European Rates Research J.P. Morgan Securities Ltd.

London, November 8, 2006

European Bond Futures Guide
European Rates: Derivatives Strategy
• This note provides an introduction to the pricing and risks of European bond futures contracts, with some examples of trades and an explanation of JPMorgan futures analytics. • Appendix shows the details of contract specifications for Eurex and Liffe bond futures contracts. Fabio BassiAC
(44-20) 7325-8615

Gurpal Kalsi
(44-20) 7325-3691

Philip Strother
(44-20) 7325-1545

Introduction to European bond futures
This note provides an introduction to the dynamics of bond futures contracts with a focus on the European contracts. The note covers the main concepts of pricing and risk, and offers some examples of trades which can be implemented with these contracts. Additionally, it explains the JPMorgan risk measures and analytics. The contracts which we refer to in this piece are the Eurex traded futures, the Buxl, Bund, Bobl and Schatz, and the LIFFE traded Gilt futures. The daily volume in Eurex and Liffe bond futures has averaged, during 2006, about €250bn and £5.7bn respectively (from an average of €210bn and £3.5bn in 2005), and total amount of Eurex open interest position as of 1st November 2006 is about €380bn and £25bn (in Gilt). This compares with the size of German and Gilt cash government bond markets of €730bn and £320bn, respectively. A significant part of the success of these contracts relies on their liquidity. The users range from a wide spectrum of investors, such as real money accounts, pension funds, prop traders and hedge funds, who trade futures as hedging, relative value or speculative instruments.

delivery and pay the invoice price for the bond. At any time three of the quarterly delivery dates (March, June, September and December) are available. Liquidity tends to concentrate in the near dated (“front”) contract until before expiry, when an active market of the “calendar spread” gains liquidity. Hence, investors not wishing to take or make physical delivery, but still willing to keep the risk, take the opposite position in (“close out”) the contract and move their exposure to the next dated (“back”) contract.

Contract grade
Futures exchanges indicate the “contract grade” for each contract. This defines the basket of bonds which are eligible for delivery into each contract. Usually the specification for the bonds in the basket is related to the remaining maturity of the bonds on the delivery date (maturity window) and the notional issue size (above a minimum threshold). This is due to a need for liquidity in the bonds which are deliverable into a futures contract. For example, the DBR 6 Jun16 falls into the 8.5-10.5 years maturity window for the deliverabilty into the Dec06 Bund contract, however with an issue size below the €5bn Bund threshold (€3.75bn) it is not eligible for delivery in the December basket (please see the appendix on page 9 for detailed contract specifications).

Standardisation, margining and delivery
A bond futures is a standardised forward contract for the sale or purchase of a fixed amount of par nominal bond that is deliverable into the contract. As with other futures contracts a position is initiated only with margin payments and gains and losses are settled on a daily basis, when the clearing house transfers money from the accounts of those with losses to the accounts of those with gains. The European contracts we analyse are for physical delivery. The shorts are required to make delivery (unless they close the position before expiry) and the longs are required to take

Conversion factor and invoice price
At expiry, the holder of a short position must deliver a certain amount of nominal to the long position. Interestingly, the choice of the “optimal” bond to deliver is “in the hands” of the short position. Hence, we can say that a long (short) position in a bond futures includes a short (long) position in the delivery option . The short can choose from any bond in

