Butterfly Trades Weighting the trades, and weighting and interpreting their yield spreads. Robin Grieves ROBIN GRIEVES is dicctot of fixed income tetearch at HSBC Secures in New York (NY 10008), nvestors who want to sell rich securities or buy cheap securities and maintain their portfolio dura- ‘ons often employ butterfly trades. A butterfly trade typically uses three securities of different durations ‘The shortest~ and longest-duration instruments are the ‘wings; the middle-duration instrument is the body. Investors can, of course, buy and sell multiple issues that net out to constant duration, Much of what comes easily in considering these trades is misleading. Consequently, butterfly trade struc- tures and their yield spreads are often misunderstood. Our objective is to explain some of the hazards. BUTTERFLY TRADE WEIGHTING There are multiple ways to weight (or structure) butterfly trades, Three common weighting schemes are cash- and duration-neutral, fifty-fify, and regression. We detail the relative merits of each. Cash- and Duration-Neutral Weighting Cash- and duration-neutral weighting is often employed by “real money” accounts — pension funds, insurance companies, central banks, Such accounts often, ‘want to swap out of one bond into two others, keeping, their durations constant, and without putting up or tak- 1g out cash, because they keep little or no cash and do not use borrowed funds.! For example, suppose we want to look ata cash- and duration-neutral butterfly of 5s/103/30s. Further sup- pose the values as in Exhibit 1.2 1H JOURNAL OF FORTFONO MANAGEMENT 7To decide how much market value of each wing, ‘we need to structure a cash~ and duration-neutral but- terfly correctly, we nced to solve two equations: ‘Mkt,Dur, a ‘Mkt, + Mkt, = Mkt, @ ‘Mkt,Dur, + Mkt,Dur, ‘where Mkt, is the market value of the short wing, Mkt, is the market value of the body, and Mkt, is the market value of the long wing; Dur,, Dur, and Dur, are their respective durations. Equation (1) matches the duration of the wings with the duration of the body. The duration of a port- folio is the market value-weighted average of the con- stituent securities. Equation (1) can also be read as ‘matching the duration dollars ofthe wings and the body.? ‘Equation (2) matches the market value of the ‘wings to the market value of the body, the condition for cash neutrality. We can arbitrarily assign a market value of 1 to the body. Then, solving for the market percent- age for cach wing, we find: Mkt, = (Dur,—Dur,)/(Dur,-Dur,) —@) Mkt, = (Dur, ~ Dur,)/(Dur, ~ Dur,) or Mkt, = 1 ~ Mkt, ® ‘Using this machinery, how is a cash- and dura- tion-neutral butterfly of 5s/10s/30s constructed? Sim- ply put, if we buy $10 million par of the ten-year, how much of the five-year and the bond should we sell? Mit, = (Duty, ~ Dtrig)/ (Dry, ~ Dur,) Mkt,, = (13.178 — 7.225)/(13.178 - 4.201) 6631 and Mktyp, = 1 ~ 0.6631 = 0.3369 The market value of the 10s is $10,304,460 ($10 millon par times a fall price of 103.0446). Market value of the 5s is 0.6631 x $10,304,460 = $6,832,887, and the market value of the bonds is $3,471,573. “The par values of 5s and 30s are $6,832,887/ 3. summary Toes 101.6857 = $6,719,615 and $3,471,573/100.8351 = $3,442,822, respectively (to be rounded). Are the dura- tions matched? ‘The wings have $6,832,887 x 4.201 + $3,471,573 X 13.178 = 74,453,347 duration dollars compared with, the body, which has $10,304,460 x 7.225 = 74,449,724 duration dollars. The values differ only because of round- ing at intermediate steps. Consequently, with equal dura- tion dollars and equal market values, we have devised a cash- and duration-neutral butterfly. Fifty-Fifly Weighting ‘The second way to weight a butterfly trade is to place 50% of the duration dollars in each wing. This ‘weighting is equivalent to doing two dv01-weighted trades — one with the short wing and the body, and another with the Jong wing and the body. Fifty-fifty weighting is typically used by market participants