Workshop schedule - Московская Биржаfs.rts.ru/f/1696/bond-futures.pdf · Workshop...
Transcript of Workshop schedule - Московская Биржаfs.rts.ru/f/1696/bond-futures.pdf · Workshop...
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Workshop schedule
• Part 1: 4:00 to 5:30 (16:00 to 17:30)– Brief history of bond futures
– Why use futures?
– Challenges to valuation
– Financial algebra of bond futures
– Trading
• Part 2: 6:00 to 7:30 (18:00 to 19:30)– Hedging
– Cash/futures spreads and yield enhancement
– Special topics
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Brief history of bond futures
• Introduced in late 1970s in Chicago (first GNMAs, then US Treasurys)
• Introduced in the 1980s in the UK and Europe
• Expanded to different maturities
• Transformation of related markets
• Breadth of coverage today (14 countries, not counting Russia)
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How to use bond futures
• In principle, there is nothing you can do in the cash market that you cannot do in the futures market (and the other way round)
• As a result, you can
– Speculate
– Hedge
– Arbitrage
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So why use futures?
• Usually cheaper to trade than related cash instruments, often more liquid than related cash markets
• Accessibility, anonymity
• Provide efficient access to forward markets (repo link between cash and futures
• Very low credit risk
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So why use futures?
• Futures allow you to separate the price from the product
• Transparency, liquidity, competitively accurate prices
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So why not use futures?
• Regulatory and legal hurdles
• Cash management practices
• Inflexible quantities and forward dates
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A high level of sophistication
• Trading futures is like playing a guitar (or balalaika)
• To play the guitar well, you need to understand music better than do other instrumentalists
• To use futures well, you need to understand financial markets better than do other financial market specialists
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The value of a workshop like this
• Cannot prevent you from making mistakes
• Can allow you to recognize your mistakes sooner
• Can allow you to learn from your mistakes faster
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The starting point
• Futures contract specifications and mechanics
• The basic financial algebra of futures
• Challenges to correct valuation
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Key contract specifications
• Notional value of 10,000 Rubles
• Short must deliver 10 (1,000 Ruble) bonds from the deliverable basket
• Invoice price is determined by the bond’s conversion factor
• Deliverable basket is determined when the contract is listed for delivery
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Contract Specifications – OFZ2
Contract Symbol OFZ2-12.11
Contract Trading Symbol O2Z1
Contract Description Delivery futures contract on 2-year Russian Federation government bonds
Type Futures
Settlement Deliverable
Contract size 10
First Trading Day 24.08.2011
Last Trading Day 02.12.2011
Delivery 05.12.2011
Settlement procedure Delivery of bonds by the conclusion of the direct trade on MICEX Government-Backed Securities Section
Price tick 1
Cost of price tick 1
Lower limit 9,741
Upper limit 10,039
Settlement price of last clearing session
9,890
Initial Margin (IM, rub) 298
IM value on 22.11.2011
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Baskets of underlying bonds
issues and conversion ratios• Futures contract on 2-year Russian Federation government bonds
Short contract code (settlement date): O2U1 – 05.09.2011
Bond Maturity date Coupon rate Conversion ratio
OFZ 25072 23.01.2013 7.15% 0.9848
OFZ 25078 06.02.2013 6.7% 0.9785
OFZ 25076 13.03.2014 7.10% 0.9726
For the purpose of calculating the conversion ratio the yield is 8.5%.
Short contract code (settlement date): O2Z1 – 05.12.2011
Bond Maturity date Coupon rate Conversion ratio
OFZ 25072 23.01.2013 7.15% 1.0028
OFZ 25078 06.02.2013 6.70% 0.9979
OFZ 25076 13.03.2014 7.10% 1.0044
For the purpose of calculating the conversion ratio the yield is 7.0%.
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Baskets of underlying bonds
issues and conversion ratios• Futures contract on 4-year Russian Federation government bonds
Short contract code (settlement date): O4U1 – 05.09.2011
Bond Maturity date Coupon rate Conversion ratio
OFZ 25075 15.07.2015 6.88% 0.9529
OFZ 25077 20.01.2016 7.35% 0.9647
OFZ 26203 03.08.2016 6.90% 0.9433
For the purpose of calculating the conversion ratio, the bond yield is 8.5%.