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and then. the choice of the CTD will be based on the comparison of (1) and (2). Example: The delivery date for the Dec06 Bund contract is 11th Dec 2006. For any bond in the basket. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545 fabio.P. (Pb + AI(s)i) * (1 + R x d / 360) = FwdPd+ AI(d)i (4) where FwdPd is the forward price of the bond at the delivery date. hence the exchange tries to place all the deliverable bonds onto an equal footing. 2006 the basket in order to fulfill their philip. the held bonds are delivered into the contract. where a bond in the basket is bought.strother@jpmorgan. they are constant for a given bond and expiration month. conversion factors are not dependent on market level. as the short position has to buy the bonds.89368 85. it will be optimal to buy cheaper bonds. hence the one which maximizes (implied repo rate . The CF is lower than one if coupon is lower than notional coupon and vice versa. in order to buy the bond we need to consider also the cost of holding such a position. R. In order to do so they compare the maturity and coupon structure of any bond with the maturity and coupon of a “theoretical” notional bond.25 Jul15 which gives a 6% yield on the 11th Dec06 is 81. For example. understanding the process of finding the optimal bond for the short to deliver is key in the valuation of a bond future’s fair value. The CF is fundamental in assessing the amount of money received by the short position going to delivery. A bond’s CF is approximately the price of the bond at the delivery date (as settlement date) if it yielded the notional coupon. can be calculated as implied repo rate (IRR): IRR = (Invoice price / Purchase Price -1) * 360/d = 360 (( Fd * CFi + AI(d)i ) / (Pb + AI(s)i) -1) / d (3) This is called the implied repo rate because it indicates the level at which the bond is implicitly financed during the cash and carry period. the notional bond. By combining (1) and (4) we can say that the implied repo Bond DBR 3 1/4 Jul15 DBR 3 1/2 Jan16 DBR 4 Jul16 Price 81.kalsi@jpmorgan.828937 0.819739. futures are sold against it. We need to look at this component to find out the most convenient bond to deliver. in the case of the Bund. Clearly. The CF is then rounded to six digits in Eurex and to seven digits for Gilts.J. over a number d of days. divided by 100.bassi@jpmorgan. All the deliverable bonds differ in maturity and coupon. we can then say that the CTD bond is the one which gives the best cash and carry return adjusted for the cost of building the postion. the CFi is the conversion factor of bond i and AI(d)i is the accrued interest for the bond i at the delivery date of the futures (consistent with the calculation of dirty bond price). this is why it is called the Cheapest To Deliver (CTD) bond.857165 By definition. The resulting number is known as Conversion Factor (CF). Cheapest To Deliver & Implied Repo Rate The holder of a short position can. as they express the difference of any specific bond coupon and maturity vs.97392. Clearly. the cost of buying can be expressed as: Purchase price = Pb + AI(s)i (2) where Pb is the clean spot price of the bond and AI(s)i is the accrued interest to the settlement date. However. Morgan Securities Ltd.actual repo rate). that is known as the “invoice price” which is defined below for a generic bond i: Invoice pricei = ( Fd * CFi ) + AI(d)i (1) where Fd is the futures settlement price. depends on the choice of bond that is delivered. Hence.d.819739 0. or repo. The return from the cash and carry transaction. The price of the DBR 3.s. at any point during the life of the contract. of purchasing of the bond. as it is only representing the revenue at delivery from the sale of futures and does not take into account the cost of bond purchase to make delivery. The invoice price is not enough to assess the optimal bond to deliver. find out what is the optimal bond to deliver by analysing the return from the “cash and carry” European Rates Research European Rates November 8. The key point is that the amount of money received by the short position 2 . Putting it all together. which is the financing. and in the assessment of the risk of a futures position. it is a bond with 10y maturity from the delivery date and a 6% gurpal. the revenue and the cost of the cash & carry transaction.71649 CF 0. rate. Table 1 Conversion factors Prices of bonds deliverable into the December 06 Bund contract such that they yield 6% on the 11th of December. The conversion factor for this bond for the December delivery is then 0.97392 82.

5% Jan 31 Futures price 4. for comparison with the futures price.strother@jpmorgan. Basis (cents) 350 300 250 200 150 100 50 0 -50 -60 -40 -20 0 20 40 60 80 100 Source: JPMorgan 4% Jan 37 5% Jan 31 European Rates Research European Rates November 8. In this way we see that the BNOC is a direct comparison of the rate the short is being charged to finance his position. However.00% Jan 37 5. we may think that the bond which gives us the lowest BNOC would be the most advantageous to deliver the CTD bond. Intuitively.122 4.futures price * CF The difference between the spot price and the forward price is the cost of carry of the position.5% Jan 31 Futures price Yield Chart 3 Option-like profiles of the basis Basis profiles of the deliverable bonds in the Buxl basket.futures price * conversion factor(CF) Yield Chart 2 Basis changes with yield curve movements The basis of the lower duation Jan 31 is like a put option. it is the forward price of the bond we need to consider.265 4. the medium duration Jul 34 a straddle profile and the higher duration Jan 37 a call option profile. Morgan Securities Ltd. and then the purchase of a bond at forward date is equivalent to a long position in the futures. as market conditions can change the CTD status between the bonds in a futures gurpal.J. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545 fabio. the implied repo rate. The only subtlety is that we must take into account the dirty price of the bond when comparing the net basis. we need to analyse the impact of the risk of a switch in the futures price. or BNOC. 3 . with the rate of return he can expect from philip. The lower duration Jan 31 show a put option profile. Chart 1 Futures price exhibits negative convexity Yield movements make the bond futures tracking different bond in the basket Illustration only Price/factor 140 130 120 110 100 90 80 70 Source: JPMorgan 4.IRR = (FwdPd . widening in a sell-off 140 Price/factor Illustration only However. we find that this difference is given by R . and for this reason the net basis is known as the basis net of carry. This is a valid approximation.P.bassi@jpmorgan. This we call the net basis: Net Basis = Fwd price . The bond which minmises BNOC/dirty price will maximise 130 120 110 100 90 80 70 Source: JPMorgan 5.( Fd * CFi )) / ( Pb + AI(s) ) which is proportional to the basis net of carry (BNOC) we have just introduced. the repo rate. the difference between the implied repo rate and the market repo rate.d. which holds unless the price of the bonds in the basket are very dissimilar.75% Jul 34 BNOC: a measure to assess CTD status The basis of a bond futures position is defined as the price of the bond in the cash market minus the future’s settlement price: Basis = Spot price .kalsi@jpmorgan. 2006 rate will be equivalent to the actual repo rate if: ( Fd * CFi ) = FwdPd which is indicating that the fair futures price times the CF should be equal to the forward price of the CTD. we can go back to the return on the cash and carry short position. Using the expressions for the repo and implied repo we had in the previous section. To see why. This is true when there is no uncertainty on which bond is going to be delivered into the futures contract.75% Jul 34 Yield shift (bp) the short’s rate of return when compared with his cost. this bond will be the cheapest to deliver.

