PRICING AND CHARTING
YIELD CURVE SPREADS
A guide to trading US and Au bond futures
KEIRAN HORTH & GUY BOWER
Contents 1.
Basic Definitions
2.
Using DV01s
3.
Calculating Hedge Ratios
4.
Directional Spreading Versus Hedging
5.
Changing Slope of the Yield Curve
6.
Factors Affecting the Shape of the Yield Curve
7.
Charting Your Spread
8.
Filtering Data
9.
Alternate Method of Charting a Spread
10. Varying the Spread Ratio 11. Trading the Spread 12. When is a Spread Not a Spread 13. Some Spreading Research Ideas 14. Contract Specs and Trading Information Disclaimer Trading involves high risks, with potential for profits as well as substantial losses and is not suitable for all persons. No information in this document or related material should be considered advice or any kind. Propex suggest you seek advice from an independent investment professional as to the suitability of trading for your personal needs. Propex Derivatives Pty Ltd. Level 4, 299 Elizabeth Street, Sydney NSW 2000. Propex Derivatives Pty Ltd (Propex) is a Proprietary Full Participant of the Sydney Futures Exchange.
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Horth & Bower
Introduction OK, let’s talk relative value. Spread trading is all about relative value. Spread trading is all about understanding how two (or more) markets relate to each other and recognising when there is opportunity based on current levels or a view on the future. Here we are going to look at some interest rate spreads, how to price them and how to chart them. For the newcomer, it is easy to get prices and yields mixed up given their inverse relationship. When charting spreads, the convention is to use price. When looking at yield curves the convention is to consider yield not price. As you go through this document, these things can get a little confusing. One trick to understand is to map out the concept with a pen and paper.
Basic Definitions Intermarket Spread - Spreading one market versus another. For example Aussie 3yr bonds versus Aussie 10yr bonds. Interexchange Spread – Spreading one market versus another from a different exchange. For example Aussie 10yrs versus the US Tnote. Steepener Spread – Buying the near and selling the far. For example, long 10 Jun Eurodollar, short 10 Dec Eurodollar. Flattener Spread – Selling the near and buying the far. For example, short 10 Jun Eurodollar, short 10 Eurodollar Gold. Butterfly – Combination of flattener and a steepener spread that share a common leg. For example: Long 5 Mar Eurodollars and short 5 June Eurodollars Plus Short 5 June Eurodollars and long 5 Sep Eurodollars = bull Consolidating the June positions we have Long 5 Mar + Short 10 June + Long 5 Sep
Using DV01s Why do we need to know our DV01s? Boiled down, it allows us to compare one interest rate security with another even if those securities are traded on different exchanges or in different currencies. The DV01 is used to calculate hedge ratios for spread positions and derive a standardized format for charting spreads. © Propex Derivatives.
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Firstly, the definition - The DV01 is a dollar value calculated for an interest rate security that represents the change in price given a one basis point change in yield. We all know this relationship:
That is prices are inverse to yield, but what is the exact relationship. If we are going to spread one market versus another, we need to know the exact relationship. That’s what DV01s tells us. It is the dollar value change in price of a $100,000 security given a fixed one basis point change in yield. Aussie Bond DV01s The SFE bond futures are quoted: Price = 100 - yield Therefore the DV01 is simply the same as the value of a 0.01 move. Currently, these are: Contract AU 3s: AU 10s:
DV01 in AUD $29.82 $91.31
DV01s in USD $31.01 $94.96
The pricing convention for Aussie bond futures is the same as most short-term interest rate futures around the world such as Eurodollar and Euribor. Therefore the DV01 for these short term securities is also simply the tick value for a $100,000 equivalent. US Treasuries It’s a little hard to calculate DV01s for Treasuries given they are quoted in price not yield. To calculate the DV01s requires the use of the bond pricing formula. The easier way is to look them up on Bloomberg or directly from the CME site: http://www.cmegroup.com/trading/interest-rates/duration.html Currently we have: Contract 2yr note: 5yr note: 10yr note: 30yr bond:
DV01 $21.56 $52.34 $80.70 $159.60
32nds 0.68992 1.67488 2.5824 5.1072
These numbers essentially show the change in price of the respective bond futures contract given a 1 basis point shift in the yield curve. © Propex Derivatives.