who finance all their positions, eg,, dealers and hedge funds. The fact that the borrowed finds for long positions do not necessarily match the lent finds ‘rom short positions usually does not enter the analysis; that the trade is net long or short cash is ignored. To weight these butterflies, we need to solve ‘two equations Mit,Dur, + Mkt:Dur,= Mkt,Dur, ‘Mkt,Dur, = Mkt,Dur,/2 Equation (6) puts half of the duration dollars in each wing, Letting Mkt, = 1: O} Mkt,Dur, o Mkt, = (Dur,/2)/Dur, © Mkt, = (Dur,/2)/Dur, o Tt would be a numerical accident for this trade to also be cash-neutral. Consequently, this is effectively a four-security trade with cash as the fourth security. Instead of the wings being a barbell around the body, the wings are one barbell, and the body and cash are a second barbell. How then isa fiy-fity butterfly of 55/10/30 strac- tured? The weight in each wing is calculated as follows: Mkt,, = (7.225/2 )/4.201 = 0.8599 Mkt, = (7.225/2 )/13.178 = 0.2741For $10 million parof 10s, Mkt, = $10,304,460% 0.8599 = $8,860,805 and Mkt, = $10,304,460%0.2741 = $2,824,452. Themarketvaluessumto$1 1,685,257, which ‘means that we mustput$1,380,797 in ash, The par values are par,, = $8,860,805/101.6857 = $8,713,915, and pary, = $2,824,452/100.8351 = $2,801,060. ‘What are the duration dollar? For 5s, $8,860,805 X 4.201 = 37,224,242 duration dollars, and for 30s $2,824,452 x 13.178 = 37,220,628 duration dollars. The duration dollars in each wing are nearly identical, and they sum to $74,445,070, which is nearly identical to {$10,304,460 X 7.225 = $74,449,724 ‘The purpose of this weighting is to make the trade curve-neutral, or at least to reduce the trade's exposure to curve reshaping. If the spread change between the short wing and the body equals the spread change between the long wing and the body, 50% ‘weighting provides risk neutrality to curve steepening and flattening for small changes. For example, in 55/10s/30s,if5s/10s steepens by 10 basis points, a dv01-weighted trade to sell 5s and buy 10s suffers a loss, and if 10s/30s steepens by 10 bp, a dv01- weighted trade to buy 10 and sell 30s realizes a gain. Fur ther, ifthe tuades are the same size in terms of 10s, the Joss in 5s/10s-will exactly oft the guin in 108/30. That is what a fifty fifty weighted butterfly is designed to do. Regression Weighting Because yield volatility of short term-to-maturity issues typically is higher than long term-to-maturity volatility, we would normally expect the short wing to ‘move farther from the body than the long wing even if the duration difference from the body to each wing is, symmetric. The “fix” for this differential movement is regression weighting.® ‘Another reason for regression weighting is that not all butterflies are symmetric. For example, with 2/10/30, the wings might move the same amount. But, ‘with, 2s/35/30s the wings are almost certain to move by different amounts. Regression weighting is achieved by regressing changes in the spread between the long wing and the body on changes in the spread between the short wing and the body. With higher yield volatility at the short end of the curve than the long end, we would expect the regression coefficient of spread changes at the long end on spread changes at the short end to bbe less than one.? ‘The caveat in regression weighting is that the regression coefficients are not necessarily stable. We right very well get different measures of lope over dif- ferent time periods and with different periods for dif- ferencing. For example, the regression coefficient for ‘weekly yield changes of on-the-run 30s minus 10s ver- sus on-the run 10s minus 5s for 1995 is 0.73, but the coefficient for monthly changes is 0.85. Further, the weekly and monthly coefficients for 1996 are 0.31 and 0.49, respectively* With this caveat in mind, we continue the exam- ple assuming that the slope coefficient (B) is 0.6 — that 5s, fora 10-basis point change in the yield spread between 5s and 10s, we are likely