Trading Host, Order
A would be given priority in execution and would be fully traded. Order B would receive the
remaining 10 lots from the incoming buy order.
Where an order satisfying the priority requirements is subsequently bettered by an order submitted
at an improved price, it will regain its priority once the better order has been executed or withdrawn,
providing that the volume of that better order was below the minimum volume threshold. If the
volume of the order at the better price was at or above the minimum volume threshold then the
original order would lose its priority amongst other orders at that price and would be subject to the
simple pro-rata algorithm.
The maximum volume cap
An order satisfying the priority requirements described above will also be subject to a volume cap
which will limit the trading priority of the order up to a maximum level. Once the priority volume
has traded, any remaining volume will be treated on a prorate basis along with all other orders at that
price. The following example illustrates the maximum volume cap:
The Long Gilt option has a minimum volume threshold of 50 lots and a volume cap of 500 lots.
A new order to sell 520 lots at a new best price (Order C) will gain trading priority since it satisfies
the minimum volume threshold. A second order submitted to sell 40 lots (Order D) at the same price
will join the offer but not gain any priority status.
29
If a buy order for 200 lots at that price was submitted, 200 lots of Order C would be executed
immediately. Priority for a further 300 lots (ie up to the maximum volume cap of 500 lots, including
the 200 lots already executed) would be retained by order C. If a buy order for 330 lots at that price
is submitted, 300 lots of the remainder of Order C would be executed immediately. However, the
remaining 20 lots of Order C and the 40 lots of Order D would be executed on a pro-rata basis
against the remaining 30 lots of the buy order, with Order D receiving 20 lots and Order C receiving
a further 10 lots.
For Long Gilt options, the minimum volume requirement is currently 50 lots and the maximum
volume cap is 500 lots.
If you would like further information on LIFFE CONNECT

, please see www.euronext.com or email

liffeconnect@liffe.com.
Wholesale Trading Facilities
Euronext.liffe provides three wholesale trading facilities that recognise the need to provide certainty of
execution to support defined trading strategies and are designed to complement the central market.
These Wholesale trading facilities comprise:
l Block Trading
l Basis Trading
l Asset Allocation
Of the three wholesale facilities available, Block Trading and Basis Trading are applicable to Bond
futures and options. In providing these facilities, Euronext.liffe meets the markets needs whilst striking
the right balance between the central market and the certainty of execution.
Euronext.liffes Block Trading Facility
The Block Trading Facility allows Euronext.liffe members and their Wholesale Clients (see definition
below) to transact business of significant size as bilaterally agreed transactions on-Exchange, without
delay and with certainty of price and execution.
Block Trades are subject to minimum threshold levels. Euronext.liffe members may not aggregate
separate orders to meet minimum threshold requirements. Euronext.liffe will monitor and adjust,
when necessary, the minimum size threshold of Block Trades to protect the quality of market
on LIFFE CONNECT

. Please refer to Euronext.liffes website (www.euronext.com) for current

threshold levels.
Contracts eligible for transaction via the Block Trading Facility
All bond futures and option contracts listed by the Exchange are eligible for trading via this facility.
Block traded contracts become positions indistinguishable from positions created through electronic
trading (thus making Block Trades subject to the standard contractual and clearing structures of
the market).
30
Available to members and wholesale clients only
There are no restrictions on Euronext.liffe members themselves entering into Block Trades. However,
with respect to non-members of Euronext.liffe, only Wholesale Clients (ie those with sufficient
knowledge, expertise and understanding of the implications of the facility) will be able to participate in
Block Trades.
Before a Euronext.liffe non-member client may participate in the facility, the Euronext.liffe member
must satisfy himself that the client meets these criteria. The client must also be notified in writing, in
advance, that he is to be treated as a Wholesale Client for the purposes of Block Trading. In addition,
before any given Block Trade may take place, the member will be required to make it clear to his client
(whether the client is a Euronext.liffe member or not) that the quote he is being given is a Block Trade
price and not a market price (ie prevailing LIFFE CONNECT