Short contract code (settlement date): O4Z1 – 05.12.2011
Bond Maturity date Coupon rate Conversion ratio
OFZ 25079 03.06.2015 7.00% 0.9549
OFZ 25075 15.07.2015 6.88% 0.9499
OFZ 25077 20.01.2016 7.35% 0.9599
OFZ 26203 03.08.2016 6.90% 0.9386
For the purpose of calculating the conversion ratio, the bond yield is 8.7%.
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Variation margin and offsets
• Gains and losses on open positions are settled in cash daily
• You need not carry open positions to delivery – instead, you can offset long positions by selling futures, or you can offset short positions by buying futures
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Conversion factors
• The role of the conversion factor is to convert the futures price into an invoice price
• The conversion factor is the hypothetical price at which the bond would produce a yield chosen by the exchange
• The conversion factor is unique both to the bond and to the contract month
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Baskets of underlying bonds
issues and conversion ratios• Futures contract on 2-year Russian Federation government bonds
Short contract code (settlement date): O2U1 – 05.09.2011
Bond Maturity date Coupon rate Conversion ratio
OFZ 25072 23.01.2013 7.15% 0.9848
OFZ 25078 06.02.2013 6.7% 0.9785
OFZ 25076 13.03.2014 7.10% 0.9726
For the purpose of calculating the conversion ratio the yield is 8.5%.
Short contract code (settlement date): O2Z1 – 05.12.2011
Bond Maturity date Coupon rate Conversion ratio
OFZ 25072 23.01.2013 7.15% 1.0028
OFZ 25078 06.02.2013 6.70% 0.9979
OFZ 25076 13.03.2014 7.10% 1.0044
For the purpose of calculating the conversion ratio the yield is 7.0%.
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Invoice prices
• In a cash market trade,
Full (dirty) price = Net (clean) price + accrued
interest
• In a futures market delivery,
Futures invoice price = Futures price x
conversion factor + accrued interest
• The converted futures price takes the place of the net or clean market price
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Futures are not forwards
• You buy and sell forwards, but go long and short futures (even so, we talk about buying and selling futures contracts)
• The short decides which bond to deliver
• Futures prices in general are lower than forward prices because of the short’s delivery options
• Consider the deliverable basket
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Create a riskless asset
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Creating a synthetic money market instrument
Buy the bond
here at its market
price plus today's
accrued interest
and sell futures at
today's market
futures price
Futures deliveryToday
Sell the bond here
at today's futures
price times the
bond's conversion
factor plus
accrued interest
at futures delivery
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Which bond is cheapest to deliver?
• Before expiration, the cheapest to deliver bond from the short’s perspective is the bond with the highest implied repo rate*
• At expiration, the bond with the lowest converted spot price is cheapest to deliver
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(I’ve used a US money
market day-count
convention)
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March 2012 4-year bond basket
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Spot/futures price spread
• The spread between a bond’s spot price and its converted futures price is generally known as “the basis”
• This spread matters because its behavior affects the performance of everything you do with futures – speculating, hedging, or arbitraging
• You need someone who knows how to value the spread correctly
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Spot/futures price relationship
for the cheapest to deliver
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Challenges to correct valuation
• Access to market data
– Bond prices
– Term repo rates – including repo specials –
for both buying and selling
• A complete understanding of the rules that govern delivery and invoicing (including the delivery schedule)
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Repo rates
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Yield levels and the ctd
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At expiry, the
futures price is the
lowest converted
spot price. This
chart assumes the
hypothetical yield
for calculating
conversion factors
is 6%.
