Government Bond Research

The Lehman Brothers Multifactor Futures Model

September 1997 Phil Weissman (212) 526-0697 Ralph Axel (212) 526-5573

Executive Summary
I The new Lehman Brothers model uses a two-factor stochastic process of yield changes and a precise evaluation of the switch option. These features result in more accurate estimates of delivery probabilities and enhanced valuation accuracy. We have incorporated both general collateral and special term repo rates. This feature allows us to account accurately for the apparent richness to the rest of the curve of the deliverable bonds. Hedging performance is significantly improved by using hedge ratios derived from the model rather than hedge ratios derived from duration.

Government Bond Research Strategies Doug Johnston Nitsan Hargil Stuart Sparks Prashant Vankudre Ralph Axel Alfredo Bequillard Peter Lindner Alex Reyfman Phil Weissman Julio Maclay Ronald Grobel John Lu Jim Wang 212-526-6566 212-526-5566 212-526-6566 212-526-8380 212-526-5573 212-526-7690 212-526-0585 212-526-7253 212-526-0697 212-526-7419 212-526-1340 212-526-6993 212-526-6808

Modeling

Analytics

Publications: M. Parker, D. Marion, V. Gladwin, A. DiTizio, C. Triggiani, B. Davenport.

_______________________________________________________________________________________________________________________________________________________________________ This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. The information in this document has been obtained from sources believed reliable, but we do not represent that it is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/ or its affiliated companies may have managed or co-managed a public offering of or acted as initial purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. 1997 Lehman Brothers Inc. All rights reserved. Member SIPC.

INTRODUCTION
The Lehman Brothers futures model analyzes the four Treasury bond and note futures contracts in a unified framework, incorporating two yield factors to simulate evolution of all the deliverable bonds yields. The model includes precise valuation of the switch option, a significant feature of the futures contract that can be worth as much as a tick. The models output includes the futures price and dollar duration of the contract as well as the probability of delivery for each deliverable bond. Measures of price sensitivity to financing rates (repo) and yield curve changes are also incorporated, and the model identifies the switch pointsthe price levels where the cheapest to deliver (CTD) changes. We tested the model using historical data to ensure accuracy of the algorithm and validity of the output. We also back-tested the duration results by forming hedge portfolios against the Lehman Brothers Treasury Index. Accurate repo data are essential to the model: the sensitivity of a deliverables forward price to its repo rate is about five cents per 10 basis point change in the financing rate for a six-month contract. Although most of the deliverables can be financed at general collateral in the repo market, the CTD and other bonds with high delivery probability frequently trade special. The Lehman Brothers trading desk provides term repo rates for each deliverable security at each contract maturity date. Our model prices the four currently traded Treasury futures contracts: the bond future and the 10-, 5-, and 2-year note futures. The model allows for the possibility of delivery of as-yet-unissued notes into the 5- and 2-year contracts.

options (or is long options in our terminology). These options lower the price of the futures contract in addition to altering its characteristics. The shorts choice of the specific bond to deliver is called the quality option. The choice of when to deliver during the delivery month is called the timing option. This option is generally considered of little value and is not addressed by our model. In an upwardly sloping yield curve environment, carry is positive making it advantageous for the short to deliver at the last possible moment. Each days accrued interest that the short receives is more than the daily financing cost of the deliverable. The futures contract stops trading at noon Chicago time on the eighth to last business day of the delivery month; this is the last trade date.1 Thereafter, the futures price does not change. The final business day of the delivery month is the last day that the short can make delivery; this is the final delivery date. To model the quality option precisely meant that we had to model the last week of the quality option accurately. We use the term switch option to refer to the final week of the quality option. Models that ignore the switch option assume that the contract trades until the final delivery date. We found that the switch option can be significant. For example, if the conversion factor of the CTD is 1.25 and the option value is constant, then before the last trade date a $1 increase in the forward price of the CTD results in a $0.80 ($1/1.25) increase in the futures price. After the last trade date, a $1 increase in the forward price of the CTD is $1 of incremental value to the longs position since the amount due the short does not change. The volatility of the longs position is greater after the last trading date than it was while the futures contract was trading. This rise in price volatility during the last week increases the likelihood of a change in the CTD, thereby increasing the option value. The switch option increases the value of the quality option when the likely deliverables have conversion factors greater than one. In the current yield environment, conversion factors greater than one are typical for the CTD of the Treasury bond futures contract. For the June 1997 contract, the
1For the 2-year note futures contract, the last trade date is the earlier of the