to get a 6-bp change in the yield spread between 10s and 30s To regression-weight a trade, we need to solve two equations: Mkt,Dur, + Mkt,Dur, = Mkt,Dur, a) Mkt, Dur,(1/8) = Mke,Dur, ® Equation (8) makes the duration dollars times the likely relative yield movements equal. Because the long swing spread is likely to move only B x 10 bp for every 10-bp movement in the short wing spread, we must put ‘more han half of the duration dollars in the long wing to make the trade curve-neutral? “Grossing up” the long wing by 1/B leads to curve neutrality Setting Mkt, = 1 leads to: Mk, = [Dur,8)/(1 + B)/Dur, © Mu, = [Dury/(1 + B)/Dur, (to) Suppose the regression coefficient is 0.6.'Then we would put 1.0/1.6 (0.625) of the duration dollars in the Jong wing and 0.6/1.6 (0.375) ofthe duration dollars in the short wing. If the regression coefficient is 1.0, the fifty-fity weighting remains optimal.” For the 5s/103/30s example, 5s get 0.375 of the duration dollars (74,449,724 X 0.375 = $27,918,646), and 30s get0.625 of the duration dollars ($74,449,724 x 0.625 46,531,077). These translate into par amounts of $6,535,545 (= (27,918,646/4.201)/1.016857) of Ss and $3,501,724 (= (46,531,077/13.178)/1.008351) of 30s, For the issues in our example, the regression weighting s close to the cash- and duration-neutral weighting, but this would not always be the case.” “riz ounnaL or roRIFONO NANIGBERTT goButterfly Yield Spread Weighting Just as there are multiple ways to weight the trades, there are competing ways to weight the mea- sure of yield spread. It is unfortunate thatthe term “weighting” appears in two entirely different contexts of butterfly trades. The first usc of “weighting” (as we have just shown) is how to structure the trade (.e., what is the recipe for con- structing this trade). The second use of “weighting” is how to evaluate the trade's prospects in particular, how best are we to measure yield spreads? That is the topic of this section, Despite the well-known shortcomings of yield to ‘maturity asa predictor of total rate of return, yield spreads and changing yield spreads are used to try to predict total returns to butterfly trade positions. Different spread ‘weighting methods can be evaluated according to how well they correlate with realized returns. ‘To make matters more confusing, there are mul tiple ways of measuring yield spreads for each way of structuring butterfly trades, although some spread mea- sures are often associated with particular trade structures. For example, when fifty-filty weighting the butterfly structure, investors often measure the butterfly spread as twice the body’ yield minus the sum of the wings’ yields. ‘As we explain below, this is a duration dollar-weighted yield spread. Market Value-Weighted Yield Spread ‘Most portfolio managers begin their analysis with market value-weighted yield spreads.'? Market value ‘weighting predicts total rate of return for the trade if none of the yields move (and any coupon payments are rein- vested at the initial yields); it measures what happens when nothing happens. Many portfolio managers are interested in this measure because they have a policy of pursuing only “pick” trades; they will execute only trades with posi- tive market value-weighted yield spreads. They reason that they will not underperform while waiting fora trade to work if they restrict themselves to pick trades; they will accumulate yield while waiting for prices to move in their favor. “Give” trades have to work soon enough to overcome the forgone yield Even though we can see why market value- weighted yield spreads are a popular measure, their changes are especially fawed predictors of total returns ‘when yields change. For example, if a portfolio man- (90, meransyy raves ager has on a dvO1-weighted position of cash/5s/10s that, is long cash and 10s, and cash richens or cheapens dra- ‘matically overnight, the mark-to-market value of the position does not change because the market price of cash does not change