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How to Measure Risk in Treasuries

When it comes to measuring risk for fixed income (rates) traders and portfolio managers, they tend to use one or two yardsticks, value of a basis point and modified duration.

Value of a basis point (VBP), also known as basis point value (BPV), or, for U.S. dollar products, dollar-value of an 01 (DV01),is the financial effect of a 0.01% (one-basis point) change in that instrument’s yield.

For example, if a 10-Year note is current 1.30% yield to maturity with a DV01 of $859 per million par value and the yield goes up by 0.01 to 1.31%, we would expect the financial value of that note to drop by $859 per million par.

DV01

One can identify the DV01 of individual securities or an average DV01 of a whole portfolio. DV01s tend to get larger as you move out the yield curve.

For example, a 2-Year U.S. Treasury note may have a DV01 of $185 per million par while a 30-year Treasury bond may have a DV01 or $2,131 per million par.

Modified Duration

Modified duration represents the financial effect as a percentage gain or loss to a 1.0% (100 basis points) change in underlying yield.

For example, consider our previously mentioned 10-Year note: if its duration was 8.95 years and yields move higher from 1.30% to 2.30%, or by 1.0%, we would expect the value to fall by 8.95% in value.

Treasury	DV01
Ultra 30-Year	$289.34
30-Year	$213.14
Ultra 10-Year	$115.84
10-Year	$76.55
5-Year	$47.94
2-Year	$36.97

In general, the longer the maturity, the greater the price sensitivity and risk. Duration measures this risk precisely.

Traders and portfolio managers routinely refer to your position or portfolio in basis point value and modified duration terms.

Implied Basis Point Value and Implied Duration

U.S. Treasury futures can also be referred to in implied duration and implied basis point value terms.

To look more closely at the BPV and modified duration of a futures contract, we must first go back to the concept of a U.S. Treasury futures contract’s cheapest-to-deliver (CTD) security. You may recall from previous modules a U.S. Treasury futures contract’s CTD security is the eligible bond or note that is most financially efficient for the short position to deliver to the long position at contract expiration. Very few market participants go all the way to delivery, in fact the number is quite low (usually less than 5% of open interest).

The reasons we want to know about the CTD security is two-fold: contracts trade like their CTD security and  we will use the CTD security and its conversion factor to arrive at that contracts implied BPV.

Once we know a U.S. Treasury’s CTD security we can determine that security’s BPV per $100,000 face value (or $200,000 face value in the case of 2-Year note futures). We use $100,000 because, with the exception of 2-year notes which have an underlying face value of $200,000 per contract, U.S. Treasury contracts have an underlying face value of $100,000 per contract.

Once we know a contract’s CTD we can determine its BPV; and using that security’s conversion factor (CF) and some simple mathematics, arrive at the implied BPV.

Assume we have a 5-Year Note futures contract and its CTD security is the 1.375% of May 31, 2021 with a BPV per $100,000 of $42.45 and a conversion factor of 0.8317.

To arrive at the BPV, we take the BPV of CTD and divide it by its conversion factor:

BPVcontract = BPV ctd ÷ CF

For our example, BPVcontract = 42.45 / 0.8317 = $51.04 per contract.

Once we have the implied BPVs for the U.S. Treasury futures contracts we can use them to calculate appropriate dollar-weighted hedge ratios versus a cash security of portfolio. We could also calculate the spread ratios between futures contracts so we can construct dollar-weighted yield curve trades.

Interest rate traders and managers of risk use basis point value and modified duration to measure their market risk. Futures contracts based on U.S. Treasury securities can also be referred to in implied basis point value and implied modified duration with a little knowledge of how the contracts price and behave and some simple math. Knowing the contract’s CTD is the starting point.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Get to Know Treasuries CTD (Cheapest to Deliver)

Now that you have a deeper understanding of the U.S. Treasury basis, we need to delve a little deeper into what is known as the cheapest-to-deliver (CTD) security. While each U.S. Treasury futures contract has its own basket of eligible securities for delivery generally one, or sometimes two, price out to be most efficient for the short position to deliver to the long position. This security is most efficient because it is considered cheaper or cheapest to deliver versus the other alternative securities.