price).
Pricing
Block Trades may legitimately take place at prices different to the prevailing market price. However,
Euronext.liffe has determined that members must ensure that any Block Trade price quoted satisfies
fair market value principles ie that such a price is fair and reasonable given the lot size of the Block
Trade and the price and size of business being quoted in the central market. As an additional safeguard,
the Exchange and LCH.Clearnet will require members to justify any trades negotiated at apparently
abnormal levels and will reserve the right to refuse to register any such trades.
Registration and reporting of Block trades
Euronext.liffe members have 3 minutes, from the verbal agreement of the details of a Block Trade
between the parties concerned, in which to report the Block Trade to the Exchange.
Block Trades will be included within existing price reports, albeit with a separate trade type indicator
K. It is possible that Block Trades create new highs/lows, as is already the case for volatility and
strategy trades. Therefore market participants are advised to ensure that they review and amend
(as appropriate) any arrangements they may have with their clients regarding the execution of any
orders which depend upon specific trading levels being reached (eg stop orders).
Euronext.liffes basis trading facility
Euronext.liffes Basis Trading Facility the BTF permits market users to enter into a conditional
transaction in a Euronext.liffe futures contract and a corresponding cash instrument.
What is a basis trade?
A basis trade is the simultaneous exchange of a financial asset or instrument (eg a cash bond, OTC
swap, or a basket of stocks) together with an appropriate offsetting number of futures contracts, in
a privately negotiated transaction between two parties.
The cash leg is not traded on Euronext.liffe, but is traded in the normal way between the two
counterparties, with the requirement that the member provides, if requested, evidence of the cash
leg transaction.
31
BTF trading procedures
Exchange members may organise basis trades outside the central order book and present the required
trade details to Exchange for authorisation. Once validated, the volume and the contract traded are
published to the market as a whole, and Euronext.liffe staff register the trade on behalf of the member.
Any Exchange member with the requisite trading right for the contract in question can arrange a
basis trade. If not, trade details can be provided to the Exchange via a member who has. The member
presenting the trade to the Exchange is referred to as the basis trade executing member.
Basis trades can be transacted during normal trading hours of the contract concerned. Registration
slips must be presented to the Exchange within 30 minutes of the trade being arranged, and no later
than 15 minutes before the close of trading in the Euronext.liffe contract. Basis trades may be
arranged on any trading day up to the day before the first notice day of the delivery month.
Registration and reporting of basis trades
The executing member must assign the price to the futures leg of the trade. This price must be within
the high/low range for the contract in question during the 30 minutes before the trade is submitted.
If there has not been a trade in the last 30 minutes, the price assigned must be within theoretical
high/low range calculated by the Exchange for the same period. Basis trades are not allowed in a
futures delivery month that has never traded.
Summary reference information on the cash leg of the basis trade should be provided to the Exchange
on the registration slip presented at the time of transaction. However, full details of this cash leg trade
must be retained by the executing member, including evidence of trade completion, and be made
available to the Exchange on request.
Euronext.liffe specifies what is acceptable for the cash leg of the trade, and on the ratio between the
amount of cash and futures traded.
The following instruments can be used as the cash leg of a basis trade:
l Government Bonds
l Non-Government Bonds
l Vanilla interest rate swaps
l Forward Rate Agreements
l Repo Transactions
l OTC Options
Details of the futures leg will be distributed to Quote Vendors, marked with the trade type
indicator J. Further information regarding Euronext.liffes BTF facility can be obtained from
www.euronext.com
32
Margining is the deposit of cash or collateral with the clearing house when you create a futures or
options position.
The role of the clearing house
The margining system is one of the unique distinctions of exchange traded futures as opposed to
the operation of over-the-counter (OTC) markets for derivative products. The margining system
provides important protection to the market. Central to this protection is the clearing house.
Euronext.liffes clearing house, LCH.Clearnet, guarantees trades registered by LCH.Clearnet members.
Any Euronext.liffe member who is not a member of LCH.Clearnet must therefore have a clearing
agreement with a member of LCH.Clearnet (ie a clearing member) in order to transact business on
the Exchange. There are several categories of clearing member at Euronext.liffe, all of whom are
subject to minimum financial requirements laid down by Euronext.liffe and LCH.Clearnet.
LCH.Clearnet members clearing Euronext.liffe business fall into one of three categories
of membership:
l a general clearing member (GCM) is entitled to clear Euronext.liffe transactions made for its
own account and for its clients, and for the accounts of non clearing members under the terms
of a standard clearing agreement;
l an individual clearing member public order (ICM POM) is entitled to clear trades executed
for its own account and its clients only; and
l an individual clearing member non public order (ICM NPOM) is entitled to clear trades
executed for its own account only.
Having satisfied LCH.Clearnets criteria and gained membership of one of the three clearing categories
referred to above, LCH.Clearnet members are monitored by LCH.Clearnet to ensure that they
continue to meet specified criteria.
Once LCH.Clearnet has registered a trade, it becomes the central counterparty to the buying
and selling clearing members, by a legal process known as novation. As central counterparty,
LCH.Clearnet ensures the financial performance of trades through to delivery. To assess and control
the risk associated with its position as central counterparty, LCH.Clearnet has a comprehensive
risk management approach. Central to this is the calculation and collection of initial and variation
margin payments.
Variation margin
The day to day gains and losses of all participants are collected by clearing member firms and
presented to LCH.Clearnet. Continuous accounting and collection ensures that all members
customers receive the gains (and pay the losses) associated with their positions each day. This
continuous collection and payment programme insulates members customers from the potential
of losing access to their gains earned during the course of substantial market movements over
extended periods of time.
At the same time the process offers its members a signal for the early identification of customers
who might be unable to fulfil their obligations. The members first line of protection comes from
the collection of daily variation margin, the mechanism for day-to-day collection of gains and losses.
This protection is augmented by the collection of initial or SPAN