as yields change.” The changing market value-weighted yield spread is a false signal of probable short-run returns in this case. (Its, of course, possible for changes in market value-weighted yield spreads to be highly correlated with returns, but these ceases are mostly numerical accidents or are caused by nearby durations of the three securities that constitute the butterfly) Consider the cash and duration-neutral 5s/ 105/30. The market value-weighted yield spread is pick 7.5 bp. We find that by taking the market-weighted yield of the wings: ($6,832,887 x 5.92 + $3,471,573 x 6.44)/ $10,340,460 = 6.095 and subtracting it fom the yield level of the body: 6.17 — 6.09: 75 bp Alternatively, we could calculate the market value ‘weights first: For 5s: $6,832,887/ ($6,832,887 + $3,471,573) = 0.6631 For 30s, $3,471,573/ (96,852,887 + $3,471,573) = 0.3369 Then the market value-weighted yield spread is, as we would expect: 0.6631 x 5.92 + 0.3369 x 6.44 = 6,095 Suppose that we have a one-year horizon, that none of the yields change, and that we can reinvest any cash flows at the yield level of 10s as an approxima- tion for all three yields. Then the body will outper- form the wings by about $7,500 on a $10 million tade, and the market-weighted yield spread will be a good predictor of that return. To repeat, market value- weighted yield spread measures what happens when nothing happens.Duration Dollar-Weighted Yield Spread ‘The duration dollar-weighted yield spread of a portfolio is very nearly the internal rate of return of all the cash flows from the instruments in the portfotio.® Te most neatly matches our intuitive definition of yield to maturity? Further, changes in dhe duration dollar-weighted yield spread times the dv0t of the body of a butterfly is an extremely good predictor of dollars gained or lost when yields change over a short period of time. Over longer periods of ime, our prediction of total returns would be changes in the duration dolla-weighted yield spread (using dluations appropriate atthe horizon) plu the matkct value ‘weighted yield spread over the holding period. The duration dollar-weighted yield spread can be calculated for any of the different ways of weighting (tructuring) the butterly trade. In gencral, the duration dollar-weighted yield for the wings ofa butterfly i (Dur,Mkt,Yid, + Dur,Mkt,Yid,)/ (Dur,Mkt, + Dur,Mkt) For the cash~ and duration-neutral butterfly trade, the duration dollar-weighted yield of the wings is: (4.201 x $6,832,887 x 5.92 + 13.178 x $3,471,573 x 6.44)/(4.201 x $6,832,887 + 13.178 X $3,471,573) = 6.240 Alternatively, we could calculate the duration dol- lar weights firs: For 5s 4.201 x 86,832,887/ (4.201 x $6,832,887 + 13.178 x $3,471,573) = 0.3855 For 308: 13.178 x $3,471,573/(4.201 x $6,832,887 + 13.178 x $3,471,573) = 0.6145 Notice how dramatically different these weights are compared with the market value weights. The dura tion dollar-weighted yield spread is, as we would expect: 0.3855 x 5.92 + 0.6145 x 6.44 = 6.240 and, subtracting it ftom the yield level of the body: 6.17 - 6.24 0b Now, suppose that the 10s richen by 2 bp overnight; the duration dollar-weighted yield spread would narrow by 2 bp. Our gain (because we own 10s and ate short 5s and 30s) will be the dv01 of the ten- year position times 2 bp. The dv01 of $100 of 10s is $0.07445, and for $10 million it is $7445.00. A 2 bp richening gains $14,890, How else might we gain $14,890? One way would be if 10s were to remain steady and both 5s and 30s to cheapen by 2 bp; then, the duration dollar-weighted yield spread would narrow by 2 bp. In this case, both the dura tion dollar-weighted yield spread and the market weighted yield spread change by 2 bp. But, this is not usually the case. ‘Another way is for either 5s or 30s to move by more than 2 bp. For example, the dv01 of $100 of the five-year is 0.04272, and for $6.72 million (the par weight of 5s in our butterfly) itis $2,870. To gain $14,890, our short postion must cheapen