Knowing which security is the CTD is important because the futures contract tends to trade like the CTD security. It is also important when calculating hedge ratios because the futures contract’s theoretical basis point value is derived from the CTD security.

What Determines the CTD?

Before we dive deeper into how to ascertain which issue is the CTD some additional background on the market forces that go into the calculation might be useful. If we take a snapshot of a typical U.S. Treasury futures contract settlement prices of quarterly contracts currently listed for trading, we will see a discernable pricing pattern.

Example

On February 10, 2017 the following were the settlement prices for the listing quarterly futures for the 10-Year Note (ZN) futures:

March 2017 = 124-250

June 2017 = 124-075

September 2017 = 123-280

Notice that as the futures contract goes out further in time, the price goes lower in value. There is a very good reason for this. Remember that the underlying product of a U.S. Treasury futures contract is a U.S. Government security that pays interest twice per year based on its coupon value established when it was originally auctioned. This means the cash Treasury is an asset. Futures contracts are not assets. They represent a price point for future delivery. Because of this opportunity cost, or time value of money, the futures prices trade at a discount or premium to cash.

The Yield Curve

On February 10 when these prices were posted, the yield curve for U.S. Treasuries was positively sloped, that is, rates at the short end of the yield curve were lower than yields further out. Generally speaking, when the yield curve is positively sloped it results in what we call positive carry. If I borrow overnight funds (short-end) and buy a long dated (long-end) U.S. Treasury security with a higher paying rate I enjoy positive carry. To account for this revenue in the underlying physical note or bond the futures contract must price at a discount and gradually converge to cash by time of delivery.

Carry can be either positive or negative depending on the level of rates and the slope of the yield curve.

Example

It might be useful to walk through the financial calculation for carry to see why this works and why it is important regarding the CTD.

Assume we buy the 1-3/4% of November 30, 2021. This issue is eligible for delivery into the March 2017 5-Year Note (ZFH7) contract. We borrow funds through the repo market to purchase this security and will be charged an interest rate known as the repo rate every day we keep this borrowed position open. Carry is defined as the difference between the coupon income and the financing cost.

Carry = Coupon Income (CI) – Financing Cost (FC)

Assume the CI = $599.45 per million face value from original trade settlement date to futures contract last delivery date. Additionally, assume the FC = $206.54 for the same terms. Therefore, Carry = 599.45 – 206.54 = $392.91. Notice the carry number is positive.

If we were to calculate the carry for all the ZFH7 futures contracts eligible securities, we could then use that number along with each security’s basis to determine each eligible security’s net basis.

Net basis = Basis – Carry

This is important because the issue with the lowest net basis tends to be the CTD issue.

Implied Repo Rate (IRR)

There is another widely accepted method for determining the CTD issue. It is called the implied repo rate (IRR). It is a theoretical yield produced by buying the cash security, selling the futures contract, lending the cash security in the repo market and finally, delivering the security into the futures contract on last delivery day. The issue with the highest IRR is generally considered CTD. What you will find if you follow these methods is they arrive at the same result. Bloomberg, for example, has a function that calculates the CTD for U.S. Treasury futures using both methods.

The point of knowing the CTD is to understand how the futures contract will behave. U.S. Treasury futures contracts trade like their CTD securities. Knowing what goes into determining the CTD issue is useful to understanding U.S. Treasury futures valuation. It can also help understand how the CTD can shift or change.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Understand Treasury Contract Specifications

Futures markets trade standardized futures contracts, which means futures that share an underlying asset are interchangeable. They have certain terms that are clearly defined by the futures contract and are usually summed up the contract specifications.

Contract specifications can be thought of as the agreement between the buyer or seller of the futures contract and the exchange that lists and clears that futures contract. Knowing a futures contract’s specification is important because it outlines the contract’s terms and obligations. Additionally, it may provide insights into how the contract will price and behave versus the underlying physical product or index.

