Eurex to Launch Futures on Italian Bonds (click DORMAN logos for more information)

Between 1997 and 2007, spreads between German Benchmark government bond yields and other EU states, namely those of Spain, Italy, France and Greece remained narrow and relatively stable. However, deteriorating economic performance, and burgeoning fiscal deficits, led to a significant widening in spreads [see Diagram 1. European Government Bond Yields Spread Relationships to German Benchmark Government Bonds (10 year’s maturity)]. The financial market turmoil in 2008 exacerbated the widening, with German Bonds benefiting from a flight to safety.

Diagram 1: European Government Bond Yield Spread Relationships to German Government Bonds.

3.00

2.75

2.50

2.25

2.00

1.75

1.50

Yield spread Yield 1.25

1.00

0.75

0.50

0.25

0.00

02/01/2006 02/05/2006 02/09/2006 02/01/2007 02/05/2007 02/09/2007 02/01/2008 02/05/2008 02/09/2008 02/01/2009 02/05/2009 Date

Spanish Spread Italian spread French Spread Greek Spread

Source: Bloomberg

Prior to the diverging fiscal fortunes of the EU member states, Eurex Bund futures were a viable hedging instrument for the majority of EU debt. However, the widening of the spreads has left traders and fund managers of the EU member countries with large basis risk hedging these bonds with Eurex benchmark government bond futures.

Diagram 2 below shows the regression coefficient for the change in yields of Ten Year German Government Bonds, to Italy, France, Spain and Greece. The table shows how the bonds have become less correlated to the Benchmark German Bonds over the past three years.

Diagram 2: Correlation of the changing yields of Ten Year German Government Bonds to Ten Year Italian, French, Greek and Spanish Government Bonds

Jan 06-Sept 07 Sept 07-May 09 Germany-Italy 0.96* 0.81* Germany-France 0.99* 0.92* Germany-Greece 0.94* 0.42* Germany-Spain 0.99* 0.81*

In response to the problems created by widening EU member states government bond yields to German Benchmark bond yields, Eurex is launching futures on Ten Year Italian Government Bonds, complimenting its benchmark Euro zone instruments. The release is planned for September 2009. The new BTP future will serve to remove the basis risk currently present by hedging with the Eurex Bund future. Additionally, the large issuance of Italian debt, as shown below in Diagram 3, make it an attractive proposition as a proxy for other A to AA rated Euro denominated bonds.

Diagram 3: Total Issuance Size of Bonds with a remaining maturity of 8 to 12 Years

17bn 60bn 116bn 23bn 35bn

Italian Government Bonds Spanish Government Bonds Greek Government Bonds German Government Bonds Portuguese Government Bonds

Source: Bloomberg March 2009

The BTP future will also offer asset managers an opportunity to generate alpha by trading the spread between the countries on exchange. See Diagram 4: German / Italy Ten Year Government Bond Yield Spread. This will allow investors to trade the inter-country euro denominated spread without counterparty risk. Investors could also potentially benefit from offsets against existing positions in Eurex listed futures contracts.

Diagram 4: Graph of the spread between Ten Year German Government Bonds and Italian Government Bonds

1.750

1.500

1.250

1.000

0.750

0.500 Yield Spread of Govt Italian Spread Bonds Yield Germany Over

0.250

0.000

02/01/06 02/04/06 02/07/06 02/10/06 02/01/07 02/04/07 02/07/07 02/10/07 02/01/08 02/04/08 02/07/08 02/10/08 02/01/09 02/04/09 Date

Source: Bloomberg

Eurex OTC Block Trade The BTP futures will be eligible for trading via the Eurex Block Trade Facility, (BTF). This allows asset managers and traders to bi-laterally agree transactions in BTP futures off exchange and novate the trade to Eurex Clearing. The BTP futures are subject to a minimum Block Trade threshold of 250 lots. See Appendix 1 – Clearing of OTC Trades.

Designated Market Making To support the new product, Eurex will implement a Designated Market Making (DMM) scheme, requiring participant to quote two way markets continuously between 09.00 and 17.30 CET. The minimum quotation will be 20 contracts at a spread of 0.08. On fulfilment, DMM firms will receive a 100% exchange fee rebate on P and M account trades. The DMM scheme will run until the end of March 2010.

Product Applications Eurex BTP futures offer investors a number of trading opportunities. The following section outlines various product applications for traditional and alternative investment managers.

BTP Futures and Portfolio Overlay The introduction of BTP futures to Eurex’s existing suite of benchmark fixed income futures increases the fund managers’ possibilities in effecting changes in portfolio asset allocation, whilst leaving the existing portfolio intact.

For example, consider a European pension fund manager who wishes to switch 10 percent of his €100 Million Current EU Benchmark Ten Year Bond portfolio into Italian bonds. The portfolio has duration of 7.47 years. The steps in the portfolio overlay to synthetically switch part of the portfolio into BTP’s are as follows:

1. Calculate the number of Eurex Bund futures to be sold to reduce the EU Benchmark Ten Year Bond portfolio by 10 percent:

(Duration * Investment * 0.0001) / BPV Bund future

 7.47 * 10 Million Euro * 0.0001 / (8.42/0.818193)

 7.47 * 10 Million Euro * 0.0001 / €10.3

 725.24

 725 Bund Futures

(The BPV of Euro-Bund future = BPV CTD / Conversion Factor)

BPV measures the change in value of an asset or portfolio resulting from a 0.01 percent change in yield.

The CTD, the (Cheapest to Deliver) is the bond, deliverable against a , for which delivery is most attractive in terms of cost from the short position holder's point of view.