by 5.2 bp ($14,890/82,870). A 5.2-bp cheapening of 5s times the duration dollar- ‘weight of 5s (0.3855) is a 2 bp change in the duration dollar-weighted yield spread of the butterfly. Notice that regardless of whether 10s richen by 2 bp or 5s cheapen by 5.2 bp, the duration dollar-weighted yield spread of the trade changes by the same amount, and the dollar gain isthe same in both cases ‘Alternatively, if 30s cheapen by 2 bp divided by their duration dollar-weight 2 bp/0.6145 = 3.25 bp), the short position will gain $14,890. This gain comes from 3.25 bp times the dvOt of the 30s position. The dv01 of 30s is 0.13288 per $100 and $4,575 for $3.44 million, Changes in the duration dollar-weighted yield spread are good predictors of capital gains or losses over short periods of time, and changes in market-weighted yield spreads are not. ‘One reason for the popularity of following dura~ tion dollar-weighted yield spreads for ffty-fifty weighted butterflies is that they are extremely easy to calculate Because the duration dollar weights are the same for both ‘wings, twice the body's yield minus the sum of the wings’ yields is twice the duration dollar-weighted yield spread, Tecan be calculated at a glance and it can be monitored for movement just as easily. For example, in our 5s/10s/30s fifty-fifty butter- fly, the duration dollar-weighted yield spread is: "THF JOURNAL OFFORTFOLIO MANAGEMINT 91EXHIBIT 1 ASSUMPTIONS FOR EXAMPLES Issue Yield Flat Price Pull Price Duration 5s 5.92 101-12 101.6857 4.201 105 6.17 102-14 103.0446 7.225, 305 644 100-25 100.8351 13.178, 6.17 — (0.5 x 5.92 + 0.5 x 6.44) = 0.01 = -1.0 bp (2X 6.17 ~5.92 ~6.48)/2 = 0.01 = -1.0 bp Suppose, again, that the 10s richen by 2 bp overnight. The duration dollar-weighted yield spread ‘would, again, narrow by 2 bp, and our gain would be $14,890, just as above. How else, in this case, could we gain $14,890? Because half of our duration dolla are in each wing, cheapening either wing by the same amount would do the job. Further, we know how much they need to cheapen — 4 bp. One-half times 4 bp moves the dura- tion dollar-weighted yield spread by 2 bp. The trade is structured so that we do not care which wing moves HOLDING-PERIOD RETURNS Exhibit 2 displays dollar returns per $10 million ‘par of the body for the three trade weightings. We con- sider two holding periods and a variety of yield changes ‘on the individual bonds. We also show market value~ ‘weighted and duration dollar-weighted yield spreads for each scenario in Exhibits 3 and 4. Whether each but- terfly makes or loses money depends on how the curve moves and reshapes compared with the movements and reshapings for which the trade is structured. One-Day Returns ‘The frst column of Exhibit 2° frst pancl displays the overnight dollar returns from the trades. To under- stand why the amounts are so small, look at the first col- ‘umn of the first panel of Exhibit 2. The pickup in annual returns for each of the trades for an unchanged market (measured with market value-weighted yields) is very few basis points. Consequently, we would not expect the ‘overnight returns to be particularly large, and they are not. In the second and third columns of Exhibit 28 first panel, we increase, then decrease all three yields by 10 ‘bp. Because nearly no time has elapsed, market-weighted yield spreads tell us very little. Because the trades are ll structured to be duration-neutral, we would expect the horizon returns to be neatly zero, Finally, because the ‘wings have more convexity than the body, we expect the body to underperform for parallel shifts in all three trades, which it docs. Similarly, because the fity-ffty butterfly hhas ess of a convexity mismatch (recall itis two barbells instead of a barbell and a bullet), we expect the under~ performance of the body to be smaller, which itis. For the steepening and flattening scenarios in which the curve rotates around the body of the butter flies with 20 bp of steepening and flattening between each wing and the body, the results are again as we would EXHIBIT 2 BUTTERFLY TRADE (BUY THE BODY, SELL THE WINGS) TOTAL RETURNS (8) Unch 10 =10 070 20-20 20/12—20/-12. ‘Overnighe Cash-Neutral 9 00) (199) 31.887 36,257) 6,495) 1,564 Filty-Fifty m (53) a7) (1.879) (4.987) 30,681) 28,799 Regression 1 (iss) @25) 35,065 (39,483) (048) (91) One Year Cash-Neuteal 6845 6.64 6,600 481598547) 13,107 (4.245) Fifty Fifty 797 (770) 2,059 11,688 (13353) (16.849) «16,885, Regression 7328-721 6,923, 5513 40.989) 15.895 2970) -20/20 means 55 richen 20 bp and 30 cheapen 20 bp with 10s unchanged. 