6 3.d. The Buxl contract has been listed with a notional coupon of 4% and with yield levels close to the notional coupon it is more likely to see a change in the CTD. We run a proprietary 2-factor model to determine the possible distribution of yield changes around the current values. The probability weighted level of the BNOC for the CTD under the various yield shift scenarios is our fair value of the delivery philip. Similarly. The basis trades benefit from the relative behaviour between a specific bond and the futures contract. The holder of a long position in the futures is always negatively impacted by a change in the CTD as the delivered bond is always the worst performing bond in the basket (the bond which rallies less or sells off more. Morgan Securities gurpal. before reverting to the Jan31 when yields fell. This basis. which could generate a change in the CTD. an investor would buy the futures only if the futures price reflects a fair compensation for the risk of receiving another bond at delivery (giving positive BNOC. The difference between the futures adjusted price and the bond price represents the value of the basis (adjusted by the conversion factor). The yield shift distribution is built using the available implied vol information from the listed options on futures. Thus we see the non-linear profile of basis trades and suggest an opportunity to create option like-profiles with combination of instrument with different convexity. tends to show a put-option-like European Rates Research European Rates November 8. 2006 OABNOC: an acronym for relative value An intuitive understanding of why a bond is CTD is useful and also provides an understanding of how and why the CTD can change overtime. If this is the case. the bond with lowest duration (Jan31) is the cheapest to deliver. in the case of a low duration bond. They are driven not only by level of yields (as shown in chart 3) but also by relative change in the slope of the curve. we see a graphical representation of the concept of delivery option. in the case of a sell-off above 4. We thus define the option-adjusted basis net of carry (OABNOC) as: OABNOC = BNOC – fair value of the delivery option If the OABNOC is zero.4 Dec-05 Source: JPMorgan 31 30y r Yields 30 29 28 CTD Yrs to Maturity 27 26 25 24 Mar-06 Jun-06 Sep-06 4 .bassi@jpmorgan. the delivery option is overvalued and the futures are cheap with respect to fair value.strother@jpmorgan. decreasing in the case of market rally (eventually it will go to zero and the current CTD will be delivered into the short futures position) and with upside in the case of market sell-off. The calculation of the value of the delivery option is a relatively computationally intensive process. Chart 4 CTD switching is taking place in European contracts Maturity of the CTD of the Buxl contract in 2006. The switch of CTD at different yields gives the long future position its negative convexity. the chart shows that the high duration bond has a profile resembling that of a call-option. intuitively).8 3. the Jan31 is replaced by higher duration bonds. Chart 1 shows the price of the Dec06 Buxl contract (adjusted by the conversion factor) as a function of the 30 year benchmark yield. 4. the CTD switched several times between the Jan37 and the Jul34. were we have the basis as a function of yield for the different bonds in the Buxl basket.kalsi@jpmorgan.2 4. We show this explicitly in chart 2 and 3. Conversely if the OABNOC is positive. in turn the Jul34 and then the Jan37. by funding rates or by futures relative mis-pricings (change in OABNOC).0 3.12%). If this quantity is negative. then the BNOC contains the delivery option value and future is fairly priced. since its low duration makes the bond cheaper than the others.4 4. Delivery option: non-linear payout of basis trades A detailed analysis of the components of chart 1 reveals the profile of basis trades as level of interest rates. then the delivery option is undervalued and the futures are rich. and hence futures price* CF cheaper than the forward price of the CTD).J. In a low yield environment (below 4. As yields moved higher in May-August. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545 fabio. and use this distribution to predict changes in the BNOC for all the deliverable bonds. The monetary value of the risk of getting a different CTD is defined as the delivery option and we can assess whether a future is fairly valued if the BNOC of the CTD is equal to the fair value of delivery option. As yields rise.

factor = CTD Price A rule of thumb commonly.0 14.5 16.2 4. the implicit change in the benchmark and in the CTD are equivalent.s. However.0 -1.5 0. gurpal. Finally. Rule of thumb At delivery. we can say that the risk of the bond futures is a weighted risk of all the deliverable bonds. it is not necessarily true that all the bonds in the basket move in a parallel fashion and our riskmeasures should be adjusted to incorporate this.0 -3. or PVBP. Morgan Securities Ltd.P. Unfortunately. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545 fabio.0 15.1 4. We assume no movement in the repo rates.5 15. used is to say that this is the case before delivery (the “expiry assumption”). when there is no carry left and there is no value in the delivery option.5 3. From this. it does not take into account the possibility of change in the CTD and its implications in the futures prices changes at different yield level.bassi@jpmorgan. the price changes of the cheapest to deliver bond.0 0.0 Dec-05 OA PVBP para OA PVBP Beta Rule of Thumb Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Source: JPMorgan 5 .0 -4. Since the future will track.Jan 31 Yield Spread (bp) 1. Our option adjusted risk measures are defined as the change in the value of the futures price for 1bp change in the yield of the benchmark (and not the CTD).kalsi@jpmorgan. but is also smooth near any CTD switch points. to first order at least. it explicitly ignores the fact that spot and forward prices do not necessarily move together. Secondly. there are three sources of error in the expiry assumption measure. Firstly.5 -1. chg futures price = chg CTD Price / Factor Hence. Under this assumption. Jan 37 . Option-adjusted risk measures In JPMorgan’s analytics. calculated according to the rule of thumb. we get: chg future / chg yield = PVBP future = PVBP ctd / factor Chart 6 Deliverable bonds for the Buxl contract The need for yield beta: the chart shows the spread between the DBR 4 Jan37 and the DBR 5. any measure of risk which is based only on the current CTD does not properly capture the risk of a switch.5 -4.5 17.0 16.strother@jpmorgan.9 4.5 14. we can then provide a duration-like measure by normalising with respect to the price. Intuitively. The option adjusted measure provides better accuracy and smoother behaviour accross CTD switches.J. in the parallel risk measure that we calculate. described above. it is possible to construct a risk measure based on the present value of a basis point move in the underlying.5 Jan 31 as a function of the yield of the DBR 4 Jan37.5 -3.5 -2.4 Jan 37 Yield (%) Source: JPMorgan and hence “a rule of thumb” would suggest that the PVBP of the future is the PVBP of the CTD divided by its conversion European Rates Research European Rates November 8.7 3. Chart 5 Option adjusted risk measures The chart shows the PVBP for the Buxl contract calculated via the expiry assumption and via JP Morgan’s option adjusted measure. we correctly adjust for the optionality by re-evaluating the option at the yield shift points used to calculate the PVBP measure.0 -2. using as weights the probability of a single bond to become CTD. This gives a significant advantage over its non-option adjusted measure in that it not only provides greater accuracy. if we take the change in respect to a change in the yield.5 3. but philip.0 4. we can say that Futures price * Conv. Chart 4 shows the change in the maturity of the CTD which has occurred over the life of the Buxl contract and chart 5 shows the different risk measures. This component has to be considered also in the case of the risk profile of a bond futures contract. or according our calculation.3 4.0 -0. 2006 Hedging On the pricing side we discussed the issue of change in CTD and its implications in terms of pricing and fair valuation of the contract. 17.6 3.8 3.d.