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Yield spreads and the ctd
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Futures price before expiry
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Shifts in the cheapest bond
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March 2012 4-year bond basket
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The value of the shift option:synthetic calls and puts
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Assign some
probabilities to
these shifts
4-year bond prices as of March 2012 contract expiration
Series 25079 25075 25077 26203
NameRFBL 7
06/03/15
RFBL 6.88
07/15/15
RFBL 7.35
01/20/16
RFBL 6.9
08/03/16
Factor 0.9523 0.9475 0.9559 0.9347
Yield 7.95 7.83 8.12 8.21
Shift Converted prices at deliveryCTD
series
Futures
price at
delivery
Basis net of carry at delivery/factor Shift
-120 106.0834 106.6499 106.5225 107.0144 25079 106.0834 0.0000 0.5665 0.4391 0.9310 -120
-100 105.4966 106.0398 105.8378 106.2416 25079 105.4966 0.0000 0.5433 0.3412 0.7450 -100
-80 104.9143 105.4347 105.1591 105.4763 25079 104.9143 0.0000 0.5204 0.2448 0.5620 -80
-60 104.3364 104.8342 104.4863 104.7183 25079 104.3364 0.0000 0.4978 0.1499 0.3819 -60
-40 103.7630 104.2385 103.8194 103.9676 25079 103.7630 0.0000 0.4756 0.0564 0.2047 -40
-20 103.1939 103.6475 103.1582 103.2241 25077 103.1582 0.0357 0.4893 0.0000 0.0659 -20
0 102.6292 103.0611 102.5028 102.4878 26203 102.4878 0.1414 0.5733 0.0151 0.0000 0
20 102.0688 102.4793 101.8531 101.7584 26203 101.7584 0.3104 0.7209 0.0947 0.0000 20
40 101.5127 101.9020 101.2090 101.0361 26203 101.0361 0.4766 0.8660 0.1729 0.0000 40
60 100.9607 101.3293 100.5704 100.3205 26203 100.3205 0.6402 1.0087 0.2498 0.0000 60
80 100.4130 100.7610 99.9373 99.6118 26203 99.6118 0.8012 1.1491 0.3255 0.0000 80
100 99.8694 100.1971 99.3097 98.9098 26203 98.9098 0.9595 1.2872 0.3998 0.0000 100
120 99.3298 99.6375 98.6874 98.2145 26203 98.2145 1.1154 1.4231 0.4729 0.0000 120
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Synthetic options
• In this example, a long position in the March 12 basis of issue 25079 would be like a put option on bonds – rising in value as yield rise and bond prices fall
• A long position in the basis of issue 26203 would be like a call
• A long position in the basis of issue 25077 would be like a straddle
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Scenario analysis and the value
of the short’s delivery option
• How are yield (changes) distributed?
• How volatile are yields?
• How variable is the slope of the curve?
• Typically, a shift and twist analysis with a reasonable number of scenarios will do a good job of handling the variables that matter
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Are futures rich or cheap?
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Looking for cash/futures trades
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Looking for
cash/futures trades
Implied repo rates Actual Spread
Trade date 2-year 4-year O/N 2-year 4-year
11/18/2011 0:00 5.74% 3.22% 5.49% 0.25% -2.27%
11/17/2011 0:00 4.85% 7.91% 5.42% -0.57% 2.49%
11/16/2011 0:00 6.05% 8.66% 5.60% 0.45% 3.06%
11/15/2011 0:00 6.77% 5.95% 5.65% 1.12% 0.30%
11/14/2011 0:00 6.35% 8.93% 5.57% 0.78% 3.36%
11/11/2011 0:00 5.41% 5.99% 5.38% 0.03% 0.61%
11/10/2011 0:00 4.52% 6.23% 5.28% -0.76% 0.95%
11/9/2011 0:00 4.99% 5.55% 5.36% -0.37% 0.19%
11/8/2011 0:00 4.37% 5.45% 5.33% -0.96% 0.12%
11/7/2011 0:00 3.33% 5.37% 5.44% -2.11% -0.07%
11/3/2011 0:00 4.10% 4.05% 5.37% -1.27% -1.32%
11/2/2011 0:00 4.21% 5.57% 5.56% -1.35% 0.01%
11/1/2011 0:00 5.09% 3.56% 5.77% -0.68% -2.21%
10/31/2011 0:00 6.14% 7.52% 5.74% 0.40% 1.78%
10/28/2011 0:00 6.95% 11.23% 5.61% 1.34% 5.62%
10/27/2011 0:00 7.28% 9.10% 5.75% 1.53% 3.35%
10/26/2011 0:00 5.69% 6.84% 5.84% -0.15% 1.00%
10/25/2011 0:00 6.97% 6.22% 5.71% 1.26% 0.51%
10/24/2011 0:00 7.02% 6.43% 5.60% 1.42% 0.83%
10/21/2011 0:00 5.56% 4.89% 5.57% -0.01% -0.68%
10/20/2011 0:00 5.65% 4.32% 5.54% 0.11% -1.22%
10/19/2011 0:00 6.35% 5.06% 5.49% 0.86% -0.43%
10/18/2011 0:00 5.89% 6.61% 5.52% 0.37% 1.09%
An implied repo rate
higher than the actual
repo rate suggests a
cheap cash/futures
spread.