THE MODEL
Options Embedded in the Contract
The bond futures contract is an agreement between two parties, the short and the long, whereby the short is obligated to deliver any bond from a list of deliverables to the long on any day during the delivery month. At the time of delivery, the long must pay the short the futures price times the bonds conversion factor plus the bonds accrued interest on the delivery date. The counterparty that is short the futures contract has some valuable Lehman Brothers

second business day prior to issue of the 2-year note auctioned in the delivery month, or the last business day of the delivery month. The final delivery date is the third business day following the last trade date.

September 1997

111/4 of 2/15/15 accounted for over 98% of the bonds delivered. Its conversion factor was 1.3111. Ignoring the switch option can result in underestimating the value of the quality option and overestimating the fair value of the futures contract. We have measured the value of the switch option to be as much as a tick (1/32 point). Figure 1 compares the value of the quality option for the September 1996 Treasury bond futures contract with and without modeling the switch option.

Calculation of the Futures Price

When the short makes delivery, the long must pay the short an amount equal to the futures price times the bonds conversion factor plus the bonds accrued interest on the delivery date. The basis of a bond is the difference between its price with accrued interest and the amount that the long would pay for delivery. To prevent arbitrage, the closing futures price on the last trade date must make the expected minimum basis on the final delivery date zero,2,3

Bi and are the clean bond prices and the futures price, respectively, as of the final delivery date. Each Bi has conversion factor i. The expectation in Equation 1 is over risk-neutral probabilities and is taken as of the last trade date. To find the futures price today, the model uses a grid of possible yield scenarios associated with the last trade date. We use a two-factor model of yield changes to construct this grid with the probabilities corresponding to the chances of realizing a given yield scenario at a particular grid point. At each grid point, the model computes the fair futures price using Equation 1. Once the futures price is determined at a grid point, it is probability weighted to solve for the futures price today. Todays futures price satisfies the relationship
today = E today ( last trade date ) .

(2)

Two Yield Factors Describe Curve Dynamics

We use two yield factors to describe yield changes for the deliverable bonds over a time horizon. The factor loadings, which compose the factors, are similar to the concept of yield betas. They represent the relative yield movement of the bonds due to the factor. The two yield factors, computed from a history of daily yield changes, typically describe 99.5% of the yield variance within the deliverable set. The first factor describes a change in the level of yields with all bonds moving in the same direction. The second factor describes a twist in the yields of the deliverable set with the shorter bonds moving in the opposite direction from the longer bonds. Figure 2 shows representative factor loadings for the deliverable set for the bond futures contract. Although the first factor accounts for close to 99% of the variance of yield changes, the second factor tends to become important over certain short periods (particularly around expectations of Federal Reserve actions). During these periods, the delivery probabilities of bonds in the deliverable set produced by the two-factor model can be affected significantly compared to those produced by a one-factor model. We use two factors to reflect the delivery probabilities more accurately.

E min B i i

{ (

)} = 0 .

(1)

2This approximation ignores the path dependency of the short rate, but over a one-week horizon the effect of the path dependency is negligible. 3In contrast to Equation 1, ignoring the switch option leads to the relationship on the final delivery date,
min

Bi = 0. i

Figure 1.

September 1996 Bond Contract Comparison of Models with Different Delivery Decision Methods

Option Value (32s)

7 6 5 4 3 2 1 0 4/5 With Switch Option Without Switch Option

Use of Fitted Yields

We use factors computed from changes in fitted yields of deliverable bonds from our fitted Treasury curve rather than from actual yield changes. Factors calculated from fitted yields indicate relative movements of