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The 32nds column shows the theoretical move in price, expressed in 32nds in the treasury contract given that 1 basis point move. For example the 30yr bond price would theoretically move just over five 32nds whereas the 10yr note would move half as much given a 1bp shift in the curve.
Calculating Hedge Ratios You can think of a DV01 as a measure of volatility. With that in mind we use DV01s of related securities (eg 10s and 30s) to calculate the ideal ratio of contracts to use when spreading the two as a hedge or speculative position. So staying within the same currency, the hedge ratio for one Treasury versus another is simply the ratio of one DV01 versus the other. Consider this table: 2yrs 2yrs 1.00 5yrs 2.43 10yrs 3.74 30yrs 7.40
5yrs 0.41 1.00 1.54 3.05
10yrs 0.27 0.65 1.00 1.98
30yrs 0.14 0.33 0.51 1.00
This shows the theoretical hedge ratios for any combination of Treasury contracts. For example to trade the 2:5 spread, you would trade 2.43 2yr contracts for every 5yr. To trade the 10:30 spread, you would trade 1.98 10yrs for every one 30yr. For spreading interest rate products, this is the place to start. Now let’s add the Aussie bonds. Again, these are simply the ratios of one DV01 to the next. For the Aussie bonds, we will use the USD converted DV01s. Au3yrs Au10yrs Au3yrs 1.00 0.33 Au10yrs 3.06 1.00 2yrs 0.70 0.23 5yrs 1.69 0.55 10yrs 2.60 0.85 30yrs 5.15 1.68 This table says we need to trade 3.06 Au3yrs for every Au one 10yr for example, or 0.85 Au10yrs for every 1 US 10yr note. Using the above data and with the help of rounding, here are the ratios for some popular spreads:
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US Spreads 5yrs 3 5yrs 3 10yrs 2 Aussie Spread Au3yrs 3 US - Aussie Spread 10yrs 6
2 1 1
10yrs 30yrs 30yrs
Nickname "Fight" Spread "Fob" Spread "Nob" Spread
1
Au10yrs
"3s, 10s"
5
Au10yrs
"10,10s"
Directional Spreading Versus Hedging Given the ratios are based on the dollar value of a basis point move, a perfect hedge would require an equal movement in yield in the two contracts. On a yield curve, this would mean a parallel shift in the curve, not a change in slope. One could argue, the purpose of spreading is to remove outright yield risk and take a position on a change in the slope of the curve. If we see anything but a parallel shift in the yield curve, these spread ratios create a position that is in some way directional – which is many respects is the purpose of a speculative spread position.
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Changing Slope of the Yield Curve Non-parallel changes in the yield curve are categorized as steepeners and flatteners. Both have bullish and bearish scenarios. Steepeners are where the difference between the long end and short ends increases. The terms bullish or bearish refers to the direction of prices. Yields fall = bullish = lower rates Yields rise = bearish = higher rates Bull Steepener – this is where rates are falling (prices rising) and short term rates are falling faster than longer term rates.
Bear Steepener – this is where rates are rising (prices falling) and long end rates are rising faster than short end rates.
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Flatteners are where the difference between the long end and short ends decreases. The terms bullish or bearish refers to the direction of prices. Yields fall = bullish = lower rates Yields rise = bearish = higher rates Bull Flattener is when yields are falling (prices rising) and the long end is moving further than the short.
Bear Flattener is when yields are rallying (prices falling) and the short end is falling harder than the long end.
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Factors Affecting the Shape of the Yield Curve Economic cycle. During strong economic expansion, short term yields will often move higher than longer term rates and the yield curve will be “inverted”. As the economic conditions turn negative, shorter term rates will go back below long term rates and the yield curve takes on a “normal” shape. As rates move lower still, the curve will steepen. As the recovery gets underway, the curve can flatten as short term rates rise. Another scenario that may cause an inverted yield curve is the perceive risk of default of government debt (eg Greece).