In this module, we will consider the contract specifications for U.S. Treasury futures. CME Group lists active futures on U.S. Treasuries at numerous points along yield curve. Each futures contract has its own contract specifications; some contracts have similar terms while other terms are specific to a unique contract.

Identifying Maturity Points

To begin, we will need to identify the maturity points of the actively traded U.S. Treasury futures curve. Be advised that the futures contract name may not perfectly reflect that contract’s true deliverable U.S. Treasury security maturity. Currently CME Group has  2-Year Note, 5-Year Note, 10-Year Note, Ultra 10-Year Note, U.S. Bond and Ultra Bond futures contracts.

Important Specifications

We will explore the following specifications that are necessary for you to understand the contract structure, pricing and quotation mechanism, and delivery grade securities that provide the underlying product and trading cycle:

Contract size
Contract factor
Delivery grade for final settlement
Price quotation
Minimum price fluctuation (tick size)
Listed contract months
Termination of trading (last trading day)

The 2-Year Note

The 2-Year Note has a contract size of $200,000 face-value per contract. This size is unique to 2-Year Notes as all other active U.S. Treasury futures have a face value of $100,000.

When calculating a 2-Year Note’s invoice amount, CME Group calculations sometimes refer to a contract factor. The contract factor for 2-Year Notes is $2,000 per contract. The delivery grade of a U.S. Treasury futures contract refers to the U.S. Treasury securities eligible to be delivered into the futures contract that will fulfil the terms for final settlement.

All CME Group U.S. Treasury futures contracts settle to a physical delivery of an underlying U.S. Treasury note or bond. But each individual contract has its own list of securities that can be delivered. In other words, the short position, responsible for making delivery, cannot simply pick any government security and deliver it to the long position, responsible for accepting and paying for delivery. The short position must choose from one of several securities eligible according to the contract specifications.

For 2-Year Note futures, the eligible securities are defined as, “U.S. Treasury notes with an original term to maturity of not more than five years and three months and a remaining term to maturity of not less than one year and nine months from the first day of the delivery month and a remaining term to maturity of not more than two years from the last day of the delivery month. The invoice price equals the futures settlement price times a conversion factor, plus accrued interest. The conversion factor is the price of the delivered note ($1 par value) to yield 6 percent.

2-Year Note futures trade in points and fractions of 1/32 of a point. The smallest increment a 2-Year Note futures contract can trade in is a ¼ of a 1/32. Since the 2-Year Note has a face-value of $200,000 per contract 1/32 is equal to $62.50 per contract. Therefore, the minimum tick, or smallest increment of price change, is ¼ of 1/32 a tick is worth 0.25 x $62.50 or $15.625 per contract.

2-Year Note futures list three consecutively quarterly contract months at a time following the March, June, September, and December expiration cycle.

Termination of trading, also known as last trading day (LTD), is the last business day of a quarterly contract month. The last delivery day (LDD) is three business days after the last business day of a quarterly contract month.

The 5-Year Note

5-Year Note futures are similar to 2-Years in their listing cycle; they are listed in three consecutive quarterly expiration months following the March, June, September, December cycle. 5-Year Notes have a face value of $100,000 per contract and a contract factor of $1,000 per contract.

The deliverable grade for 5-Year Notes is, “U.S. Treasury notes with an original term to maturity of not more than five years and three months and a remaining term to maturity of not less than four years and two months as of the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor, plus accrued interest. The conversion factor is the price of the delivered note ($1 par value) to yield 6 percent.”

Like all U.S. Treasury futures, 5-Year Note futures trade in points and fractions of a 1/32. The minimum price fluctuation, or tick size, is ¼ of a 1/32. Since the face value of the 5-Year Note future is $100,000 a 1/32 is worth $31.25, therefore ¼ of a 1/32 is equal to 0.25 x $31.25 = $7.8125, rounded to the nearest cent per contract.