4/20

5/5

5/20

6/5

6/20
Date

7/5

7/20

8/5

8/20

9/5

9/18

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the deliverable set that maintain any richness or cheapness already present in the prices. We use this approach to avoid the potential problem that some bonds could become unrealistically rich or cheap compared to other bonds in certain yield curve scenarios. Factors calculated from actual yield changes (actual factors) describe relative yield movements only within the range of the yield history. For example, the 11 1/4 of 2/15/15 is the deliverable bond with the shortest duration for the Treasury bond futures contract.4 In low yield environments (below about 7%), this bond is the CTD. During 1996, a period when yields fluctuated within the 6 1/2% - 7% range, a statistically significant correlation of 75% between zero volatility spread (a measure of richness) and yield was observed for this bond. As yields rose, the yield of the 11 1/4 of 2/15/15 rose faster
4To be deliverable into the bond futures contract, a bond must have remaining at least 15 years from the first day of the delivery month until the first redemption date. The September 1994 contract was the last with a callable bond in the deliverable set. Since then, the 11 1/4 of 2/15/15 has been the deliverable with both the highest coupon and the closest maturity date. It will be in the deliverable set for all bond contracts up to and including the one maturing in December 1999.

than that of similar bonds. As yields fell, the yield of the 11 1/4 of 2/15/15 fell faster than that of similar bonds. Yield factors computed from actual yield changes show elevated volatility for the 11 1/4 of 2/15/15 and decreased volatility for bonds such as the 7 1/4 of 5/15/16, bonds that are most likely to be delivered if yields rise sufficiently. Figure 3 compares the factor loadings of two bonds using actual and fitted yield changes. If these relative volatilities were to be extrapolated to the yield changes necessary for a change in the CTD, the 11 1/4 of 2/15/15 would be unrealistically cheap relative to the 7 1/4 of 2016. Estimating factors from changes in fitted yields avoids this problem.

Out-of-sample Explanatory Power

We compute factors using 60 days of yield history. To measure the explanatory power of these factors, we find the difference between yield changes that occur in the deliverable bonds over a given period and the best representation of those yield changes using the two factors. This difference, called the residual, is the portion of yield changes not explained by the factors. The ratio of the residual to the size of the actual changes gives a measure of the factors explanatory ability. These ratios, expressed in percent, are shown in Figure 4. The ratio of residual magnitude to yield change magnitude is smaller on average for factors computed using 60 days of history

Figure 2.

Representative Factor Loadings for Bond Deliverables

Factor 1 79.8 bp 79.5 79.3 79.0 78.7 78.4 78.2 78.1 77.7 77.4 77.3 76.9 76.8 76.7 76.6 76.3 76.2 76.2 76.1 75.7 75.7 75.6 75.3 75.4 75.4 75.2 75.0 75.1 75.1 75.1 75.0 Factor 2 2.5 bp 2.3 2.1 2.0 1.6 1.5 1.5 1.4 1.1 0.9 0.8 0.5 0.4 0.4 0.3 -0.1 -0.1 -0.2 -0.3 -0.7 -0.7 -0.9 -1.3 -1.4 -1.5 -1.8 -2.2 -2.1 -2.2 -2.3 -2.5

Deliverable 11.250 02/15/15 10.625 08/15/15 9.875 11/15/15 9.250 02/15/16 7.250 05/15/16 7.500 11/15/16 8.750 05/15/17 8.875 08/15/17 9.125 05/15/18 9.000 11/15/18 8.875 02/15/19 8.125 08/15/19 8.500 02/15/20 8.750 05/15/20 8.750 08/15/20 7.875 02/15/21 8.125 05/15/21 8.125 08/15/21 8.000 11/15/21 7.250 08/15/22 7.625 11/15/22 7.125 02/15/23 6.250 08/15/23 7.500 11/15/24 7.625 02/15/25 6.875 08/15/25 6.000 02/15/26 6.750 08/15/26 6.500 11/15/26 6.625 02/15/27 6.375 08/15/27

Figure 3.

Ratios of the First Factor Loading of Two Bonds to that of the 9 7/8 of 11/15/15
111/4 2/15/15 1.0047 1.0301 105/8 8/15/15 1.0014 1.0092

Factors Using Fitted Yields Actual Yields

Figure 4.

Percent of Yield Changes Not Explained by Historical Factors

RMS* Residual/RMS Yield Change 30-day Estimation 60-day Estimation Windows Windows 0.83% 0.76% 0.81 0.71 0.63 0.58 0.66 0.68 0.60 0.59

Look-ahead Period (days) 5 10 15 20 25

* Root mean square. Data: Fitted yields from January 3, 1995 to January 21, 1997.