Cautions:
Risk in O/N repo.
Implied repo rates
become increasingly
sensitive to small
price difference as
you approach
contract expiration.
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Synthetic bonds
• A synthetic government bond can be created by combining
– Duration (or PV01) equivalent futures position
– Term money market instrument with a
maturity equal to the futures contract’s
expiration date
• Possible opportunities for 1-way arbitrage by bank funding desks
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Futures risk and return algebra• Futures + cash = real bond
• Futures = real bond – cash (i.e., a fully leveraged or geared position in the bond)
• Real bond – futures = cash
• Futures profit/loss is the result of futures price change only
• Bond profit/loss is the result of bond price change, accrued coupon income, and actual or implied financing cost
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Synthetic and real bonds
• The payoff on a synthetic bond is the sum of
– Changes in the value of the futures position
– Interest income on the term money market
instrument
• The payoff on a real bond is the sum of
– Changes in the value of the bond
– Coupon income on the bond
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Synthetic and real bonds (2)
• If futures are fairly priced, the total return to the real bond will equal the total return to the synthetic bond except for the cost of and payoff to any embedded delivery options
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Uses of futures
• The RTS’ excellent summary of strategies includes uses that fall into three categories
– Directional/speculative (outright buys and
sells and spreads)
– Hedging (actual and anticipatory, duration
management)
– Arbitrage (cash/futures spreads, yield
enhancement)
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Directional strategies
• Buy futures in lieu of buying cash bonds to bet on a fall in interest rates
• Sell futures in lieu of shorting cash bonds to bet on a rise in interest rates
• Buy futures on one part of the curve (e.g., 2 years) and sell futures on another part of the curve (e.g., 4 years) to bet on a steepening of the yield curve
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2-year and 4-year zero coupon
yields
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Comments on outrights
• Futures provide efficient access to the government bond market
• Relative richness or cheapness of the contracts may be relatively unimportant
• Comparing a futures trader’s gains and losses with those of a cash bond trader’s requires you to keep track of coupon income and financing costs
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Comments on spreads
• You are trading the forward yield spread, not the spot yield spread
• Important to use the right contract ratios to isolate a trade on the slope (or shape) of the curve from a trade on the level of the curve (see next slide)
• Tricky to compare gain or loss on futures trade with gain or loss on equivalent spread trade done in the cash market
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Constructing a yield curve trade
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To bet on a steepening of the yield
curve, you would buy 2-year contracts
and sell 4-year contracts
If you use a ratio of 1:1, your net rv01
would be 1.84 rubles using the values
for 11/18/11.
To be rv01 or duration neutral, you
would buy 1.92 2-year contracts for
each 2-year contract you sell
Ruble values of a basis point(December 2011 contracts
Date 2-year 4-year
11/18/2011 -2.01 -3.85
11/17/2011 -2.01 -3.85
11/16/2011 -2.02 -3.46
11/15/2011 -2.02 -3.47
11/14/2011 -2.03 -3.88
11/11/2011 -2.04 -3.88
11/10/2011 -2.04 -3.48
11/9/2011 -2.04 -3.50
11/8/2011 -2.04 -3.51
11/7/2011 -2.04 -3.50
11/3/2011 -2.05 -3.51
11/2/2011 -2.05 -3.51
11/1/2011 -2.05 -3.50
The notional or face value of a single
contract is 10,000 rubles
Each contract calls for the delivery
of 10 bonds, each with a face value
of 1,000 rubles
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Workshop: Part 2
• Hedging
• Cash/futures spreads
• Special topics
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Hedging strategies
• Hedge a position against a rise in interest rates (great for dealers)
• Manage a portfolio’s duration
• Manage a portfolio’s exposure to a change in the slope of the curve
• Asset allocation
• Anticipatory hedges
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Comments on hedging
• Why hedge? Why not sell the actual bond?
