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Yield Curve Spreads Are Mean Reverting 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. © Propex Derivatives. 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. Horth & Bower 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 DV01 in AUD DV01s in USD AU 3s: $29.82 $31.01 AU 10s: $91.31 $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 DV01 32nds 2yr note: $21.56 0.68992 5yr note: $52.34 1.67488 10yr note: $80.70 2.5824 30yr bond: $159.60 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. Horth & Bower 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 5yrs 10yrs 30yrs 2yrs 1.00 0.41 0.27 0.14 5yrs 2.43 1.00 0.65 0.33 10yrs 3.74 1.54 1.00 0.51 30yrs 7.40 3.05 1.98 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: © Propex Derivatives. Horth & Bower US Spreads Nickname 5yrs 3 2 10yrs "Fight" Spread 5yrs 3 1 30yrs "Fob" Spread 10yrs 2 1 30yrs "Nob" Spread Aussie Spread Au3yrs 3 1 Au10yrs "3s, 10s" US - Aussie Spread 10yrs 6 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. © Propex Derivatives. Horth & Bower 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. © Propex Derivatives. Horth & Bower 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. © Propex Derivatives. Horth & Bower 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.
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