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than using 30 days. In both cases, however, the percentage of yield changes explained by the two factors always exceeds 99%.

vCTD and wCTD the scaled factor loadings of the CTD for the first and second factors, respectively, and by 1 and 2 the proportion of the historical variance explained by the two factors, respectively. Then we set
1 2 v CTD = 1 + 2 2 2 w CTD = 1 + 2

Constancy of Factors
The factors computed from 60-day rolling windows using changes in fitted yields are very stable. Our measure of constancy is determined by comparing the factors from a particular 60-day window to the factors computed for the entire sample period.5 The first and second factors are considered separately. A measure in the range of 0 to 1 indicates the degree to which the factors are the same, with 1 indicating perfect constancy. Factor one is very close to being perfectly constant over time. Figure 5 shows the constancy of the second factor. The results show that both the factors possess a high degree of constancy over the sample period.

(3)

where is the implied yield volatility in basis points of the at-the-money option on the CTD that matures closest to the final delivery date. To maintain the factor structure, we adjust all the other factor loadings by the same proportional amount as the CTD for the first and second factor.

Standard Deviation
We next scale the factor structure, created from historical yield changes, to match the implied volatility in the over-the-counter options market. The implied volatility of the at-the-money option on the CTD, with expiration most similar to that of the futures contract, determines the magnitude of the factors. Our scale process maintains the percentage of overall variance explained by each factor. We scale the first and second factor loadings of the CTD so that a unit realization of both factors corresponds to a one standard deviation yield change. We denote by
5 The actual measure is the normalized inner product of the two factors.

Construction of Grids
We use grids to identify possible yield scenarios at a date in the future. These grids are constructed to maintain the no-arbitrage condition; the expected price of each bond on the grid is its forward price. The center point for each grid is initially the forward yield of every deliverable bond. Each grid point is constructed by adding to the forward yield of each bond an amount equal to the bonds first factor loading multiplied by a first factor realization plus the bonds second factor loading multiplied by a second factor realization. The realizations take on discreet values ranging from -4 to +4 standard deviations. We then make a convexity adjustment to each bond so that it satisfies the no-arbitrage condition.

Figure 5.
1.05

Constancy of Second Factor over the Last Two Years for the Bond Contract

HEDGING
The factors are designed to describe the relative yield changes of the deliverable bonds. They can, therefore, be used to find effective hedge ratios. The factor hedge ratio is the number of futures needed to hedge against price changes in $1,000,000 par of a particular deliverable bond. Our calculation uses bond price and futures price sensitivities to small changes in the factor. The factor hedge ratio equals the price sensitivity of the bond divided by the price sensitivity of the futures. This factor hedge ratio is a direct output

1.00

0.95

0.90

0.85

0.80 450

400 350 300 250 200 150 100 50 End of 60-day window (# of business days before 1/1/97).

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from the model. A hedge ratio can also be interpreted as the ratio of the dollar duration of the bond to the dollar duration of the futures contract. This implies that D, the duration of the futures contract, satisfies

D =

P D H

shows the factor hedge ratios and the futures duration calculated with each of the deliverables on August 12, 1997 for the September 1997 Treasury bond futures. For example, the duration relative to the 6 5/8 of 2/15/27 is over 7% higher than the duration relative to the 11 1/4 of 2/15/15. We calculate an average dollar duration of the futures contract by weighting the dollar duration calculated with each deliverable by its probability of being delivered. This duration number is applicable for hedging portfolios. Another use of the futures duration is to determine the number of futures to use to hedge a position in a nondeliverable bond. This hedge ratio, Hd , is called the duration hedge ratio to distinguish it from the factor hedge ratio. It is calculated by
P D D*

(4)

where H is the factor hedge ratio, P is the price of the bond with accrued interest, D is the modified duration of the bond, and is the futures price. Duration is a measure of price change that results from parallel shifts of the yield curve; however, neither of our factors is a parallel shift. As a result, the duration of the futures varies depending upon which bond is the reference. Shorter bonds are more sensitive to the first factor, representing their greater yield volatility. This translates into a slightly shorter duration for the futures when hedging shorter bonds. Figure 6

Hd =

(5)

Figure 6.

Future Duration and Hedge Ratios for September 1997 Deliverables, 8/12/97

* where D is the average dollar duration of the futures contract, is the futures prices, and P and D are the price with accrued interest and the duration of the bond. For comparison with the factor hedge ratio, Figure 6 also shows the duration hedge ratio.