margin, which provides protection

to LCH.Clearnet against the default of a clearing member.
Margining
33
One of the largest and most significant differences between forward markets and futures markets is
the handling of day-to-day gains and losses. Generally in over-the-counter forward markets, all of the
gains or losses associated with a position are exchanged at some designated date in the future. This
deferral or disassociation between the economic event causing a gain or loss and its ultimate payment
introduces a level of credit risk. The counterparties must each consider if the other will be capable of
paying what might become a very substantial sum at some deferred date. Such a practice introduces a
high degree of credit risk between counterparties leading to the requirement that firms investigate
each others financial conditions and set credit lines and limits for each potential counterparty.
An enormous investment in credit screening results from this practice.
On Euronext.liffe, the process of members daily collection and payment of variation margin effectively
removes a vast amount of this credit risk from customers concerns. A customer who had purchased
futures and then watched the market move up from the purchase price will have received the profits
of the position on a daily basis and need not be concerned with the ability of any specific counterparty
to be able to pay their losses at a distant future date.
The determination of the daily settlement price
The key to the variation margin process is the Exchanges determination of an accurate daily
settlement price for each and every futures and options contract. At the close of trading of a contract,
the Exchange publishes a final end of day price. If at the close there is insufficient trading volume to
observe this final price the Exchange officials will use the price generated by the Exchange pricing
model, pertinent to the futures or options contract, which is based on prices from the underlying
market. Settlement prices are automatically transmitted to member back offices.
Options delayed payment of premium
The same variation margin calculation applies to options on futures. For these options the premium
is not paid in-full up front, but takes the form of variation margin payments and receipts.
Initial margin
The initial margin provides protection to the member and LCH.Clearnet in the event that sufficient
client funds are not readily available to satisfy day to day variation margin requirements. In this way the
initial margin acts as a deposit which may be used by the member to satisfy the customers or clearing
members obligations if the customer or clearing member fails to do so. The amount of this initial
margin is set by LCH.Clearnet based on historical trends in terms of market price volatility as well
as forthcoming events which may further affect volatility.
SPAN

margining requirements
The initial margining system employed by LCH.Clearnet is SPAN