000) = 768 contracts (Target change in duration is 0.40 1.75/ (46. We do this by regressing the weekly changes in yield for any particular bond against the changes in the benchmark over a period of 6 months.262 3. Curve movements are not.J. D. A little algebra allows us to arrive at the following expression for the number of contracts we need to extend the duration of our portfolio by one year: N = MV/PVBP However. we simply divide by the futures price (F) to arrive at the duration.25% Jul 14 4% Jul 16 105.01 Once we have a correctly adjusted PVBP measure.25% Jul 10 3.744 7. 2006 Beta-adjusted and option-adjusted risk measures Additionally.85 (22Sep06) PVBP Buxl Rule of thumb: 14.722 6.164 contracts OA beta-adj PVBP: 15. The PVBP is expressed as cents per bp or in terms of € per contract. as is the case in the Buxl (see chart 5).41 350.407 Portfolio 474. beta adjusted) 46. Although the relation is not always very stable it is possible to see some directionality of the yield spread.P.25 103. Morgan Securities Ltd.43 104.5% Apr 11 5% Jul 11 4.d.774 70 71. tells us how much an issue will move for a given movement in the benchmark.246 95 99. Dur 3. Since the PVBP measure gives us an absolute change in price for a given (1bp) change in yield.kalsi@jpmorgan.213 contracts OA // PVBP: 15.140 75 78. A duration measure represents the relative change in price for a given change in yield. we may construct a duration measure by normalising to the futures price. DF: DF = PVBP / F If we buy N contracts to extend our portfolio’s duration.71 1. we simply multiply the PVBP of the bond by the bond specific beta. we provide a further adjustment of risk measure across the curve. the level of yields. so we will need to construct all quantities in our hedge ratio relative to the benchmark. We may then use this measure to alter the duration of an existing portfolio of bonds by entering into the appropriate number of futures contracts.strother@jpmorgan.2 99.057 50 52. Empirically. but with the yields of the other bonds in the basket moving in proportion to their yield betas. We then recalculate the PVBP of the future using a 1bp movement in the benchmark yield.86 401.264 324. 2006) PVBP (option. We refer to this as the beta adjusted PVBP. The first step is to establish the relative movements of the bonds in the basket to the movements of the benchmark.44 102. the unit of measure needs to be adjusted accordingly.75 years through the purchase of 768 Dec06 Bobl futures Price DBR OBL DBR DBR DBR DBR European Rates Research European Rates November 8.79 555.005 Years 6 . Chart 6 shows the change in the slope of the Buxl basket vs. in general.75 years) Source: JPMorgan Yield Mod. Portfolio value: €474.bassi@jpmorgan.3 mn Portfolio duration: 5.18 105.702 4.929 90 89. completely described by parallel shifts and we tried to take that into account by providing risk measures not only option-adjusted. the duration of this portfolio is extended by 0.715 3. but also “beta-adjusted”.33 €/bp N = 474.693 3.71 213.712 5.005 years Dec06 Bobl contract ( Oct 13th. Number of futures = PVBP of the bond * Yield Beta of the Bond / Option and beta adjusted PVBP of the future Example: Hedge for 100mm of DBR Jan37. would be D = ( MV*DP + N*PVBP ) / MV where MV is the market value of our portfolio. Dur. Notional (mm) Market value (mm) Mod.3 mn * 0.5% Jul 13 4. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545 fabio.88 527.33 1. Example: We refer to the portfolio in table 2. PVBP = gurpal. The regression coefficient. To do this. This PVBP measure may be thought of as being rebased to movements in the benchmark. DP then the new duration of the portfolio.12 5.188 3. The beta adjustment tries to improve the hedge ratio of bond and futures PVBP by incorporating the most recent directionality.940 3. the betaadjustment is smaller than the option-adjustment when there is philip. hence we need to multiply the € risk of a bp by ten thousand in the above formula.s.752 3.33 * 10.701 3.159 contracts From PVBP to a duration measure Table 2 Example bond portfolio In the example in the text. beta.378 80 82.