Average Future Duration: 9.34 yrs. Duration of Future (yrs.) 9.31 9.36 9.39 9.44 9.51 9.54 9.54 9.57 9.60 9.64 9.67 9.73 9.74 9.74 9.76 9.82 9.81 9.83 9.84 9.91 9.89 9.93 9.99 9.95 9.96 10.00 10.04 10.01 10.01 10.02 Factor Hedge Ratio 12.954 12.636 12.165 11.735 10.274 10.546 11.672 11.818 12.231 12.236 12.162 11.581 12.025 12.330 12.366 11.609 11.914 11.943 11.880 11.225 11.670 11.178 10.336 11.889 12.058 11.296 10.363 11.320 11.081 11.289 Duration Hedge Ratio 12.908 12.667 12.228 11.858 10.459 10.773 11.921 12.104 12.572 12.627 12.593 12.061 12.545 12.855 12.926 12.205 12.514 12.574 12.513 11.909 12.358 11.885 11.050 12.664 12.857 12.089 11.141 12.133 11.878 12.109

Deliverable 11.250 02/15/15 10.625 08/15/15 9.875 11/15/15 9.250 02/15/16 7.250 05/15/16 7.500 11/15/16 8.750 05/15/17 8.875 08/15/17 9.125 05/15/18 9.000 11/15/18 8.875 02/15/19 8.125 08/15/19 8.500 02/15/20 8.750 05/15/20 8.750 08/15/20 7.875 02/15/21 8.125 05/15/21 8.125 08/15/21 8.000 11/15/21 7.250 08/15/22 7.625 11/15/22 7.125 02/15/23 6.250 08/15/23 7.500 11/15/24 7.625 02/15/25 6.875 08/15/25 6.000 02/15/26 6.750 08/15/26 6.500 11/15/26 6.625 02/15/27

For deliverable bonds, using the duration hedge ratio rather than the factor hedge ratio is not taking full advantage of the model. Figure 7 compares the daily tracking error of the two hedging methods for a cash and carry trading strategy. A position in a bond is hedged with the number of futures contracts given by the factor hedge ratio and duration hedge ratio, respectively. Net proceeds are invested in the bond so the position is long carry. In Figure 7, the ratio of the tracking error shows that it is most important to use the factor hedge ratio for longer bonds. Shorter bonds, with greater deliverable probability, are fairly well served by the duration hedge ratio. Using the duration hedge ratio to hedge longer deliverable bonds leads to an increase in tracking error of as much as 30%.

MODEL PERFORMANCE
Historical Rich/Cheap
We compared the fair value calculated by our model with the market price of the Treasury bond contract. The model price shows occasional deviation from the

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September 1997

Figure 7.

Tracking Error Comparison for 27 Deliverable Bonds

Bonds hedged with the bond futures contract using different futures hedge ratios. Daily data, 1/1/96-6/1/97 Using Factor Hedge Ratio 0.77 0.76 0.74 0.76 0.82 0.80 0.83 0.83 0.83 0.84 0.88 0.90 0.92 0.91 0.92 0.99 0.99 1.00 1.00 1.06 1.05 1.12 1.15 1.14 1.16 1.24 1.28 Using Duration Percent Hedge Ratio Increase* 0.79 2 0.77 1 0.74 -1 0.76 0 0.83 2 0.82 3 0.85 3 0.85 3 0.87 5 0.89 6 0.95 8 0.99 10 1.02 10 1.02 12 1.04 13 1.14 15 1.14 15 1.16 15 1.17 16 1.28 20 1.27 21 1.38 23 1.43 24 1.43 26 1.45 26 1.59 28 1.67 30

Index and those of a futures portfolio constructed to have equal yield curve exposure. The portfolio uses all four futures contracts plus the 3-month Treasury bill with monthly rebalancing. The process is described in detail in the forthcoming Lehman Brothers publication, Replication of Index Returns Using Treasury Futures. Figure 9 compares monthly returns with the futures hedging strategy. Overall, the tracking error is 6.5 bp and
Figure 8. Model Price Deviation and Option Value for December 1996 Bond Futures Contract,
June 5-December 18, 1996
32nds 8

Security 11.250 02/15/15 10.625 08/15/15 9.875 11/15/15 9.250 02/15/16 7.250 05/15/16 7.500 11/15/16 8.750 05/15/17 8.875 08/15/17 9.125 05/15/18 9.000 11/15/18 8.875 02/15/19 8.125 08/15/19 8.500 02/15/20 8.750 05/15/20 8.750 08/15/20 7.875 02/15/21 8.125 05/15/21 8.125 08/15/21 8.000 11/15/21 7.250 08/15/22 7.625 11/15/22 7.125 02/15/23 6.250 08/15/23 7.500 11/15/24 7.625 02/15/25 6.875 08/15/25 6.000 02/15/26

Option Value Price Deviation

-2 6/5

7/5

8/5

9/5
Date

9/20

10/18

11/20

12/18

* Annualized root mean square error in percent.