(Standard Portfolio Analysis of

Risk) which was originally developed by the Chicago Mercantile Exchange. The SPAN

system looks at
both futures and options contracts relating to a single underlying contract/portfolio (such as all Gilt
futures and options positions, across a range of different contract months). It then defines a range of
potential movements of futures prices (both up and down), called a scanning range, and a range of
potential changes in the implied volatility of options, called a volatility shift. An accounts initial margin
requirement is calculated as the largest possible loss that a customers portfolio (including all futures
and options positions based on the same underlying instrument) would face in the worst case scenario
of market events.
34
This largest possible loss is known technically as scanning risk. Futures contracts values are not
affected by the movements in implied volatility of options and thus the largest possible loss will
come from the greatest futures market movement. The determination of a scanning range by
LCH.Clearnet, effectively defines the initial margin requirement for a position involving a single futures
contract. These scanning ranges are periodically reviewed by LCH.Clearnet and can be adjusted as
circumstances change. Scanning ranges are not changed with great frequency and can be relied upon
without requirement to consult LCH.Clearnet on a daily basis. Frequent checks however are made.
Euronext.liffe rules concerning initial margins, stipulate that clients must be charged at least the same
level as LCH.Clearnet would charge clearing members in respect of the same position.
The scanning risk is not the entire amount of initial margin required. A positions initial margin
requirement will also reflect charges and credits associated with all of the other contracts maintained
in the customers account. Some of these are explained briefly below.
Inter-month spread charge
In the case of a customer with a position including both long positions for delivery in one contract
month and short positions in the same bond futures contract for a different delivery month, a
substantially reduced margin will be levied. The SPAN

system imposes an inter-month spread charge

reflecting possible changes in the basis which is significantly lower than it would be if the long and
short legs were calculated individually.
Spot month charge
Between the last trading day and the delivery day, a spot month charge is added to the calculation
of the initial margin requirement to cover the risk of a delivery default on delivery during the
delivery process.
Inter-commodity credit
The SPAN

system recognises that there are strong correlations between some contracts traded on
Euronext.liffe and credits accounts with offsetting positions in these correlated contracts (eg long
Long Gilts versus short Bunds).
Levels of protection and supervision
Members of the Exchange are supervised at several levels. The Exchange itself is responsible for
enforcing rules relating to fair trading practices and the ongoing behaviour of its own members and
their employees in their handling of customer orders and accounts. Customers may be concerned as
to the level of protection and supervision offered in the safekeeping of their initial margin deposits.
The Financial Services Authority (FSA) is a self regulatory organisation operating under the Financial
Services Act 1986. The FSA has responsibility for creating policies relating to its members conduct,
overseeing members activities and enforcing its policies.
Due to the fact that brokers are required to collect initial margins from customers and to enforce the
rules of LCH.Clearnet as regards maintenance of sufficient margins in customer accounts, the FSA has
established rules and procedures governing the members handling of those funds. The cornerstone of
customer protection is the principle of segregation. Customer funds held in fulfilment of margin rules
and requirements must be kept separate from, or segregated from, the member firms own funds.
Audit teams from the FSA make regular, unannounced visits to member firms to confirm compliance
with rules covering the segregation and integrity of customer funds.
Further information on SPAN

margining can be found on www.euronext.com.