Last trading day  and last delivery day are the same as 2-Year Notes. LTD for 5-Year notes is the last business day of a quarterly contract month and LDD is three business days following the last business day of the quarterly contract month.

The 10-Year Note

10-Year Notes and all the consecutively longer maturity contracts also have a $100,000 face value and $1,000 contract factor amount. The 10-Year Note’s delivery grade is, “U.S. Treasury notes with a remaining term to maturity of at least six and a half years, but not more than 10 years, from the first day of the delivery month. The invoice price equals the futures settlement price times a conversion factor, plus accrued interest. The conversion factor is the price of the delivered note ($1 par value) to yield 6 percent.”

10-Year Note futures minimum price fluctuation, or tick size, is ½ of 1/32. Therefore, the minimum price change would be 0.50 x $31.25 = $15.625, rounded to the nearest cent per contract. CME Group lists three consecutive quarterly contracts in 10-Year Notes.

LTD and LDD are different than 2- and 5-Year Note futures. The 10-Year Note ceases trading (LTD) seven business days prior to the last business day of the quarterly contract month. The LDD for 10-Year Notes is the last business day of the quarterly contract month.

Ultra 10-Year Note

Ultra 10-Year Notes list, price and trade just like the original 10-Year Notes described above.

The only difference in specifications between the 10-Year Note and Ultra 10-Year note is in the delivery grade. Securities eligible for delivery into the Ultra 10-Year are referenced as, “Original issue 10-Year U.S. Treasury notes with not less than 9 years 5 months and not more than 10 years of remaining term to maturity from first day of futures delivery month. The invoice price equals the futures settlement price times a conversion factor, plus accrued interest. The conversion factor is the price of the delivered note ($1 par value) to yield 6 percent.”

U.S. Treasury Bonds

The original U.S. Treasury Bond contract, sometimes referred to as the Classic Bond, has a face value of $100,000 per contract and a contract factor of $1,000.

Its deliverable grade is defined as, “U.S. Treasury bonds that have remaining term to maturity of at least 15 years and less than 25 years from the first day of the futures delivery month.* The delivery invoice amount equals the futures settlement price times a conversion factor, plus accrued interest. The conversion factor is the price of the delivered bond ($1 par value) to yield 6 percent.”

The minimum price fluctuation is 1/32 of a point or $31.25 per contract. CME Group lists three consecutive quarterly month contracts of this contract. Its LTD is seven business days prior to the last business day of the quarterly contract. LDD is the last business of the quarterly contract month.

The Ultra Bond

The Ultra-Bond contract is just like the Classic Bond except in deliverable grade terms.

The delivery grade terms for the Ultra-Bond are, “U.S. Treasury bonds with remaining term to maturity of not less than 25 years from the first day of the futures contract delivery month. The invoice price equals the futures settlement price times a conversion factor, plus accrued interest. The conversion factor is the price of the delivered bond ($1 par value) to yield 6 percent.

Summary

Understanding how to read contract specifications is important because the specs define the terms and obligations of the buyers and sellers and may provide clues into how a contract prices versus its underlying product.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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At the expiration of a futures contract, the contract is usually settled one of two ways, through a physical settlement involving a delivery of the underlying product or by means of a financial, or cash, settlement to an index or widely accepted price benchmark.

Knowing the final settlement process of a futures contract is important, even though most open futures positions never go all the way to expiration. Interest rate futures traded at CME Group are settled both financially and through physical delivery.

U.S. Treasury notes and bonds are settled through physical-delivery. It is the prospect of having to make or take delivery of an actual U.S. Treasury security that imposes the pricing integrity to the U.S. Treasury futures market. Therefore, understanding the delivery process is essential to understanding how futures on U.S. Treasuries price and trade.

Delivery Process

The U.S. Treasury futures delivery process takes place over or near the quarterly contract delivery month. Quarterly contract months are defined by CME Group as March, June, September and December.