Figure 9.

Performance of Futures Replication Strategy vs. Treasury Index,

January 1994-July 1997, monthly

market prices of as much as 3/32, but no systematic bias is apparent. Richness or cheapness of the model price often accompanies a supporting perception in the market, perhaps due to excessive specialness in the repo market or technical issues pertaining to rolling from the near to the next contract. Figure 8 shows the models price deviation and option value for the December 1996 Treasury bond futures contract from June 5, 1996 to December 18, 1996. According to the model, the contract was particularly rich toward the end of June and from the end of August through September. These times correspond to periods when investors roll from the nearest maturing contract into longer maturity contracts, which may explain the richness. The option value of the contract declined more or less continuously from June through December.

Returns (%) 5 Treasury Index Strategy

1 0 -1

-3
Difference (bp) 20

10 0 -10 -20 J M M J S N J M M J S N J M M J S N J M M J 1994 1995 1996 1997

Duration Performance
We tested the durations of the futures contract by comparing the returns of the Lehman Brothers Treasury Lehman Brothers

September 1997

the average error is 0. These results indicate that hedge ratios derived from the model can be used to hedge positions typically hedged with Treasuries. Using futures as hedges has the advantage of employing instruments that are liquid and not subject to squeezes.

option value, duration figures, and historical and implied volatilities of the CTD. Below this, each deliverable is listed with its delivery probability, price, yield, forward price and yield, gross and net basis, actual repo and implied repo, duration futures hedge ratio, and factor futures hedge ratio. An additional scenario page (the second report) considers movements in the on-the-run Treasury of as much as 100 bp up and down. The first factor relates the yield movements of the other deliverables to the scenario movement of the on-the-run. For each scenario, the CTD is identified along with the number of ticks each bond is away from being the CTD.

REPORTS
Daily reports produced by the model provide information on the two nearest expiration dates for the four Treasury futures contracts. Sample reports are shown in the Appendix. The top of the first report identifies the contract and its characteristics, the model futures price,

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Lehman Brothers

APPENDIX
December 1997 Bond CBOT Futures Multifactor Analysis
Pricing:09/11/97 Trade: 09/12/97 Settle: 09/15/97 First Delivery: 12/01/97 Last Trade: 12/19/97 Last Delivery: 12/31/97 Model Future Price: 112-032 Market Future Price: 112-050 Difference: -0-016 Historical Vol of CTD (bp): 78.5 Implied Vol of CTD (bp): 93.9 Option Value: 0-016 Repo/Yield Beta: 54% Dollar Duration:102.1 Modified Duration: 9.11

Coupon 11.250 10.625 9.875 9.250 7.250 7.500 8.750 8.875 9.125 9.000 8.875 8.125 8.500 8.750 8.750 7.875 8.125 8.125 8.000 7.250 7.625 7.125 6.250 7.500 7.625 6.875 6.000 6.750 6.500 6.625 6.375

Maturity 2/15/15 8/15/15 11/15/15 2/15/16 5/15/16 11/15/16 5/15/17 8/15/17 5/15/18 11/15/18 2/15/19 8/15/19 2/15/20 5/15/20 8/15/20 2/15/21 5/15/21 8/15/21 11/15/21 8/15/22 11/15/22 2/15/23 8/15/23 11/15/24 2/15/25 8/15/25 2/15/26 8/15/26 11/15/26 2/15/27 8/15/27

Delivery Probability 51.1 40.4 0.0 4.2 0.1 3.3 0.0 0.0 0.0 0.0 0.5 0.1 0.0 0.0 0.1 0.0 0.0 0.1 0.0 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Price 146-180 140-132 132-246 126-116 105-157 108-011 121-197 123-035 126-072 125-025 123-233 115-127 119-271 122-257 122-291 112-272 115-270 115-287 114-155 105-230 110-081 104-101 93-276 109-073 110-266 101-207 90-235 100-097 97-070 98-287 96-020