35
4. Price Factor
4.01 The List of Deliverable Gilts published by the Board in respect of a delivery month under
term 3.01 will specify a price factor (the Price Factor) for each Deliverable Gilt calculated
in accordance with:
(a) in the case of a Deliverable Gilt which is fully paid, the formula set out in term 4.02; and
(b) in the case of a Deliverable Gilt which is not fully paid, the formula published from time to
time by General Notice.
4.02 (a) For each Deliverable Gilt which is fully paid the Price Factor will be calculated in accordance
with the formula:
P(6)
100
where P(6) equals the price per 100 nominal of such Deliverable Gilt at which it has a gross
redemption yield of 6% per annum, calculated as at the first day of the delivery month, minus
the undiscounted amount of accrued interest on such Deliverable Gilt on that day, using the
formulae set out in paragraphs (b) and (c) of this term.
(b) P(6) shall be calculated in accordance with the following formula:
where: d
1
= Cash flow (which could be zero) due on the following quasi-coupon date, per 100
nominal of the gilt. d1 will be zero if the first day of the delivery month occurs in the
ex-dividend period or if the gilt has a long first coupon period and the first day of the
delivery month occurs in the first full coupon period. d1 will be less than c/2 if the first
day of the delivery month falls in a short first coupon period. d
1
will be greater than c/2
if the first day of the delivery month falls in a long first coupon period and the first day
of the delivery month occurs in the second full coupon period;
d
2
= Cash flow due on the next but one quasi-coupon date, per 100 nominal of the gilt. d
2
will be greater than c/2 if the first day of the delivery month falls in a long first coupon
period and in the first full coupon period . In all other cases,d2 = c/2;
c = Annual coupon per 100 nominal of the gilt;
r = Number of calendar days from and including the first day of the delivery month up to
but excluding the next quasi-coupon date;
s = Number of calendar days in the full coupon period in which the first day of the delivery
month occurs;
n = Number of full coupon periods between the following quasi-coupon date and the
redemption date;
AI = Accrued interest per 100 nominal of the gilt calculated using the formula set out in (c);
AI -
1.03
100
+
1.03
1
-
1.03
1
06 . 0
c
03 . 1
1.03
1
= P(6)
n n
2
1 ]
]
]
,

,
(
,
\
,
(
j
+ +
d
d
s
r
36
Appendix A
Long Gilt futures contract price factor
(c) The accrued interest (AI) in the formula set out in paragraph (b) will be calculated in
accordance with the following formulae:
(i) If the first day of the delivery month occurs in a standard coupon period, and:
the first day of the delivery month occurs on or before the ex-dividend date:
the first day of the delivery month occurs after the ex-dividend date:
where: AI = Accrued Interest per 100 nominal of the gilt;
c = Annual coupon per 100 nominal of the gilt;
t = Number of calendar days from and including the last coupon date up to but excluding
the first day of the delivery month;
s = Number of calendar days in the full coupon period in which the first day of the delivery
month occurs;
(ii) If the first day of the delivery month occurs in a short first coupon period, and:
the first day of the delivery month occurs on or before the ex-dividend date:
the first day of the delivery month occurs after the ex-dividend date:
where: t* = Number of calendar days from and including the issue date up to but excluding the first
day of the delivery month;
r = Number of calendar days from and including the issue date up to but excluding the next
quasi-coupon date;
and c and s have the same meanings as in (i) above.
(iii) If the first day of the delivery month occurs in a long first coupon period, and:
the first day of the delivery month occurs during the first full coupon period:
2 s
u
= AI
1
c

2 s
t
= AI
*
c r

2 s
= AI
*
c t

2
1
s
t
= AI
c
(
,
\
,
(
j

2 s
t
= AI
c

37
the first day of the delivery month occurs during the second full coupon period and on or
before the ex-dividend date:
the first day of the delivery month occurs during the second full coupon period and after
the ex-dividend date:
where: u = Number of calendar days from and including the issue date up to but excluding the first
day of the delivery month;
s
1
= Number of calendar days in the full coupon period in which the issue date occurs;
s
2
= Number of calendar days in the next full coupon period after the full coupon period in
which the issue date occurs;
r
1
= Number of calendar days from and including the issue date up to but excluding the next
quasi-coupon date;
r
2
= Number of calendar days from and including the quasi-coupon date after the issue date
up to but excluding the first day of the delivery month which falls in the next full
coupon period after the full coupon period in which the issue date occurs;
and c has the same meaning as in (i) above.
Short and long first coupon periods
When the DMO issues Gilts, it tries to arrange the payment of coupons on a standard cycle.
Currently it is every March and September. However the auctions themselves do not always occur on
coupon dates. This means that a Gilt which is auctioned on a date which is between standard coupon
payment dates will have a long or short first coupon. The PF formulae above illustrates the different
methods by which accrued interest must be calculated depending on whether the first coupon period
is standard, long, or short.
2
1
s
r
= AI
2
2
c

