THE DURATION OF A BOND FUTURES CONTRACT

It is important to remember that the traditional calculation for duration is not valid for futures contracts because they do not generate cash flows, that is to say a futures contract does not have the same duration as the underlying bond, because the underlying bond as we know is a sequence of cash flows made up of coupon payments and final maturity. A common method used calculates the interest rate risk; we adjust the basis point value of the current Cheapest to Deliver (CTD) (the least expensive underlying product that can be delivered upon expiry to satisfy the requirements of a derivative contract) by its conversion factor (a link between each deliverable bond and the futures market) The calculation would appear as futures price x conversion factor + accrued interest. This approach captures the interest rate risk of the underlying bond, then converting it to a futures based measure of risk. This way the futures risk will change as the risk of the underlying CTD bond changes. When current CTD bond changes, futures risk will be determined by the new CTD’s basis point value adjusted by its unique conversion factor. This approach minimises large jumps in futures risk and their effect on hedge ratios resulting from CTD changes.