Tag: Peter Knight Advisor

Trading the Link Between USD/JPY and U.S. Treasury Securities

In the latest Trader’s Edge video, we explore the relationship between U.S. Treasury securities and the USD/JPY exchange rate, and the opportunities it can present with Treasury yields on the rise. Topics include:

Recent weakening of the U.S. dollar vs. the Japanese yen
Why rising yields in U.S. rates have not strengthened the dollar
How a higher yield and weaker dollar affects Japanese holders of U.S. Treasuries
Why Japanese investors could be on verge of selling U.S. Treasuries
How higher Treasury yields could help strengthen the USD/JPY exchange rate

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

Regards,
Peter Knight Advisor

—————————————————————-

Trading the U.S. Treasury Curve: Twos versus Tens

The U.S. Treasury Bond market is the largest and deepest government debt market in the world. Individual U.S. Treasury Notes and Bonds provide important benchmark yields at various points along the yield curve.

Trading the slope of the U.S. Treasury curve using futures contracts involves the execution of an inter-commodity spread. One very common and widely quoted yield curve spread is the twos versus tens yield spread. This spread compares and reflects the difference in yields between the current U.S. Treasury 10-Year note and the current U.S. Treasury 2-Year note.
Watch this video to learn more about this spreading technique.

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

Regards,
Peter Knight Advisor

—————————————————————-

Treasury Intermarket Spreads – The Yield Curve

Once you understand how to calculate the basis point value (BPV) of a U.S. Treasury futures contract and dollar-weighted hedge ratios versus other fixed income securities, it is short walk to how to spread one contract versus another.

Understanding Spread Trades

A spread trade is one where the trader buys one and simultaneously sells another highly correlated futures contract. Spreads can be intra-market, like a time spread, also known as a calendar spread, buying one month and selling another of the same product. Or spreads can be constructed between similar products like buying corn and selling wheat.

Within the U.S. Treasury futures complex it is very common to spread one U.S. Treasury contract against another. Because CME Group lists multiple U.S. Treasury futures based on targeted maturities (2-year, 5-year, 10-year, Ultra 10-year, Bond and Ultra-Bond) traders can construct spread trades to express a point of view on the slope of the yield curve.

The Yield Curve

U.S. Treasury securities are traded based on price, but also reflect a corresponding yield-to-maturity (YTM). If you were to take all of the government securities and plot them on a grid with the x-axis showing their maturity dates and y-axis showing their yield-to-maturity you would end up with what looks like an upward sloping pattern left to right.

The grid of yields versus maturity is known as the U.S. Treasury yield curve, or simply the yield curve, . Normally quoted using the most recently auctioned U.S. Treasury securities called on-the-runs (OTR), the yield curve expresses the yield difference between various points along the curve.

For example, one frequently quoted yield spread is the difference between the 2-year note and 10-year note. If you were told the 2/10 yield curve was 150 basis points that would generally mean the yield of the 10-year was 150 basis point higher than the yield of the 2-year note.

Yield curves can be positively sloped, flat or negatively sloped (inverted). When a trader or risk manager places a yield curve trade she is more concerned with the relative value, or difference in yields, between the securities than whether absolute yields rise or fall.

Traders can and do express opinions on the U.S. Treasury futures yield curve by spreading one U.S. Treasury futures contract versus another. Looking back at the 2/10 spread mentioned above, a similar trade could be constructed using futures contracts.

Building a Spread

The spread begins with what we already know about U.S. Treasury futures, they trade like their CTD securities and we can calculate their implied BPV.

If we wanted to buy a 2/10 yield spread using futures, we must first identify which U.S. Treasury futures contracts we want to use to build the spread. We know there is a 2-year futures contract but what about the 10-year side?

There are two futures contracts listed by CME Group that derive their value from 10-year U.S. Treasury securities, the Classic 10-Year and the Ultra 10-Year. Which should we use? The Ultra-Ten Year tracks a CTD that trades closer in maturity to the OTR 10-year so we will use it for our example. So for our example we would buy the 2-year future and sell the appropriate number of Ultra 10-Year futures.

The second step is to identify each contract’s CTD issue, then, based on its CTD’s BPV and conversion factor, calculate each contract’s implied BPV. Then we can compare the respective BPVs and, with a little math, arrive at the appropriate spread ratio (SR). Mathematically it would look like this:

Spread Ratio (SR) = BPVultra-ten ÷BPV2-year

Assume that the 2-Year (TUH7) has a BPV of $46.25 per contract and the Ultra 10-Year (TNH7) has a BPV of $128.78. Plug this into the formula above and we get:

SR= 128.78 ÷ 46.25 = 2.78, or roughly 3:1 TUH7 to TNH7

By buying three TUH7 contracts versus one TNH7, this spread is effectively dollar-neutral. That means it is less subject to profit and loss based on direction of the market and more subject to change in the yield difference between the contracts. This trade is about changes in slope rather than changes in outright yield. Because U.S. Treasury futures prices move in an inverse relationship to yield, if one is buying the 2/10 they are anticipating the slope to steepen, or increase, between 2/10s.