(
(
,
\
,
,
(
j

2 s
r
= AI
2
2
1
1
c
s
r

(
(
,
\
,
,
(
j
+
38
Bond futures
Long Gilt JGB
ADP LN# NJ#
Bloomberg Financial Markets GA <CMDTY> N A <CMDTY>
Bridge Profit Centre GB\R GB\N
Bridge Station GB@R GB@N
CQG QG QJ
Futuresource LGL LJB
Reuters FLG:<F3> FYB:<F3>
Telerate 25693 25603
ILX Global Systems TOPIC3 20012 20021
Track Data LG LJ
Bond options
Long Gilt
ADP FG#
Bloomberg Financial Markets GA <CMDTY> OMON
Bridge Profit Centre GB\R
Bridge Station GB@R
CQG QG
Futuresource PLGL/CLGL
Reuters FLG++<F3>
Telerate 25605-25620
ILX Global Systems TOPIC3 19900
Track Data LG
Appendix B
Quote vendor contract codes
39
Introductory to Intermediate
Introduction to Derivatives Don Chance
ISBN 0-03003-588-0 Dryden
Options and Financial Futures David Dubofski
ISBN 0-07112-583-3 McGraw Hill
Introduction to Futures and Options Markets John Hull
ISBN 0-13783-317-2 Prentice Hall
Futures Options and Swaps Robert Kolb
ISBN 1-57718-063-1 Blackwell
Options as a Strategic Investment Lawrence G. McMillan
ISBN 0-13636-002-5 New York Institute of Finance
Option Volatility and Pricing Sheldon Natenberg
ISBN 1-55738-486-X McGraw Hill
Intermediate to Advanced
Fixed Income Mathematics Frank Fabozzi
Analytical and Statistical Techniques Irwin
ISBN 0-78631-121-5
Valuation of Fixed Income Securities Frank Fabozzi
and Derivatives FJF
ISBN 1-88324-906-6
Option Futures and other Derivatives John Hull
ISBN 0-13264-367-7 Prentice Hall
The European Bond Basis Christopher Plona
ISBN 0-7863-0852-4 Irwin
Money Market and Bond Calculations Stigum and Robinson
ISBN 1-55623-476-7 Irwin
Dynamic Hedging N. Taleb
Managing Vanilla and Exotic Options Wiley
ISBN 0-471-15280-3
40
Appendix C
Further reading
Amsterdam
P.O. Box 19163,
1000 GD Amsterdam,
The Netherlands.
Tel: +31 (0)20 550 5555
Fax: +31 (0)20 550 4900
Brussels
Palais de la Bourse/Beurspaleis,
Place de la Bourse/Beursplein,
1000 Brussels,
Belgium.
Tel: +32 (0)2 509 12 11
Fax: +32 (0)2 509 12 12
Lisbon
Av. da Liberdade, no 196, 7 Piso,
1250-147 Lisbon,
Portugal.
Tel: +351 21 790 00 00
Fax: +351 21 795 20 26
London
Cannon Bridge House,
1 Cousin Lane,
London EC4R 3XX,
United Kingdom.
Tel: +44 (0)20 7623 0444
Fax: +44 (0)20 7588 3624
Paris
39, rue Cambon,
75039 Paris Cedex 01,
France.
Tel: +33 (0)1 49 27 10 00
Fax: +33 (0)1 49 27 11 71
www.euronext.com
June 2006
4434/June-06/500/US