Workshop schedule - Московская Биржаfs.rts.ru/f/1696/bond-futures.pdf · Workshop schedule • Part 1: 4:00 to 5:30 (16:00 to 17:30) – Brief history of bond futures

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

28 November 11 Introduction to the uses of bond futures/Burghardt

2

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)


3

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


4

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


5

So why use futures?

• Futures allow you to separate the price from the product

• Transparency, liquidity, competitively accurate prices


6

So why not use futures?

• Regulatory and legal hurdles

• Cash management practices

• Inflexible quantities and forward dates


7

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


8

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


9

The starting point

• Futures contract specifications and mechanics

• The basic financial algebra of futures

• Challenges to correct valuation


10

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


11

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

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


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






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%.



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%.

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


15

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


16





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




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


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


18

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


19


20

Create a riskless asset


21

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

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


22

(I’ve used a US money

market day-count

convention)

March 2012 4-year bond basket


23

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


24

Spot/futures price relationship

for the cheapest to deliver


25

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)


26

Repo rates


27

Yield levels and the ctd


28

At expiry, the

futures price is the

lowest converted

spot price. This

chart assumes the

hypothetical yield

for calculating

conversion factors

is 6%.

Yield spreads and the ctd


29

Futures price before expiry


30

Shifts in the cheapest bond


31

March 2012 4-year bond basket


32

The value of the shift option:synthetic calls and puts


33

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

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


34

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


35

Are futures rich or cheap?


36

Looking for cash/futures trades


37

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.

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


38

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


39

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


40

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


41

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)


42

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


43

2-year and 4-year zero coupon

yields

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


45

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


46

Constructing a yield curve trade


47

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

Workshop: Part 2

• Hedging

• Cash/futures spreads

• Special topics


48

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

– Expected bond issuance

– Expected cash inflow to be invested28 November 11 Introduction to the uses of bond futures/Burghardt

49

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


50

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


51


52


53

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

options28 November 11 Introduction to the uses of bond

futures/Burghardt54

Competing Hedge Ratios


55

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)


56

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


57

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


58

2-year and 4-year zero coupon

yields

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


60

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


61

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


62

Cash/futures spreads

• Creating synthetic term cash

• Buying or selling mispriced cash/futures spreads

• Using synthetic bonds to enhance portfolio yields


63

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


64

Looking for cash/futures trades


65

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.

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


66

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


67

Government Securities Positions in

Bonds and Bond Futures


68

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)


69

Example of selling the basis


70

Selling the 10-year basis, 2000


71

Selling the 10-year basis: 2001


72

Selling the 10-year basis: 2002


73

Yield enhancement (1)


74

Yield enhancement (2)


75

Additional topics

• Power of forward pricing

• Squeezes

• Importance of financing

• Absence of a term repo market

• Managing the rolls

• Fails


76

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)


77

Spot and forward curves


78

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?


79

Squeezes

• Short squeezes are the most common

• Long squeezes are possible


80

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


81

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


82

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


83

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


84

Special topics in short-term

rates• Riding the yield curve

• Stub risk


85

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


86

Riding the yield curve


87

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


88

Sources of interest rate risk


89

Level and changes, 5-years


90

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)


91

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 - ?)


92

More eras?

• The ultra bond contract

• A new dry spell?


93

Conclusion

• For more information, see Burghardt, Belton, Lane, and Papa, The Treasury

Bond Basis, 3rd edition (McGraw-Hill)

• Questions?


94

Disclaimer


95

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Workshop schedule - Московская Биржаfs.rts.ru/f/1696/bond-futures.pdf · Workshop schedule • Part 1: 4:00 to 5:30 (16:00 to 17:30) – Brief history of bond futures