Inflation. The yield curve will be steep when expectations for short-term inflation are low. Expectations of strong inflationary pressures will flatten the yield curve. Monetary Policy. The yield curve will steepen when the Central Bank moves towards a loose monetary policy. The curve will flatten and can gradually move inverted when policy is tightened. ‘Operation Twist’ in 2011 was a good example of the US Fed’s policy changing the yield curve. In September the Fed announced they would sell short term bonds and buy long term bonds in an effort to reduce longer term rates. The effect of such policy is to flatten the curve by increasing short term rates and reducing long term rates. The curve trade to make is this scenario would to be to get long the 30yr bond and spread off with shorter term notes such as the 2yrs. In two days the long end rallied © Propex Derivatives.
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over 5 handles whereas the short end hardly moved (nobody expected much of a change in short end rates given the Fed’s commitment to keeping short end rates low). Supply of and Demand for Treasury Bonds. Activity in treasury financing (supply) and large managed funds (demand) can also have an effect on the yield curve. Specifically supply or demand constraints in particular maturities can lead to changes in the relative prices of certain points along the curve.
Charting Your Spread Wouldn’t it be easy if every contract we look at is traded in the same currency and quoted the same way? Unfortunately they are not. So to chart these spreads, we have to make a few calculations. The easiest to chart these spreads is to bring them back to yield. CQG has a function where it can turn an fixed interest security price into a yield chart. From there, we simply calculate the spread price and chart.
So to chart any of the US Treasury spreads for example, the following codes would be used: US Spreads Code Nickname 2s/5s TUA-FVA "Tuf" Spread 2s/10s TUA-TYA "Tut" Spread 5s/10s FVA-TYA "Fight" Spread 5s/30s FVA-USA "Fob" Spread 10s/30s TYA-USA "Nob" Spread Then right click the title bar, select More, then Yield as the above image shows.
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The same goes for the US-Aussie spreads. We do not need to convert the currency of one to the other as we already did this when calculating the hedge ratios earlier. With the yield function on CQG, it is comparing apples with apples. The codes are: Aussie Spread Code 3rs-10yr HTS-HXS US - Aussie Spread 10yrs TYA-HXS
Nickname "3s, 10s" "10,10s"
Note, this method of charting looks at the futures yields, not cash note/bond yields. There is often a difference between futures and cash (known as “basis”).
Filtering Data When trading a cross-border spread, it can be useful to filter the display to show only certain trading hours. You might do this if you are trading the US-Au spreads during the night session only.
Alternate Method of Charting a Spread On CQG there is a function called SHAREDSCALE. It takes one market and puts in on the same price scale as another. US Treasuries are quoted in 32nds and fractions thereof. The SHAREDSCALE function allows you to change that back to decimal therefore making
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it easier to either chart a spread or overlay one or more markets. For these charts, we will convert Treasuries to decimal using the Eurodollar (code:EDA) market. This approach to charting spreads adjusts the price of the securities by its DV01 so the dollar value of an up or down tick on the chart is constant. Note, the DV01s change regularly and therefore so does these numbers.
The CQG formulas for his approach are: Two-legged US Spreads: 2s/5s SHARESCALE((TUA?1*.464-FVA?1*.191),EDA) 2s/10s SHARESCALE((TUA?1*.464-TYA?1*.124),EDA) 5s/10s SHARESCALE((FVAH2*.191-TYAH2*.124),EDA) 5s/30s SHARESCALE((FVAH2*.191-USAH2*.063),EDA) 10s/30s SHARESCALE(TYAH2*.124-USAH2*.063,EDA) Butterflies: 2s/5s/10s: SHARESCALE((TUA?1*.464-FVA?1*.191)(FVA?1*.191-TYA?1*.124),EDA) 5s/10s/30s: SHARESCALE((FVAH2*.191-TYAH2*.124)(TYAH2*.124-USAH2*.063),EDA) US-Aussie Spread: US10-AU10: (TYA?1*.124-HXS?1)
Varying the Spread Ratio Ok, the hedge ratios calculated a few pages back assume a parallel shift in the yield to maintain the perfect hedge. Given a change in the slope of the curve is far more common than parallel shifts. This is evidenced simply by the fact that the spread chart does not remain constant – it moves up and down. So even with a theoretically perfect hedge ratio we are taking a directional position with any spread. The short cut to working out the directional position is to overlay the spread with the outright and look for the correlation.