Yield 6.685 6.713 6.723 6.731 6.727 6.746 6.747 6.748 6.752 6.755 6.761 6.766 6.767 6.767 6.768 6.772 6.771 6.772 6.772 6.771 6.770 6.766 6.754 6.753 6.752 6.742 6.735 6.725 6.718 6.710 6.680

Val 01 0.1351 0.1326 0.1280 0.1242 0.1095 0.1128 0.1248 0.1268 0.1316 0.1323 0.1318 0.1263 0.1314 0.1346 0.1354 0.1279 0.1311 0.1318 0.1311 0.1248 0.1295 0.1246 0.1159 0.1326 0.1346 0.1267 0.1167 0.1271 0.1244 0.1265 0.1247

Forward Price 145-227 139-205 132-025 125-243 105-036 107-200 121-022 122-180 125-205 124-16+ 123-061 114-302 119-112 122-087 122-125 112-135 115-121 115-14+ 114-012 105-113 109-270 103-307 93-191 108-267 110-142 101-10+ 90-156 99-320 96-29+ 98-193 95-253

Forward Yield 6.716 6.745 6.755 6.761 6.758 6.777 6.779 6.778 6.783 6.785 6.791 6.795 6.795 6.797 6.796 6.800 6.801 6.800 6.801 6.798 6.798 6.793 6.779 6.780 6.777 6.767 6.759 6.749 6.742 6.734 6.703

Factor 1.2992 1.2450 1.1759 1.1182 0.9285 0.9517 1.0728 1.0857 1.1117 1.1002 1.0883 1.0127 1.0514 1.0772 1.0777 0.9869 1.0129 1.0132 0.9998 0.9200 0.9597 0.9060 0.8108 0.9450 0.9588 0.8756 0.7778 0.8605 0.8320 0.8458 0.8170

Gross Basis 0-272 0-250 0-28+ 0-30+ 1-11+ 1-09+ 1-095 1-110 1-173 1-220 1-21+ 1-262 1-295 1-316 2-012 2-052 2-075 2-08+ 2-113 2-171 2-196 2-22+ 2-296 3-076 3-095 3-143 3-161 3-25+ 3-290 4-012 4-136

Net Basis -0-000 0-003 0-062 0-111 0-313 0-283 0-240 0-25+ 0-306 1-037 1-042 1-115 1-137 1-147 1-166 1-235 1-247 1-261 1-290 2-05+ 2-065 2-112 2-211 2-272 2-291 3-040 3-082 3-155 3-19+ 3-237 4-051

Repo 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52 5.52

Implied Repo 5.52 5.50 5.03 4.59 2.42 2.78 3.46 3.36 2.98 2.53 2.46 1.57 1.52 1.55 1.37 0.37 0.40 0.27 -0.03 -1.35 -1.16 -2.02 -3.96 -3.20 -3.27 -4.77 -6.49 -6.12 -6.87 -7.15 -8.98

Duration Hedge Ratio* 13.229 12.984 12.534 12.162 10.722 11.046 12.221 12.416 12.886 12.955 12.906 12.367 12.867 13.180 13.259 12.524 12.837 12.906 12.837 12.221 12.681 12.201 11.349 12.984 13.180 12.407 11.427 12.446 12.181 12.387 12.211

Factor Hedge Ratio 13.313 12.956 12.369 11.967 10.338 10.624 11.813 12.029 12.394 12.398 12.371 11.754 12.222 12.479 12.575 11.781 12.045 12.130 12.007 11.379 11.788 11.328 10.456 12.007 12.231 11.446 10.480 11.466 11.178 11.410 11.229

10
September 1997

*Uses the futures dollar duration directly against the Val 01 of the deliverable, as if bond yields moved 1-for-1. We do not recommend this hedge method, but provide it for comparison purposes.