• If you do hedge, you can
– Sell the bond forward
– Sell a different bond in the spot market
– Sell a different bond forward
– Sell a bond futures contract
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Hedges turn bonds into term
money market instrumentsConvergence of the spot and
futures prices reduces the
bond’s yield to a money
market yield and may cost
you the price of the delivery
options
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Hedges never work perfectly
• The only perfect hedge is to sell the position
• All other hedges produce unexpected gains and losses
– Repo
– Changes in yield spreads
– Changes in cheapest to deliver bond
– Changes in the value of short’s delivery
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Competing Hedge Ratios
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Hedge a spot position
• Excellent for dealers who want to underwrite a large cash position while in the process of sales and distribution
• Experience shows the cash markets are always more liquid when futures markets are open than when they are closed (or only lightly traded)
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Manage a portfolio’s duration
• One great advantage of futures is that you can control exposure to a change in the general level of interest rates without undoing a well constructed portfolio
• Another is that you can extend the duration of the portfolio beyond what is available in conventional bond markets
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Manage exposure to the curve
• In many cases, an investor cares about his exposure to a change in the slope of the yield curve
• The availability of bond futures at three points on the Russian government bond yield curve makes it possible to take a more nuanced approach to controlling interest rate risk
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2-year and 4-year zero coupon
yields
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Asset allocation
• An extension of the duration management argument is that one can use futures to change the exposure of an entire portfolio to stocks and bonds (and to commodities and, possibly, foreign currencies) without touching the actual portfolio
• Futures overlay programs also allow you to create portable alpha products
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Anticipatory: Expected issue
• The sale of futures can provide protection against a rise in interest rates between now and when you plan to do a bond offering
• Comment: the futures sale will protect you against a change in the government bond rate but not against a widening of your spread against government bond yields
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Anticipatory: Expected cash
inflow• The flip side of the expected issue
problem is the expected investment problem – that is, an inflow of cash that you intend to invest at a fixed rate
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Cash/futures spreads
• Creating synthetic term cash
• Buying or selling mispriced cash/futures spreads
• Using synthetic bonds to enhance portfolio yields
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Synthetic term cash
• Buying bonds and selling bond futures creates a synthetic short-term bond with a maturity coinciding with the futures’settlement date
• Similar to a reverse repo trade where cash is lent against a pledge of securities
• Reverse the trade to borrow synthetically
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Looking for cash/futures trades
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Looking for
cash/futures trades
Implied repo rates Actual Spread
Trade date 2-year 4-year O/N 2-year 4-year
11/18/2011 0:00 5.74% 3.22% 5.49% 0.25% -2.27%
11/17/2011 0:00 4.85% 7.91% 5.42% -0.57% 2.49%
11/16/2011 0:00 6.05% 8.66% 5.60% 0.45% 3.06%
11/15/2011 0:00 6.77% 5.95% 5.65% 1.12% 0.30%
11/14/2011 0:00 6.35% 8.93% 5.57% 0.78% 3.36%
11/11/2011 0:00 5.41% 5.99% 5.38% 0.03% 0.61%
11/10/2011 0:00 4.52% 6.23% 5.28% -0.76% 0.95%
11/9/2011 0:00 4.99% 5.55% 5.36% -0.37% 0.19%
11/8/2011 0:00 4.37% 5.45% 5.33% -0.96% 0.12%
11/7/2011 0:00 3.33% 5.37% 5.44% -2.11% -0.07%
11/3/2011 0:00 4.10% 4.05% 5.37% -1.27% -1.32%
11/2/2011 0:00 4.21% 5.57% 5.56% -1.35% 0.01%
11/1/2011 0:00 5.09% 3.56% 5.77% -0.68% -2.21%
10/31/2011 0:00 6.14% 7.52% 5.74% 0.40% 1.78%
10/28/2011 0:00 6.95% 11.23% 5.61% 1.34% 5.62%
10/27/2011 0:00 7.28% 9.10% 5.75% 1.53% 3.35%
10/26/2011 0:00 5.69% 6.84% 5.84% -0.15% 1.00%
10/25/2011 0:00 6.97% 6.22% 5.71% 1.26% 0.51%
10/24/2011 0:00 7.02% 6.43% 5.60% 1.42% 0.83%
10/21/2011 0:00 5.56% 4.89% 5.57% -0.01% -0.68%
10/20/2011 0:00 5.65% 4.32% 5.54% 0.11% -1.22%
10/19/2011 0:00 6.35% 5.06% 5.49% 0.86% -0.43%
10/18/2011 0:00 5.89% 6.61% 5.52% 0.37% 1.09%
An implied repo rate
higher than the actual
repo rate suggests a
cheap cash/futures
spread.