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Trading the Spread There are three ways to enter a spread: Exchange Traded Spreads. The simplest way to transact in a spread is when the exchange offers that spread as an exchange traded product. The CME offer the NoB (1030) as an exchange spread – pictured here. The thing to note here is that a one lot trade in the spread equates to a traded amount in each contract equivalent to the ratio set by the exchange. At the time of writing, the NoB spread trades at a ratio of five 10yrs and three 30yrs (as opposed to what we calculated at 2:1 in the previous pages – close, but not exact). Autospreader. Trading platforms such as CQG have a ‘spreader’ feature where you can program a tradable synthetic spread. The end result is the ladder is tradable much like an exchange traded spread. Legging. The good old fashioned method to enter a spread is roll up your sleeves and enter each ‘leg’ manually. A tip for the best entry is to identify which market is most volatile and work a limit order entry in this market. After getting a decent price in the choppy market, go to the second market and either work best bid/offer or hit market. Legging in a spread can be a tricky method to get used to, but you’ll get the hang of it with a little practice.
When is a Spread not a Spread 1. Bad Timing - A spread should not be used to cover up a bad trade. Consider this scenario: Trader Ted gets long the Tbond at 142-26 after what he sees as a decent rally and one he expects will continue (exhibit A).
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The market then falls away, down to 142-00 before Ted decides to act. Rather than stopping out the trade and admitting the trade was simply a bad one, Ted sells some 10yr notes against it, thinking he will “spread it off” and watch it come back (exhibit B).
Think about the logic here. Ted is 26/32nds offside and then enters into a position that will require the bonds to rally well beyond his original buy price just for that spread to make a decent advance. Pure logic suggests he has a far better chance of simply holding the outright bonds in anticipation of a bounce. Admittedly the trade would reduce the downside if the market kept falling, but it virtually gives away any chance of making back the ticks already lost. As a rough estimate, the bond would have to rally by twice as much as the fall for that spread to make back the lost ticks. Turning an outright losing trade into a spread is not a spread strategy.
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Admittedly the example above shows a trade that was off side by a large amount before spreading. However the exactly the same logic applies to smaller moves. Spreading something off makes it harder for you to make money. 2. Bad Correlations – A spread involves opposing positions in correlated markets and the same positions in inversely correlated markets. Most of the time, stocks and bonds are inversely correlated. It is not unprecedented for a trader to spread these markets, perhaps trading relative values or extremes in one versus another.
So what does a spread in say the S&P versus the Tnote look like? Are you long one and short the other? If you think about it, that is a double directional trade. If they are inversely correlated (stocks go up bonds go down), then being long one and short the other is taking an even bigger directional position that you would be trading just one of the markets outright. The correct spread trade to make in inversely correlated markets is to be long both or short both. That is a spread. 3. Bad Ratios If we look at the Aussie 3s:10s spread as being a 3:1 ratio, then are you spreading when you are long 30 threes and short 30 tens? The answer is yes and no. One way to look at it is you have a spread of 30 threes and 10 tens PLUS another 20 tens. You are essentially overweight in one leg of the trade and therefore adding a directional bias. There is nothing wrong with doing this if it fits into your view, but it’s not a simple spread trade in the strict definition. Placing these trades requires a directional view as well as a relative value or spread view. In many cases you may simply be better off placing a smaller directional trade.
Some Spreading Research Ideas All of these may seem like leading questions. That is because they are. However, a little bit of homework here can teach you how spreads behave in certain scenarios. Know your market!
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1. How does a move in the currency affect a spread between the Aussie 10s and the US 10ys Note? Is it worth tracking the Aussie when looking at this spread? 2. At different times of the day, a spread between two markets in different time zones (e.g. Australia and the US) will behave differently. At certain times of the day such as the open, close and when data is released, traders will look at one market more than another. As such spread relationships can break down, albeit temporarily. Does this provide an opportunity? 3. How is a data release going to affect the short end of the curve versus the long end (i.e. a slope change)? Run some scenarios where the change in slope is affect by stronger or weaker data. 4. In reacting to data, is the change in the slope instantaneous or can you find examples where the change takes hours or even days? Does the market give you time to get in the spread and require patience when holding? 5. How would a surprise rate cut/hike affect the yield curve? 6. There is a general assumption that yield curve spreads are mean reverting. While mean reversion is certainly possible most if not all spread driven by fundamental factors are directional not mean reverting. This is why it is important to think about how general fundamental affect one part of the curve versus another. Run some of these ideas through your head and go back through charts and data releases. You might just find a pattern.