92. sernnry ranesexpect. For the cash~ and duration-neutral butterfly, the body outperforms in steepening and underperform in flattening. This is because more of the duration dollars in the trade are in the long wing than are in the short ‘wing (61% in the long wing and 39% in the short) ‘These cases also demonstrate the importance of using the duration dollar-weighted yield spread instead of the market value-weighted yield spread when con- sidering spread changes in trades. For the steepening sce- ratio, the market value-weighted yield spread in Exhibit 3 widen by 9.1 bp (the body purportedly cheapens to the wings by 9. 1 bp — 15.99 bp ~ 6.89 bp), which has the wrong sign. On seeing this spread change, we would expect the wings to have outperformed the body. That yield change times the dv01 of the body would be under- performance of $67,750 instead of the $31,887 ouiper- formance that we observe. ‘The duration dollar-weighted yield spread, on the other hand, narrows by 3.4 bp, which isthe right direc tion, and when multiplied by the dv01 of the body has, nearly the right size ($25,685 versus $31,887). For the fifty-fifty butterfly, the returns are nearly ccurve-neutral for equal changes between the short wing and the body and between the long wing and the body, which is how we weighted the trade to begin with. Returns are negative because of convexity. As the five ‘year richens by 20 bp, its duration increases (hurting the EXHIBIT 3 short 5s position as it richens more than we would have ‘expected), and as the thirty-year cheapens, its duration decreases (hurting the 30s position because it cheapens less than we would have expected). In the steepening and flattening scenarios, the yield of the body does not move, while the wings move 20 bp each. Because the wings have convexity and yield movement, they outperform the body. ‘The regression-weighted trade is closest to neu- tral in the pair of scenarios for which it was designed (20/12 and 20/~12). The returns are symmetric, and, again because of convexity differences between the wings and the body, they are negative. In addition, for these two scenarios, notice that the fitty-fifty trade is not curve neutral. Ifthe yield spreads move according to our aver- age regression results, a fifty-fifty butterfly trade is a flattening trade — it outperforms in curve flattening and underperforms in curve steepening, Curve-neutral trades must specify the curve dynamics, and they must be correct for the neutrality to be realized. ‘One-Year Returns ‘The first thing to notice in the second panel of Exhibit 2 is returns for an unchanged scenario. The $6,845 for the cash- and duration-neutral trade accords quite nicely with the 6.9-bp market-weighted yield spread at the outset, since one basis point is worth $1,000 MARKET VALUE-WEIGHTED BUTTERFLY (BUY THE BODY, SELL THE WINGS) SPREAD (BP) Initial Pices and Initial Durations Cash-Neutral 6.89 Fifty Filly 097 Regression 753 Horizon Durations and Horizon Prices Unch 10 =10 20/20 20-20 20/12 2012. Overnight Cash-Neutral 689 6.98 6.77 15.99 16.26 2.35 Fily-Fity 097 2at 21 1178 1204 937 Regression 7330072 7.0 1644 1682 154 One Year Cash-Neutral 6.77) selec ol 16.37 2.85 167 3.02 Fity-Fity Ml 0.14 0.83 12:52 10.03, 1280 Regression (736) e762) 350 1678 am 1719 20/20 means 5s richen 20 bp and 30s cheapen 20 bp with 10s unchanged. "ir Jouna OF PORIFOHO MANIC 93EXHIBIT 4 DURATION