Morgan Securities Ltd. Hence if the carry is positive but small compared to the time decay. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545 fabio. especially when there is chance for that bond to become the CTD of the contract.9 3.P. Table 3 shows the basis analysis where the when-issued Dec08 will be the CTD for the March gurpal. hence we get a coupon from the current benchmark yield rounded to the nearest quarter European Rates Research European Rates November 8. Broadly speaking. This gives the short an extra “timing” option.strother@jpmorgan.92 3. our fair value of the delivery option. We may either assume that the future is fairly valued with respect to the (when issued) CTD.88 3. In the Eurex contracts (Buxl. fair value of delivery option at different 30-year bmk yield level 40 35 30 25 20 15 10 5 0 -5 Mar 10 Source: JPMorgan Benchmark yield Buxl estimated option value Buxl BNOC Schatz Mar06 Futures Price = 103. as an indication of the market valuation of the delivery philip. Going back to our definition for the option-adjusted-basisnet-of-carry (OABNOC) we see that it shows the mispricing of the net basis (BNOC) vs. we make the assumption that the bond is issued at or below par. we can read the information about the futures richness or cheapness. Clearly. Alternatively. valuation and risk consideration the yet-to-be-issued bond has to be included in the futures projection. In general. if there is positive carry on the CTD. The different approaches of our assumption can be seen in the table showing the true-asset-swap calculation. the short should deliver at the end of the window.d.J. and imply from this an asset swap spread (coming from the invoice price).83 => invoice AS = -21.4 Bond WI-BKO 3½ Dec08 DBR 3 ¾ Apr 09 OBL-148 3 ¼ Apr09 Asset Swap Spread BNOC -21. This is often the case in the Schatz contract.84 3. decrease in value over the life of the contract (theta or time decay). Bobl and Schatz) there is no delivery window so the optionality is restricted only to which bond is delivered. In JPMorgan analytics. the option available to the short will. or we may assume the level of the asset swap spread for the when-issued bond relative to an existing one.1 26 -25.86 3. and then back out the fair value of the future when the when-issued bond is taken into account. The flaw of not using the when-issued information can be quite significant as pricing and risk would be based on an incorrect CTD. it is still possible that the optimal delivery time may be somewhere prior to the end of the contract.98 3. Once we have all the details in terms of dates and coupon (assumption) we can then proceed in two directions to assess relative value of the futures. Table 3 When-issued true-asset-swap analysis Asset swap calculation based on swap spread assumption and invoice asset swap spread levels. The current coupon assumption is from current yield level. like any option.94 3. where the yet-to-be-issued 2year benchmark becomes CTD of the back month Schatz contract. The assumption is that the when issued bond will be 4bp narrower than the OBL-148 Delivery windows In Europe The Gilt futures (on UK government bonds) contract provide a delivery window in which the short can pick up not only the best bond to deliver but also the optimal time for delivery. In order to find out what is the expected coupon. for pricing.8 1 -29. they can become deliverable in a specific basket.bassi@jpmorgan. if they satisfy the criteria for deliverability.kalsi@jpmorgan. we would like basis trades where we can Chart 7 Delivery option not necessarily fairly priced by BNOC Net basis vs. these bond specifications are updated as the bond-issuing authority announces the details of the auction schedule. However. Bund.8 81 Mar 14 Mar 18 Mar 22 Mar 26 Mar 30 4 3. This scenario will only occur when the optionality of the contract is significant and the time decay is then comparable to carry measures. every day is costing the short carry so the preference is to deliver as early as possible in the window.96 3. whereas in a negative carry scenario.82 3.8 7 . Basis trade: option-like profile We have seen that the futures option adjusted basis net of carry (OABNC) gives us an indication as to whether the futures is rich or cheap with respect to fair value. we forecast the issue dates and maturities based on debt issuing patterns. 2006 When-issued As new bonds are issued during the life of a bond futures contract.