The Conversion Factor is that factor used to equalize for the difference in issue terms between the notional bond underlying a bond futures contract and the real bonds eligible for delivery.

2. Calculate the ratio of BTP futures to Bund Futures

The BPV of the Bund Future is €10.3, from above

The BPV of the BTP Future is, using the same calculation:

 7.58 / 0.882668

 €8.59

Therefore, the ratio of Bund futures to BTP futures is 1 Bund: 1.199 BTP

The Fund manager sells 725 Bund Futures and buys 869 BTP futures to synthetically switch 10 percent of his core European Bond exposure to Italian bond exposure.

By way of this portfolio overlay strategy, the fund manager can quickly switch part of his core exposure into Italian exposure, whilst keeping the underlying portfolio intact. When the fund manager believes the out performance of Italian Bonds has run its course, he can unwind the long BTP / short Bund futures spread position. The diagram below outlines portfolio overlay using Eurex Bund futures and Eurex BTP futures.

Initial New Synthetic Portfolio Portfolio

Long Core Long Core European European Bond Bond Portfolio Portfolio Buy Eurex BTP Futures Long Italian Sell Eurex European Bond Bund Futures Exposure

Portfolio Overlay

Synthetic Cash Investment A fund manager can use the Eurex BTP future to create a synthetic Bond investment. He creates a synthetic bond investment by buying Eurex BTP futures. The fund manager has a target duration of 7.5 years.

The steps in the creation of the synthetic cash investment are as follows:

Calculate the number of Eurex Euro BTP futures to buy to synthetically invest 10 million Euros.

(Duration * Investment * 0.0001) / BPV BTP future

 7.50 * €10 Million * 0.0001 / (BPV CTD / Conversion Factor CTD)

 7.50 * €10 Million *0.0001 / 8.59 (from above)

 873.10

 873 BTP Futures.

By way of this synthetic investment strategy, the fund manager can quickly gain exposure to a market, by buying 873 Eurex Euro BTP futures.

Synthetic Spread Trading A fund manager who has a particular view on the spread between Benchmark German Government Bonds and Italian Government Bonds can enter into a spread trade between Eurex Bund and BTP futures. Under these circumstances, he can buy (sell) the Eurex Euro Bund and simultaneously sell (buy) the Eurex Euro BTP future. This offers a fast and effective way to take a directional view on the spread between the German and Italian bond markets

The steps involved are a combination of the two examples above.

To calculate the ratio of each futures contract the fund manager needs to calculate the ratio of the BPV of the two contracts:

BPv Bund Future = (BPv Bund CTD / CF CTD) = (8.42 / 0.818193) = 10.3

BPv BTP Future = (BPv BTP CTD / CF CTD) = (7.58 / 0.882668) = 8.59

Therefore, the ratio of Eurex Bund futures to Eurex BTP futures is 1 Bund future: 1.199 BTP Future

Therefore, using the methodology described previously, to synthetically gain €5 million exposure to the yield spread between German Bunds and Italian Bonds, the fund manager would buy 362 Eurex Euro Bund Futures, and sell 434 Eurex BTP futures.

Conclusion The widening of spreads of European Government Bonds during the financial crisis has created both problems and opportunities for market participants. The Eurex Euro BTP futures offer a more suitable contract to hedge Italian and other non core European bond exposure, whilst also offering opportunities to generate alpha by trading the spread between German Benchmark Government Bonds and Italian Government Bonds.

Appendix 1 – Clearing of OTC BTP trades Eurex OTC facilities provide all participants with the possibility to enter bi-laterally agreed OTC transactions into Eurex Clearing, for clearing and settlement. With this facility, it is possible to take advantage of the benefits of OTC trading, whilst maintaining the advantages of standardised clearing and settlement. The minimum number of contracts for Block Trading in BTP futures is 250 contracts.

To facilitate Basis trading the EFP and EFS functionalities allow for the simultaneous purchase (sale) of futures along with a sale (purchase) of the underlying bond, vanilla or another futures contract block trade. Such transactions are not subject to a minimum number of contracts.

For example, consider a fund manager or trader wishing to trade the yield spread between Bund and BTP. He can agree the trade off exchange and use the EFP facility to bring the transaction to Eurex Clearing. The fund manager must trade a minimum of 250 lots in the Eurex BTP future, and create this via the Eurex Block Trade Facility (BTF). He can then use this as a qualifying transaction to create the corresponding Eurex Bund Futures leg via the EFP Fin functionality.

Appendix 2– Contract Specification

Contract Specifications Notional long-term debt instrument issued by Italy with an original maturity not longer than Contract Standard 16 years and a remaining term of 8.5 to 11 years and a six percent coupon

Contract Value EUR 100,000

Fee and Pricing EUR 0.20 per contract; OTC: EUR 0.30 per contract

Price Quotation In percentage of the par value, with two decimal places Tick Size / Value 0.01% / EUR 10 Italian government bonds that have an original maturity of not more than 16 years and Settlement remaining term of 8.5 to 11 years on the Delivery Day. Such debt securities must have a minimal issue amount of EUR 10 billion and a nominal fixed payment

Delivery Day Tenth calendar day of the respective quarterly month (Mar, Jun, Sep, and Dec)

Two exchange trading days prior to the Delivery Day of the relevant delivery month. Last Trading Day Trading in the maturing delivery month ceases at 12:30am CET

Trading Hours 8:00am to 7:00pm CET

Market Making 9:00am to 5:30pm CET for the first six months

Block Trade Size 250 contracts