The short (seller) position has all the optionality regarding delivery. This means the short position choses when to deliver and which eligible security to deliver based on the contract’s specifications and their own financial self-interest.

The long (buyer) position is passive until assigned delivery by the clearing house. The short position may deliver security for contract on any business day of the expiring quarterly contract month. In this case, futures on U.S. Treasuries behave like an American-style option, in that the short can exercise its option before the last trading day of the contract. This is an important and defining feature.

The actual delivery process is a three-day event. It is always three days and cannot be shortened nor extended. The three days are known as intention day, notice day and delivery day.

Large Open Interest Holders

The possibility of an unexpected early delivery effects when the large open interest holders roll forward to the next quarterly contract.

Because many large open interest holders do not want to assume the responsibility of delivery and want to avoid delivery completely, they chose to roll their positions into the next quarterly contract prior to intention day. By rolling forward early they avoid any chance of an unintended delivery.

By rolling forward they also take liquidity in the front quarterly contract and transfer it to the next quarterly contract. Which causes the roll, or calendar spread, between front and next quarterly contract to be most liquid and tight during the last few days of the month preceding the quarterly expiration month. This is unique to physically-settled futures and distinct from cash-settled contracts.

Intention Day

Because the delivery process is a three-day event and because the short can elect to deliver securities the first business day of the quarterly contract expiration month, it is necessary that the first intention day precede the first business by two business days. This date, two business days prior to the first business day of the expiration month, is first intention day, also known as first position day.

Example

For the March 2017 contracts, the first business day of March 2017 is Wednesday, March 1. First position day would therefore be Monday, February 27, 2017. On February 27, an open long position could be subject to being assigned delivery of a U.S. Treasury security for settlement March 1.

When a short futures position decides to make delivery, they must notify CME Clearing by 6 p.m. Central Time of their intention to deliver. This is where the name, intention day comes from.

The short notifies CME Clearing of its intention to deliver, causing the process to begin. The first thing to note is that day’s official CME Group settlement price of the intended contract, which is now used to create the invoice amount for this delivery. Then CME Clearing assigns the delivery to the oldest outstanding long position. The longest, or oldest-dated longs, have the greatest chance of an early delivery.

On intention day, the short position declares they are making delivery, final contract price is determined and the long position is assigned by CME Clearing.

Notice Day

Notice Day is when the short position declares which U.S. Treasury security they will deliver versus cash payment to the long position.

The short must select a government security that fulfills the eligibility requirements determined by the contract specifications of the respective contract being delivered. Each eligible security has its own conversion factor, which is based on the security’s coupon, maturity date and the expiration date of the futures contract. This conversion factor is used along with the final futures price and accrued interest to determine the final invoice amount of the delivery.

At the end of notice day, the second day in the three-day delivery process, the short and the long know the final price, security, conversion factor for the security and accrued interest of that security. They calculate, using those inputs, the invoice amount. CME Clearing confirms these amounts for each matched short versus long for that delivery and assures the respective parties have exchange bank wire instructions.

Delivery Day

Having confirmed all the details and instructions, all security versus cash transactions are completed by 1 p.m. on the third day, delivery day, and the delivery process is over.

Summary

It is important to remember that this process may occur prior to the last trading day  of a contract. 10-year note and bond contracts cease trading seven business days prior to the last business day of a quarterly contract month and 2-year and 5-year notes cease trading the last business day of the month.

If the short elects to deliver after last trading day, the final price on last trading day is used to determine the final invoice amount. Last delivery day  for 10-year notes and bonds is the last business day of the expiring quarterly contract month. Last delivery day for 2-year and 5-year notes is three days after the last business day of the expiring quarterly contract month.

Though most traders and hedgers never go all the way through to delivery, it is important to understand the delivery process because the concepts and formula that define the final invoice amount drive the pricing and trading behavior of the futures contract.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Understanding Eurodollar Packs and Bundles

Previously, we discussed how market participants can use Eurodollars to hedge floating rate loans by using strips of Eurodollar futures.  You might choose to hedge a one year loan (hedge against higher interest rates) with quarterly reset dates by selling four quarterly Eurodollar futures contracts in what is known as a strip hedge. The strip consists of quarterly ED futures strung together.