without going to delivery.d.bassi@jpmorgan. as the two contracts have different duration. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545 fabio. The difference between 3month Libor rate and the forward financing rate is called the implied repo rate specialness. since the back month contract has three months more of carry in its basis. the mispricing between delivery option and BNOC actually narrowed. 2006 buy the delivery option (long basis: long bond & short futures) at a cheaper level compared to our fair value. and there is low risk of a CTD switch. where the probability of a switch in the CTD is higher). and especially in the 4 to 6 weeks before delivery an active and liquid market of the calendar spread is available.P. resembling the profile of a put option from a market sell-off. In the bond futures world. For example an investor with a long position in the front contract needs to sell the spread (sell the front contract and buying the back contract) to keep the exposure in the back contract.kalsi@jpmorgan. The suggested long basis trade could benefit from either a convergence of the delivery option market value (BNOC) to its fair value. JPMorgan analytics provide daily information on relative value between futures and cash and offer useful information on relative value opportunities in the basis space the same CTD. If the specialness is historically low (high). The calendar spread can be traded on its own. or to aid rolling contracts. Our views on the rolls can be found in the quarterly “European Bond futures rollover outlook”. For example. relative value. This is dependent on relative value and macroeconomic considerations. The long calendar position is equivalent to receiving the bond at expiry of the front contract and delivering it at expiry of the back. The calendar spread When managing futures position. such as the option-adjusted basis net of carry of the two contracts or the relative level of swap spread for the different CTD European Rates Research European Rates November 8. the calendar may be considered cheap (rich).com philip. for speculative purposes. or clearly. the dynamic of calendar spread is extremely critical and can be a source of further alpha in portfolio management. such as level of rates. Thus the calendar spread reflects changes in the shape of the short end of the yield curve: for example. If the CTD of the front and back contracts are different the change in the level of yield has an impact on the calendar spread.J. Additionally. with the net basis was trading at about 10 cents. The task of the analyst is not only in finding the different drivers of the spread. we need to consider relative value components. Lastly spreads may become richer or cheaper depending on the balance of long and short hedgers and investors who are rolling positions. In the simple case where the front and back contracts have 8 .strother@jpmorgan. but also in pointing out in a specific case which ones are likely to be the dominant gurpal. change in funding rates and supply and demand dynamics. driven by macro movement or by idiosyncratic bond effects. Where the optionality in the contract is significant (i. The JPMorgan Rollover Outlook provides hedge ratios for rolling futures positions and analysis of the dynamics of duration neutral calendar spreads. the calendar spread would be expected to fall. The breakeven repo rate for holding the bond between expiries can be compared to the 3-month forward funding rate. There are different drivers of the calendar spread. with long yields rates moving higher. has an effect on spreads. The relative value of this specialness and its dynamic going into delivery is often used to make a call on dynamic of the calendar spread. Morgan Securities Ltd. In the following period.Back Future During the life of the front contract. with net-basis moving closer to the fair value of delivery option. An increase in funding rates generally causes futures prices to rise relative to cash prices. since it decreases the carry. if four-month funding rates rise while one-month rates remain the same. which would be equivalent to a forward financing rate high (low).s. any change in the slope of the yield curve.e. chart 7 shows an opportunity when the fair value of the delivery option exceeded the level of the net basis at trade inception. the main driver of the calendar spread is the forward financing rate of the bond between the front and the back month delivery. a calendar spread is defined as: Spread = Front Future . Changes in funding rates affect back month futures more than front month futures. yield curve.

the trading day. 2006 Delivery Two exchange trading days Two exchange trading days Two exchange trading days Two exchange trading days Two business days prior to the Two exchange trading days prior to the Delivery Day of the prior to the Delivery Day of the prior to the Delivery Day of the prior to the Delivery Day of the last business day in the prior to the Delivery Day of the relevant maturity month.22:00 08:00 .Liffe 9 Delivery Month . day. relevant maturity month.22:00 Source: JP Morgan.bassi@jpmorgan. if respective quarterly month. European Rates Research European Rates November 8.22:00 March June Sep and Dec with nearest three tradable 08:00 .1 10 EUR 0.005 5 EUR 0.d. Min Price Change % Value 1point 0. Euronext. if respective quarterly Specifications of European Bond Futures for Eurex and Liffe.10. Any business day in the delivery month ( at seller's choice ) The tenth calendar day of the respective quarterly month.13 8 .000 EUR 100. otherwise. otherwise.000 GBP 100.75 .000 EUR 100.35 8. day. otherwise.5. otherwise.01 10 GBP 0.strother@jpmorgan.s.2 20 EUR 0. relevant maturity month.5 .25 Coupon 6 J. if this day is an exchange trading day.13 Schatz Bobl Bund Buxl Gilt Conf Appendix Basket Range (yrs) 1.75 . otherwise.5 Bln GBP 500 Mil CHF 100.2.000 CHF 6 4 6 6 8.22:00 Trading hours 08:00 . the trading day.22:00 08:00 . if respective quarterly philip. the exchange trading day exchange trading day exchange trading day exchange trading day immediately succeeding that immediately succeeding that immediately succeeding that immediately succeeding that day. LTD 08:00 gurpal. Morgan Securities Ltd.Term 4.5 24 . day.P.18:00 08:00 .1 10 EUR 0.5 6 100. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545 Contract Value 100.000 EUR Min Issue 5 Bln EUR fabio. Eurex.5 . the exchange trading day immediately succeeding that day. if this day is an exchange this day is an exchange this day is an exchange this day is an exchange trading day.000 EUR 5 Bln EUR 5 Bln EUR 10 Bln EUR 1. relevant maturity month. the trading day.01 10 CHF The tenth calendar day of the The tenth calendar day of the The tenth calendar day of the The tenth calendar day of the respective quarterly month. delivery month relevant maturity month.