We recognize traders and risk managers utilize U.S. Treasury futures to trade the slope of the yield curve and conveniently list yield curve trades weighted and rounded to whole number ratios on our website and on CME Globex.

Summary

Yield curve trades are a common and frequently executed trade in both cash and futures U.S. Treasury markets. They can provide added value to risk managers and traders alike. Understanding the pricing and trading behavior of CME Group U.S. Treasury futures contracts and how they relate to the underlying cash Treasuries is essential to using them effectively.

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

Regards,
Peter Knight Advisor

—————————————————————-

Treasuries Hedging and Risk Management

Hedging interest rate risk with CME Group U.S. Treasury futures begins with identifying the futures contract’s CTD security. Once identified, we can determine the implied basis point value (BVP). BPV is also known as value of a basis point (VBP) or dollar-value of an .01 (DV01). They all refer the same thing, the financial change of the security or portfolio to a change in a 0.01% change in yield. To construct the proper dollar-weighted hedge ratio versus the product or position at risk we need to first determine the BPV.

Calculating Basis Point Value

The calculation for the BPV is simple: the contract’s CTD BPV divided by the CTD conversion factor (CF).

BPVcontract = BPVctd ÷ CFctd

Once we have the BPV, all we need is the BPV at risk.

Example

Assume you are long $100 million of a U.S. Treasury portfolio with an average BPV of $450 per million. This BPV is closest to the BPV of the CME Group U.S. Treasury 5-Year Note futures contract so we will use it as our hedging instrument.

The CTD for the 5-Year contract versus the March 2017 expiry is the 1.375% of May 31, 2021. It has a BPV of 42.45 per $100,000 face value and a conversion factor of 0.8317.

We use $100,000 because that is face value of one 5-Year Note futures contract. Our risk position is quoted in million-dollar increments so we will make a slight multiplication to adjust apples for apples.

For our example, we have the following: BPVcontract = 42.45 / 0.8317 = $51.04

The next step is to determine the value at risk. Our portfolio was $100 million and the average BPV per million was $450. Therefore, 450 x 100 = $45,000 value at risk.

Now we can calculate our hedge ratio. We will use the following formula:

Hedge ratio (HR) = Value at risk ÷ Value of contract, or

HR = BPVrisk ÷ BPVcontract

HR = 45,000 / 51.04 = 881.66 or 882 5-Year futures

Because we are hedging a long position that is exposed to higher interest rates we would sell the futures contracts.

It would be highly unlikely for a portfolio manager to hedge her entire risk position. That would effectively leave her with no rate exposure. In other words, if rates went lower, she would not participate in the capital gain of higher prices. Usually risk managers of large rate positions use futures contracts to hedge a portion of their risk or to modify their portfolio’s target duration.

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

Regards,
Peter Knight Advisor

—————————————————————-

Calculating U.S. Treasury Pricing

Treasury Price/Yield Calculator

Pricing U.S. Treasury bonds, notes and futures can look at first glance to be much different than the pricing of other investment products.

Cash bonds and futures based on U.S. Treasury securities do not trade in decimal format but in full percentage points, plus fractions of a 1/32 of par value. For example, if you were to see a quote on a broker/dealer screen showing U.S. Treasury prices you might encounter something like this:

10 YR 2.250 2/15/27 99-032 / 99-03+ 10/20

This quotation would indicate the current on-the-run (OTR), or most recently auctioned, 10-year note with a coupon of 2.250% and a maturity date of February 15, 2027 is currently 99-032 bid and offered at 99-03+, $10 million bid with $20 million offered.

The bid-side price of 99-032 is not 99.032 but rather 99 full points of par value plus 3.25 1/32s of a point. In the cash market, the third digit might be two, plus or six. The two constitutes 2/8, or ¼, of a 1/32. A plus constitutes ½ of 1/32, and six constitutes 6/8, or ¾, of 1/32. So our bid-side quote converted from 1/32 to a decimal would be: 99-032 (1/32s) = 99.1015625, or 99.1015625 percent of par. The offer-side price would convert to 99-03+ = 99.109375.

If you were to view a U.S. Treasury futures price quotation you might encounter something like this: TNM7 134-010/134-015.

The same concept as the cash market convention applies. The bid-side quote represents 134 full points plus 1/32 of a point. The converted price into decimal would be 134-010 = 134.03125, and so forth for the offer-side price. In futures you might see 134-012 for 1-1/4 (1/32), 134-015 for 1-1/2 (1/32), or 134-017 for 1-3/4 (1/32).