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Yield Curves – at the time of writing Aussie Bonds
US Treasuries
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Contract Specs Name: Aussie Bond Futures (3yrs and 10yrs)
Name: Aussie Bond Futures (3yrs and 10yrs) Exchange: SFE
Exchange code: Tick Value: Daily Volatility: 3: YB 3: 0.01 = ~a$29.82 $331 10: XB 10: 0.005 = ~a$45.655 $940 Comment: Like all markets, Aussie bonds have gone through cycles of volatility and lack thereof. For the day trader, it means adapting to what is in front of you. It means trading what the market is saying, not sticking to inflexible and outdated rules. In the 1990s, the 10yr bond was the market more suitable for active day trading. Large daily ranges made for great short and sharp trend trades. These days, interest rates are lower and the government bond market is smaller. This has caused a volume shift to the shorter end of the curve. As such the 3yrs are now the leading market. Lower intraday ranges now mean fewer opportunities compared with say the S&P. Intraday volatility tends to be small and as such larger traders use either a long term strategy or one of market making where queue position is of utmost importance. Correlations – these markets are tied to global bond markets such as the Bund or the US 10yr Tnote. Because the Aussie market is smaller, there are good opportunities for lag trades. Spreading – Spreading 3s versus 10s or bank bills versus 3s is common as well as spreading the Australian bonds versus the US Treasuries (Au 3yrs against US 5yr note or tens versus tens).
More information: www.sfe.com.au Daily Volatility = ATR * tick value. Note this will change every day. © Propex Derivatives.
~ = Approximately Horth & Bower
Name: US Treasuries (5yr bond, 10yr note and 30yr bond)
Name: US Treasuries (5yr bond, 10yr note and 30yr bond) Exchange: CBOT
Exchange code: Tick Value: Daily Volatility: 5: ZF 5: 0.0025 = us$7.8125 5: us$350 10: ZN 10: 0.005 = us$15.625 10: us$790 30: ZB 30: 0.01 = us$31.25 30: us$1,740 Comment: The 10yr note or just the ‘Tnote’ is the primary market among these three. They all have good liquidity. They can be traded as outrights or as spreads between each other or related markets. There are good correlations here with international bond markets such as Australia and Germany as well as stock and commodity prices. The markets still trade open outcry in Chicago, but have side-by-side electronic trading on Globex. 5yr Note: The small tick size makes it a good market for learning to size up when you are just starting out. It can also be a good market for ladder stacking without risking too much. One thing to watch in this market is for new intraday highs and lows triggering a similar move in the 30yrs. Normally we see the long end lead the short, but this can reverse in quiet ranging markets. Spreading: These are great markets for spreading. There is the 5s versus 30s (the “fab”); the 10s versus 30s (the NoB) and the 5s versus 10s (the fight). If you are new to spreading and want to get involved, pick one spread and just watch it.
More information: www.cmegroup.com © Propex Derivatives.
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More Reading Book: Trading STIR Futures by Stephen Aikin http://www.amazon.com/gp/product/1897597819/ref=as_li_ss_tl?ie=UTF8&tag=mrrnk -20&linkCode=as2&camp=1789&creative=390957&creativeASIN=1897597819 CME Treasury Futures General Info: http://www.cmegroup.com/trading/interest-rates/yield-center.html CME Treasury Futures Duration and DV01 Tool: http://www.cmegroup.com/trading/interest-rates/duration.html Measuring the price sensitivity of U.S. Treasury Futures doco: http://www.cmegroup.com/trading/interest-rates/files/Empirical_Duration.pdf Calculating the Dollar Value of a Basis Point doco: http://www.cmegroup.com/trading/interest-rates/calculating-the-dollar-value-of-abasis-point.html
Links Propex main website: www.Propex.net.au Propex training site: www.PropexTraining.com
Contact Guy Bower Training Manager
[email protected]
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