at maturity of the option. and Underweight (over the next three months. Investors who sell call options against a long position in the underlying give up any appreciation in the level of the underlying above the strike price of the call option.P.P. Morgan S. Taiwan: J.Morgan Securities (Taiwan) Limited is a participant of the Taiwan Stock Exchange (company-type) and regulated by the Taiwan Securities and Futures Commission. Options are a decaying asset. Pricing Is Illustrative Only: Prices quoted in the above trade ideas are our estimate of current market levels. Singapore branch (JPMCB Singapore) which is regulated by the MAS..K. the disclosure may be based on the month end data from two months’ prior. in the course of and for the purposes of their business.: J. Additionally. affiliates and accepts responsibility for its contents. such information is available only to persons who have received the proper option risk disclosure documents. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. or benchmark). JPMorgan’s Emerging Market research uses a rating of Marketweight.pdf. In other EEA countries. India: J. Mumbai and is regulated by the Securities and Exchange Board of India. please contact your JPMorgan Representative or visit the OCC’s website at http://www. 2006 Analyst certification: The research analyst(s) denoted by an “AC” on the cover of this report (or.P.kalsi@jpmorgan.. Periodic updates may be provided on companies/industries based on company specific developments or announcements. or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report. Frankfurt Branch who are regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. sector. Seoul branch.P. Singapore: This material is issued and distributed in Singapore by J.P. the research analyst denoted by an “AC” on the cover or within the document individually certifies.htm. All rights reserved. New Zealand: This material is issued and distributed by JPMSAL in New Zealand only to persons whose principal business is the investment of money or who. they will define their higher exit point by the call strike and lose twice as much below the put strike. 47 and 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 (all such persons being referred to as “relevant persons”). No. Morgan Broking (Hong Kong) Limited is the liquidity provider for derivative warrants issued by J.J.P. or needs and are not intended as recommendations of particular securities. We also analyze the issuer’s ability to generate cash flow by reviewing standard operational measures for comparable companies in the sector. Ltd. Indonesia: PT J. they remain exposed to a decline in the underlying in return for the receipt of the option premium. Morgan Futures Inc. they remain exposed to a rise in the underlying in return for the receipt of the option premium.bassi@jpmorgan. sector. This document must not be acted on or relied on by persons who are not relevant persons. All pricing is as of the close of market for the securities discussed. Morgan Securities Ltd. Options are a decaying asset.. and the EEA by JPMSL.P. Morgan Securities Singapore Private Limited (JPMSS) [mica (p) 069/09/2006 and Co. The opinions and recommendations herein do not take into account individual client circumstances. Therefore. margins. Morgan Securities (Far East) Ltd. Therefore. Call Purchase. India: For private circulation only not for sale. Past performance is not indicative of future results. and the composition of the issuer’s balance sheet relative to the operational leverage in its business. Reg.P. Investors who sell call or receiver options are exposed to level of the underlying rising above the strike of the option. Put Purchase. 2006. N.P. Other Disclosures: Options related research: If the information contained herein regards options related research.P. or benchmark). Valuation & Methodology: In JPMorgan’s credit research. (For research published within the first ten days of the month. where multiple research analysts are primarily responsible for this report.K. Philippines: This report is distributed in the Philippines by J.P. Japan: This material is distributed in Japan by JPMorgan Securities Japan Co. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545 fabio. the issuer’s credit position using standard credit ratios such as cash flow to debt and fixed charge coverage (including and excluding capital investment). only to persons of a kind described in Article 19 (5). Call or Receiver Sale. Inc. market conditions or any other publicly available information. (JPMSL) is a member of the London Stock Exchange and is authorised and regulated by the Financial Services Copyright 2006 JPMorgan Chase & Co. certain strategies may expose investors to significant potential losses. Analysts’ Compensation: The research analysts responsible for the preparation of this report receive compensation based upon various factors. Hong Kong: The 1% ownership disclosure as of the previous month end satisfies the requirements under Paragraph 16.S. Morgan Securities Ltd. 38. The recipient of this material must not distribute it to any third party or outside New Zealand without the prior written consent of JPMSAL. and European Economic Area (EEA): Issued and approved for distribution in the U. the report has been issued to persons regarded as professional investors (or equivalent) in their home jurisdiction Germany: This material is distributed in Germany by J. is.P. An updated list can be found on HKEx website: http://www. client feedback. J.hkex.P.S. the recommended risk position is expected to perform in line with the relevant index. Morgan Securities Australia Limited (ABN 61 003 245 234/AFS Licence No: 238066. If an investor has a short in the underlying and overlays this with selling a straddle or European Rates Research European Rates November 8. or provide equivalent financial compensation if it is a “cash settled” option. JPMSAL does not issue or distribute this material to “retail clients. taking into account the ratings assigned to the issuer by credit rating agencies and the market prices for the issuer’s securities. Legal Entities Disclosures: U. General: Additional information is available upon gurpal.P. .s. Additionally.d. Singapore: JPMSI and/or its affiliates may have a holding in any of the securities discussed in this report. Risks to Strategies: Put or Payer Sale. South Africa: J.pdf. among other is regulated by the Comissao de Valores Mobiliarios (CVM) and by the Central Bank of Brazil. and investors risk losing 100% of the premium paid if the underlying level is above the strike of the put option at maturity. Thailand: JPMorgan Securities (Thailand) Limited is a member of the Stock Exchange of Thailand and is regulated by the Ministry of Finance and the Securities and Exchange Commission.. This report has been issued in the U. Morgan Securities (Far East) Ltd.P. Risks to strategies: Not all option strategies are suitable for investors. which is regulated by the Japan Financial Services Agency (FSA). we assign a rating to each issuer (Overweight.A. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice.P. Investment research issued by JPMSL has been prepared in accordance with JPMSL’s Policies for Managing Conflicts of Interest in Connection with Investment Research which can be found at http://www. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. Korea: This report may have been edited or contributed to from time to time by affiliates of J. Malaysia: This material is issued and distributed in Malaysia by JPMorgan Securities (Malaysia) Sdn Bhd (18146-x) (formerly known as J.” The recipient of this material must not distribute it to any third party or outside Australia without the prior written consent of JPMSAL. N. Morgan Securities (Asia Pacific) Limited (CE number AAJ321) is regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission in Hong Kong. N. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. unless otherwise stated. Investors who sell put options against a short position in the underlying give up any decline in the level of the underlying below the strike price of the call option. Clients should contact analysts and execute transactions through a JPMorgan subsidiary or affiliate in their home jurisdiction unless governing law 10 permits otherwise. sector.P. if the spread on the underlying is above the strike. with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers. Morgan Securities Ltd. research published by non-U. for securities where the holding is 1% or greater. We advise investors to consult their tax advisors and legal counsel about the tax implications of these strategies. or benchmark).K. is regulated by the Korea Financial Supervisory Service. Morgan Securities Philippines. Australia: J. Investors who sell put or payer options are exposed to the level of the underlying falling below the strike of the option.: 199405335R] which is a member of the Singapore Exchange Securities Trading Limited and is regulated by the Monetary Authority of Singapore (MAS) and/or JPMorgan Chase Bank. Straddle or Strangle. the specific holding is disclosed in the Legal Disclosures section above. The seller of a straddle or strangle is exposed to underlying level ending up above the call strike or below the put strike at maturity of the option. Morgan Chase Bank.P. an investor will have to purchase the underlying position from the buyer of the option in return for the strike of the option.5(a) of the Hong Kong Code of Conduct for persons licensed by or registered with the Securities and Futures Commission. Frankfurt Branch and JPMorgan Chase Bank.P. a Market Participant with the ASX) (JPMSAL) are licensed securities dealers. which is equivalent to a Neutral rating. competitive factors and overall firm revenues. Seoul branch. the recommended risk position is expected to underperform the relevant index. Morgan Malaysia Sdn Bhd) which is a Participating Organization of Bursa Malaysia Securities Bhd and is licensed as a dealer by the Securities Commission in Malaysia Country and Region Specific Disclosures: U.A. Revised September 29. regulated by ASIC) and J. Explanation of Ratings: Ratings System: JPMorgan uses the following sector/issuer portfolio weightings: Overweight (over the next three months. habitually invest money.) J. NASD and SIPC. is a member of the NFA. U. Morgan India Private Limited is a member of the National Stock Exchange of India Limited and The Stock Exchange. financial instruments or strategies to particular clients.: JPMSI is a member of NYSE. sold or redistributed without the written consent of JPMorgan.A. JPMSI distributes in the U. We assess this by analyzing.K. they will lose twice as much as an outright short risk position if the underlying is above the call strike. and (2) no part of any of the research analyst’s compensation was. Underweight or Neutral) based on our credit view of the issuer and the relative value of its securities. Additionally. at maturity of the option. Our credit view of an issuer is based upon our opinion as to whether the issuer will be able service its debt obligations when they become due and payable. Brazil: Banco J. the recommended risk position is expected to outperform the relevant index. Morgan Australia Limited (ABN 52 002 888 011/AFS Licence No: 238188. Any investment or investment activity to which this document relates is only available to relevant persons and will be engaged in only with relevant persons. or its affiliates and/or subsidiaries (collectively JPMorgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMSI and/or its affiliates and the analyst’s involvement with the issuer that is the subject of the philip. and are not indicative trading levels. JPMSAL does not issue or distribute this material to members of “the public” as determined in accordance with section 3 of the Securities Act 1978. if the level of the underlying is below the strike. Neutral (over the next three months. such as revenue and earnings growth rates. Conversely if an investor is long the underlying and overlays this with selling a The firm’s overall revenues include revenues from its investment banking and fixed income business units. Morgan Securities Indonesia is a member of the Jakarta Stock Exchange and Surabaya Stock Exchange and is regulated by the BAPEPAM. Call Overwrite. Morgan Equities Limited is a member of the Johannesburg Securities Exchange and is regulated by the FSB. For a copy of the Option Clearing Corporation’s Characteristics and Risks of Standardized Options. is a member of FDIC and is authorized and regulated in the UK by the Financial Services Authority. they will define their lower exit point where underlying falls below the put strike. an investor will have to source a long position which he/she must hand over to the buyer of the option in return for the strike of the option. including the quality and accuracy of research. Korea: J. This report or any portion hereof may not be reprinted. Morgan International Derivatives Ltd and listed on The Stock Exchange of Hong Kong Limited. or provide equivalent financial compensation if it is a “cash settled” option. For the purposes of this paragraph the terms “wholesale client” and “retail client” have the meanings given to them in section 761G of the Corporations Act 2001. Put Overwrite. Australia: This material is issued and distributed by JPMSAL in Australia to “wholesale clients” only. and investors risk losing 100% of the premium paid if the underlying level is below the strike of the call option at maturity.A. Hong Kong: objectives. We have summarized the risks of selected derivative strategies.

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