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Pricing and Charting Yield Curve Spreads
Pricing and Charting Yield Curve Spreads
YIELD CURVE
SPREADS
Contents
1.
Basic Definitions
2.
Using DV01s
3.
4.
5.
6.
7.
8.
Filtering Data
9.
Propex Derivatives.
Introduction
OK, lets 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.
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.
Thats 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
Its 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.
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.
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 lets 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.
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
Au10yrs
"3s, 10s"
Au10yrs
"10,10s"
Propex Derivatives.
Bear Steepener this is where rates are rising (prices falling) and long end rates are
rising faster than short end rates.
Propex Derivatives.
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.
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 Feds 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.
over 5 handles whereas the short end hardly moved (nobody expected much of a
change in short end rates given the Feds 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.
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.
Propex Derivatives.
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.
Propex Derivatives.
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.
Propex Derivatives.
Propex Derivatives.
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.
Propex Derivatives.
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 its 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.
Propex Derivatives.
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.
Propex Derivatives.
US Treasuries
Propex Derivatives.
Contract Specs
Name: Aussie Bond Futures (3yrs and 10yrs)
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).
~ = Approximately
Horth & Bower
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 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
Guy.Bower@Propex.net.au
Propex Derivatives.