Cautions:
Risk in O/N repo.
Implied repo rates
become increasingly
sensitive to small
price difference as
you approach
contract expiration.
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Strategy: Buy or sell cash/futures
spread
• Cash and Carry (if futures are rich)
– Purchase bonds and sell futures
– If income exceeds the funding cost (or, if
losses from convergence are less than your
positive carry), an arbitrage profit is realized
• Sell the spread (if futures are cheap)
– Sell bonds and buy futures
– If gains from convergence exceed your
negative carry, an arbitrage profit is realized
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Trades when futures are cheap
• Sell bonds/buy futures (i.e., sell the basis)
• Replace expensive bonds with synthetic bonds (yield enhancement)
• Treasury bond futures cheap in late 1980s
• Treasury note futures and Bund futures cheap in early 1990s
• Treasury note futures cheap in early 2000s
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Government Securities Positions in
Bonds and Bond Futures
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Selling the cash/futures spread
• Sell the bond short (overnight or term repo)
• Buy an appropriate number of futures
• Experience selling the 10-year Treasury note basis during the early 2000s
• The problem with selling the bond basis in the spring of 1986 (and other squeezes)
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Example of selling the basis
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Selling the 10-year basis, 2000
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Selling the 10-year basis: 2001
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Selling the 10-year basis: 2002
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Yield enhancement (1)
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Yield enhancement (2)
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Additional topics
• Power of forward pricing
• Squeezes
• Importance of financing
• Absence of a term repo market
• Managing the rolls
• Fails
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The power of forward pricing
• Forward yield curves are better behaved than spot yield curves
• Forward prices are breakeven prices
• Forward price relationships reveal opportunities that are not apparent in the spot market (when a friend bought the forward TED for 0 basis points)
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Spot and forward curves
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Buying the forward ted for free
• To buy the “ted” spread, you buy Treasuries and sell Eurodollar futures
• You can trade the spread forward by using term repo to buy the Treasuries
• How could the spread have been free?
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Squeezes
• Short squeezes are the most common
• Long squeezes are possible
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Financing is half the battle
• Easily half the difference between a spot trade and an equivalent futures trade can be explained by financing
• Have someone on the team who knows repo markets inside and out
• Know where the collateral is
• The repo desk will be the last profitable desk in the financial world
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Absence of a term repo market
• Absence of a term repo market makes it difficult to value futures properly
• On the other hand, one might create a synthetic term money market instrument (buy bond/sell futures), finance it in the overnight market with an eye to profiting from the spread between the implied term rate and the sequence of overnight rates
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Managing the rolls
• Anyone who maintains long or short futures positions for extended periods of time will need to deal with contract rolls –that is, the replacement of an expiring position in one contract month with an open position in the next contract month
• Managing these rolls correctly can, depending on how the market treats them, either save you or make you a great deal
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Fails
• Fails in the futures market are penalized heavily while fails in the spot market can be normal practice
• It is extremely important to know the rules governing deliveries in the futures market if you intend to take positions to delivery
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Special topics in short-term
rates• Riding the yield curve
• Stub risk
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Insights into cash and carry
• Money market futures (e.g., Eurodollar futures) allow one to disaggregate the deposit curve to understand how standard banking trades makes money
• The following slide shows the payoff to borrowing short and lending long
• This payoff, in turn, would be a cost of maintaining a short position
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Riding the yield curve
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Stub risk
• Stub risk is the risk associated with term financing from today until contract expiration
• Changes in repo rates are largely unrelated to changes in bond yields
• Useful to know when deciding how to construct your hedge
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Sources of interest rate risk
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Level and changes, 5-years
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Eras of the US Treasury bond
basis • Cash and carry (1977-78)
• Negative yield curve (1979-81)
• Positive yield curve (1982-84)
• Golden age of yield enhancement (1985-89)
• Volatility arbitrage (1990-91)
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Eras of the US Treasury bond
basis • Death of gamma (1991-93)
• Callables’ last hurrah (1993-94)
• The long dry spell of the 11-1/4s (1995-99)
• 6% factors and the rebirth of bond basis trading (2000 - ?)
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More eras?
• The ultra bond contract
• A new dry spell?
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Conclusion
• For more information, see Burghardt, Belton, Lane, and Papa, The Treasury
Bond Basis, 3rd edition (McGraw-Hill)
• Questions?
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Disclaimer
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