DOLLAR-WEIGHTED BUTTERFLY (BUY THE BODY, SELL THE WINGS) SPREAD (BP) Initial Prices and Initial Durations (Cash-Neutral 146 Fifty-Fity =155 Regression 8.01 Horizon Durations and Horizon Prices Unch 10 -10 20/20 20-20 -20/12_—20/-12 Overnight Cash-Neutral 4460 277.86 10.91 3.03 643 197 Fifty Fifty 455 1351.76 ~038 170 3.18 572 Regression 8020 783 8.21 =11.90 3.5 33 8.18 ‘One Year (Cash-Nevtral 370-951 9.89 14.99 352 10.12 8.80 Fifty-Fifty 397 376 4.17 472 224 078 6.63 Regression 1023-1004 10.41 18.93 3.64 10.98 9.00 20/20 means 5s rchen 20 bp and 30s cheapen 20 bp with 10s unchanged. ‘on $10 million. Similarly, the $797 for the fify-fifty but- terly ties quite well with its 0.97-bp inital marker- weighted yield spread. The regression-weighted trade begins with a yield spread of 7.53 bp and realizes hori~ zon returns of $7,328, again a quite good match. ‘The one-year returns for the cash- and duration neutral butterfly for 10-bp parallel shifts are quite close to the sum of the $6,845 yield spread and the $200 con- vexity loss for overnight changes. Those numbers add ‘up because the market value-weighted average dura~ tion of the wings shortens nearly an identical amount to the duration shortening of the body over the year. Consequently, this trade shows very litle duration drift. We would not usually expect the durations to remain as well matched. ‘The returns to the fifty-fifty butterfly do not add up in the same way because the duration of the wings drifts away from the duration of the body. This demon= strates the importance of using horizon durations when structuring and evaluating trades. Unfortunately, investors typically do not know how long a trade will be held, and current durations are about the best they can do for weighting trades. Nevertheless, the notice- able increase in the sensitivity of this butterfly to steep- ning and flattening can be attributed to duration drift. Periodic rebalancing of butterfly trades as time passes 94. surrexny mans: and as yields change should be part of portfolio man- agers’ plans, ‘The reason that the absolute dollar amount of the returns to the cash- and duration-neutral butterfly under steepening and flattening scenarios increases with the holding period of the trade also has to do with duration drift. With the passage of time, bonds shorten slowly. (Over a one-year holding period with unchanged yields, the bond's duration shortens from 13.18 to 13.03 years the ten-year shortens from 7.22 to 6.68; and the five~ year shortens from 4.20 to 3.46, The shorter the dura- tion ofa coupon-paying security, the faster the duration decreases with the passage of time. The converse is true for longer-duration securities. Ti the process, because the market values remain relatively unchanged, the distribution of duration dol- Jars changes. With bonds changing least and 5s chang- ing most, more of the duration dollars in the trade are in the long wing as time passes. Consequently, the trade becomes more sensitive to steepening and flattening. The same phenomenon of redistribution of the duration dollars occurs with the fitty-ffty butterfly. The original equal split moves toward more heavily ‘weighting the long wing with the passage of time. This is why the trade becomes market-directional with the passage of time.CONCLUSION ‘Bureerfly trades are usefll tools in a fixed-income portfolio manager's toolbox. The tades are weighted to reflect portfolio constraints on the uses of cash and leverage and to reflect potential curve reshaping. They are subject to duration drift with the pasage of time and with interest rate changes. Consequently, they should be monitored and rebalanced from time to time, Yield spreads provide different information depending on how they are measured. Market-weighted spreads predict performance in an unchanging world. For changing yield curves, duration dollar-weighted spreads «an be used to estimate capital gains or losses ENDNOTES “The author would ike co think — without implicating — Vincent Butkenice, Louis Cebber, Ants mssen, Jon Kil and Steven V. Mann. "This weightings equivalent Bloomberg's BBS, In sea ‘where investor dv0t-seeight (dla valve of shai poincweight) 2 ade using only two ise, they are spc wang cash sche Shore wing. Such tade is ortion-neutral, but noe exh-aencal For example, in trading Ix/bonds dv01-weighted, for every ml ion dolla of matket vale of ten-year bought (old) we would sell (by) about $550,000 market valve of bonds, and sell uy) about $450,000 of shor bills 0 serve seas. these yield, pice, and duration dats ate spproximatly ‘omoc forthe on-the-ran Treasures on November 15, 196,10 4t~ tle November 18,1996. The Ss ae US, 6.25 10/31/2001, the 10, are US. 65 10/15/2006; and the bonds are US. 65 11/15/2026 ‘These numbers te used in examples chrovghout When we ue Bloowbergs BBS page fr calling cash- and durton-neutl utes, the default weighting for darations Jb nsk” weighting or dation dollar weighting, Duron dollt- ‘weighted durations have no paiclar meaning, and we are neaty ‘cemtin to ind the dations of the buy and sel ides tobe irene “The ude not mieweighted, but mieported. To see the dations comecty, elect Proceeds in the Proceeds Risk box. ‘aration dallas are poison total dvOs times 10,000. “This weighting equivalent to Bloombers BBA. Sve ate following a consent computation syle here, ‘which makes the calculations look round about Since a fifty buttery sew dvO_ weighed tar, we could simply ake the ato ‘ofthe dvs (reported on Bloomberg ik) and mally by $5 zal lion for each rade egresion weighing a bute trades elated to ola sry weighing 2 tvo-bond swap. Nomally ewo-bond swaps ae ‘weighted (01/01). In voltiity weighting, dhe hedge ratio is {@v01, 401, oo, /vo. This weighing allows for non-parall his ofthe yield eve, butt asumes perfect comeation between the Yield movements. A yield B berween the ewo sues, estimated by Fegresion, would include det respective veal and their cor relation: B= p,(v0l,/vol). The swap is then weighted {G0 01,8. Iwe begin with ty-fty bowery Gi the sense that ite fo dvOl-weghted trade with the body), but with each ‘ofthe swap fom wing to body volt or represion-weghte, Se would end up wath 3 regeson-weighted buts. "Innitively we ae aming nest symmetry in te but teoly trade — thatthe long and shor wings are oughly equidistant om the body ax in 2/08/30 or 2/510. Other security choices are posible For exarpl, i 2/48/20, we would no longer expect thelong wing eld spend change tobe salle tan the shor wings Non-oveapping weeky and monthly perio. The sar- ing ate canal infloence the seals. Moniay to Monday yield changes can fer fom Wednesay to Wednesday changes, as can fit wo fine changes compar wich Eiicenh to ents changes. Using ovetpping period to get more clerations woud not alter the findamental point about Aileen dine period and dierent i ferencing length "ae wih al beet weighing, sf curve moves ferenly fom out ssumed shaping, dhe wade wll outperform oF ‘This weighting nods tobe clit independently fom Bloomberg's analy, but, once weighted, the wade canbe amlyzed sing page BBSW. ‘0Par amounts for the cath= ad daion-neutl bute fy ae $6.72 milion 5s and $3.44 milion 30s "Mater value weightings euialent co proceed weight= dng in Bloomberg. Tei alate by enupying cach sue’ yield by the ratio ofthat ees make vale to toll matket value. The ‘weigh sm to one “the changing maket-weighed yield spread woud mat- tee withthe panage of ime, however. ‘he yields tne decimal places ae nr precise forthe Prices, bit its more convenient computasonally to ck wih three decimal "Daration dolla weighting i equivalent ik weight- ing in Bloomberg "FF we pice a porlio of sx STRIPS dt exacly match the ath ows of a tae-year Treasury note so that Bath have the ‘ame (ll) pice the markecwreghted yield of the STRIPS porto~ ‘io wl anon cresyl Som the yield ofthe thee-yeat, while the darason dolr-weigheed yield wil very neatly match the yield ofthe threeyear. ‘rz ounnsL oF roRiToUD maNcDARET 95