While strips solved the problem of interest rate risk for some, they came with another issue: creating the strips necessitated legging futures contracts individually. Moreover, longer-dated loans and other hedges would require even longer strips of Eurodollars. Legging each contract individually entailed some risk, as the market sometimes moved appreciably before you could get all the legs completed. There was also the risk of execution mistakes as well as unfilled orders. In response to the marketplace, CME Group developed the concept of packs and bundles to simplify transactions for the increasing number of traders using strips of Eurodollar contracts.

Packs and Bundles: A Logical Evolution

A pack or bundle may be thought of as the purchase or sale of a series of Eurodollar futures representing a particular segment along the yield curve. They may be used to create or liquidate positions along the yield curve. Packs and bundles offer the advantage of being transactable at a single price or value, eliminating the necessity of entering multiple orders in each contract and the further possibility that some orders may go unfilled.

The popularity of packs and bundles is reflected in Eurodollar volume and open interest patterns. Unlike most futures contracts, where virtually all volume and open interest is concentrated in the nearby or lead month, Eurodollar futures have significant volume and open interest in the deferred months going out 10 years along the yield curve. During the first half of 2013, some 14% of all Eurodollar futures contracts were transacted in the form of packs or bundles. In 2016, packs and bundles were approximately 20% of overall Eurodollar volume.

What are Bundles?

A Eurodollar bundle consists of the simultaneous sale or purchase of one each of a series of consecutive Eurodollar futures contracts. The first contract in any bundle is typically the first quarterly contract in the Eurodollar strip, but bundles may be constructed starting with any quarterly contract. CME Group lists bundles in 1-, 2-, 3-,4-, 5-, 6-, 7-, 8-, 9- and 10-year terms to maturity.

Eurodollars are sometimes color-coded to facilitate reference to individual contract months or to packs and bundles. Eurodollars have 40 expirations: four quarterlies going out 10 years. That means there is a March expiration for 2017 as well as 2018 and all the way until 2027. To avoid confusion, CME Group created color codes. White represents the first year, red the second and so on until coppers, which represents the quarterly expiration in the tenth year. The chart below illustrates how bundles are constructed along the entire Eurodollar yield curve.

You may buy a 1-year white bundle by purchasing the first four quarterly expiration Eurodollar futures contracts. This way the entire strip of four quarterly futures contracts are conveniently bundled, eliminating execution risk and promoting efficiencies. Another example, you may sell a 3-year green bundle, which would bundle the first 12 quarterly expiration together in one package. A 5-year gold bundle would involve 20 quarterly expirations all bundled in one transaction.

What are packs?

Packs are similar to bundles in that they represent an aggregation of several Eurodollar futures contracts traded simultaneously. They are designed to represent a series of four consecutive quarterly Eurodollar futures whereas some bundles represent multiples of four quarterly expirations.

For example, you may buy a white pack by buying the first four quarterly expiration Eurodollar futures contracts. Or, you may sell a red pack in the second year by selling the fifth through eighth quarterly cycle month contracts. Or you may buy a gold pack in the fifth year by buying the 17th through 20th quarterly cycle month contracts.

Notice the BPV (basis point value) remains at $100 per pack whereas the BPVs continually rise as you add more quarterly expirations.

Both packs and bundles transacted on the CME Globex electronic trading platform.

Quoting Packs and Bundles

The price of a pack or bundle is quoted by reference to the average change in the value of all Eurodollar futures contracts included in the pack or bundle since the prior day’s settlement price. They are quoted in increments of 1/4 of one basis point (0.01%). E.g., if the first four quarterly Eurodollar contracts have advanced two basis points for the day, while the next four quarterly Eurodollar contracts have advanced three basis points for the day, then a 2-year, or red bundle, may be quoted as +, or up, 2.5 basis points.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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