APPENDIX (cont.)
Lehman Brothers December 1997 Bond CBOT Futures Multifactor Scenario Analysis
Pricing: 9/11/97 Trade: 9/12/97 Typical Move (bp) 105.4 105.1 104.9 104.7 104.4 104.0 103.7 103.6 103.1 102.8 102.7 102.3 102.1 102.0 101.9 101.5 101.4 101.4 101.2 100.8 100.8 100.7 100.4 100.4 100.4 100.2 99.9 100.1 100.0 100.1 100.0 Settle: 9/15/97 Horizon: 11/28/97

Coupon 11.250 10.625 9.875 9.250 7.250 7.500 8.750 8.875 9.125 9.000 8.875 8.125 8.500 8.750 8.750 7.875 8.125 8.125 8.000 7.250 7.625 7.125 6.250 7.500 7.625 6.875 6.000 6.750 6.500 6.625 6.375

Maturity 2/15/15 8/15/15 11/15/15 2/15/16 5/15/16 11/15/16 5/15/17 8/15/17 5/15/18 11/15/18 2/15/19 8/15/19 2/15/20 5/15/20 8/15/20 2/15/21 5/15/21 8/15/21 11/15/21 8/15/22 11/15/22 2/15/23 8/15/23 11/15/24 2/15/25 8/15/25 2/15/26 8/15/26 11/15/26 2/15/27 8/15/27

-100 0.0 11.3 26.3 39.1 78.3 77.3 69.0 72.4 83.8 94.8 98.0 113.5 118.7 120.9 125.3 139.2 141.8 145.3 150.5 166.5 169.2 176.6 191.5 206.8 210.9 221.0 227.0 240.5 245.8 252.9 271.2

-75 0.0 8.2 20.8 31.4 65.4 63.8 56.5 59.3 69.0 78.3 80.7 94.0 98.2 100.1 103.8 115.7 117.9 120.8 125.2 139.2 141.4 148.0 161.5 174.0 177.4 186.6 192.1 203.9 208.8 215.1 231.9

On the Run Move (bp) -50 -25 0 25 32nd Changes Needed to Become CTD 0.0 0.0 0.0 2.0 5.4 2.8 0.3 0.0 15.6 10.8 6.2 3.9 24.2 17.5 11.1 7.1 53.4 42.0 31.2 22.9 51.2 39.4 28.3 19.6 44.9 34.0 23.9 16.3 47.2 35.9 25.4 17.4 55.2 42.5 30.7 21.6 63.1 48.9 35.8 25.6 64.7 49.9 36.1 25.3 75.9 59.1 43.5 31.0 79.3 61.9 45.7 32.7 80.9 63.1 46.7 33.5 83.9 65.6 48.7 35.0 94.0 74.0 55.5 40.2 95.9 75.5 56.7 41.3 98.1 77.3 58.0 42.2 102.0 80.6 60.8 44.5 114.0 90.8 69.3 51.3 115.8 92.3 70.5 52.4 121.7 97.5 75.1 56.3 133.9 108.5 84.9 65.0 144.0 116.5 91.1 69.8 146.8 118.8 93.0 71.2 155.2 126.4 99.8 77.3 160.2 130.9 104.0 80.9 170.3 139.6 111.5 87.4 174.8 143.8 115.3 91.0 180.4 148.8 119.7 94.8 196.0 163.2 133.0 107.1

50 4.2 0.0 2.0 3.5 15.0 11.5 9.5 10.3 13.4 16.3 15.5 19.5 20.8 21.5 22.5 26.3 27.2 27.7 29.6 34.9 35.8 39.0 46.6 50.3 51.4 56.7 59.8 65.5 68.7 72.1 83.5

75 6.4 0.1 0.2 0.0 7.4 3.7 3.0 3.5 5.8 7.7 6.4 8.7 9.7 10.4 11.0 13.2 14.1 14.3 15.7 19.5 20.4 22.9 29.3 32.3 33.1 37.6 40.1 45.1 48.0 51.1 61.5

100 12.8 4.4 2.6 0.7 3.7 0.0 0.8 1.2 2.7 3.7 2.0 2.5 3.4 4.1 4.4 5.0 5.8 5.7 6.8 9.0 9.9 11.7 16.8 19.5 20.1 23.6 25.3 30.1 32.6 35.3 44.9

Future Price Dollar Duration Option Value

123.8 118.8 0.0

120.8 114.7 0.0

117.8 110.7 0.0

114.9 107.2 0.0

112.1 104.4 0.0

109.4 102.0 0.1

106.8 99.8 0.1

104.2 98.7 0.2

101.6 99.0 0.4

Lehman Brothers

11

September 1997