While seemingly complicated, it becomes second nature after a while. Cash Treasuries and futures based on U.S. Treasuries trade in points and fractions of points (1/32). But when doing any mathematical calculations, we must first convert from 1/32 to decimal, do the calculation, then convert back to 1/32 price convention.

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

Regards,
Peter Knight Advisor

—————————————————————-

Eurodollar Futures Pricing And The Forward Rate Market

Forward Rate Agreements (FRA)

A Forward Rate Agreement (FRA) is a forward contract on interest rates. While FRAs exist in most major currencies, the market is dominated by U.S. dollar contracts and is used mostly by money center banks.

An FRA is a cash-settled contract between two parties where the payout is linked to the future level of a designated interest rate, such as three-month LIBOR. The two parties agree on an interest rate to be paid on a hypothetical deposit that is to be initiated at a specific future date. The buyer of an FRA commits to pay interest on this hypothetical loan at a predetermined fixed rate and in return receive interest at the actual rate prevailing at the settlement date.

Example Trade

Assume that in December 2017, a June 2017 Eurodollar futures is priced at 99.10. This price reflects the market’s perception that by the June 2017 expiration, three-month LIBOR rates will be .90% (IMM Price convention= 100 – 99.10 = .90%). Eurodollars are really a forward-forward market and their prices are closely linked to the implied forward rates in the OTC market.

Eurodollars and FRAs

Just as stock index futures reflect the cash S&P 500 market and soybean futures reflect the spot soybean market, Eurodollar futures should price at levels that reflect rates or implied rates in the FRA market. In addition, Eurodollar futures prices directly reflect, and are a mirror of, the yield curve. This is intuitive if one considers that a Eurodollar futures contract represents a three-month investment entered into N days in the future. Certainly, if Eurodollar futures did not reflect IFRs, an arbitrage opportunity would present itself.

Example

Consider the following interest rate structure in the Eurodollar (Euro) futures and cash markets. Assume that it is now December. Which is the better investment for the next six months:

Invest for six months at 0.80%;
Invest for three months at 0.70% and buy March Euro futures at 99.10 (0.90%); or
Invest for nine months at 0.90% and sell June Euro futures at 98.96 (1.04%)?

Assume that these investments have terms of 90- days (0.25 years), 180-days (0.50 years) or 270- days (0.75 years).

March Euro Futures 98.10 (0.90%)

June Euro Futures 98.96 (1.04%)

Three-month Investment 0.70%

Six-month Investment 0.80%

Nine-month Investment 0.90%

The return on the first investment option is simply the spot six-month rate of 0.800%. The second investment option implies that you invest at 0.700% for the first three months and lock in a rate of 0.900% by buying March Eurodollar futures covering the subsequent three-month period. This implies a return of 0.800% over the entire six-month period.

The third alternative means that you invest for the next 270 days at 0.90% and sell June Eurodollar futures at 1.04%, effectively committing to sell the spot investment 180 days hence when it has 90 days until maturity. This implies a return of 0.83% over the next six-months.

The third alternative provides a slightly greater return of 0.83% than does the first or second investment options with returns at 0.80%.

Eurodollar futures prices reflect IFRs in the FRA market because of the possibility that market participants may pursue arbitrage opportunities when prices become misaligned. Thus, one might consider an arbitrage transaction by investing in the third option at 0.83% and funding that investment by borrowing outright at the term six-month rate of 0.80%. This implies a three basis point arbitrage profit.

Conclusions

This module demonstrates the close linkage of the FRA and Eurodollar futures market. These contracts allow a firm to replace floating interest rates with fixed interest rates or vice-versa. FRAs are customized contracts that can be obtained through investment banks. These banks hedge the risk of these products by using Eurodollar futures. In hedging the sale of a forward contract with futures, the marking to market feature of futures must be considered. As a result, the pricing of FRAs is very competitive and bid-ask spreads are very narrow as arbitrage opportunities keep prices in the two markets very closely aligned.

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

Regards,
Peter Knight Advisor

—————————————————————-

Understanding Eurodollar Strips

One of the key reasons the Eurodollar contract has become so liquid and successful is because of hedgers using the market to hedge against adverse interest rate fluctuations.

Because Eurodollar futures move inversely with interest rates, if you are concerned about rising rates, you can sell Eurodollar futures and if you are concerned about declining rates, you might buy Eurodollar futures.

Many loans are structured such that the rate floats periodically (i.e. the interest rate is reset quarterly) as a function of LIBOR plus a fixed premium. This introduces a periodic risk that rates may fluctuate before the time of each periodic loan reset date. Eurodollar futures may be used to address this possibility to the extent that they are listed on a quarterly basis extending 10 years out into the future.

Eurodollar Strip Example

There exist various strategies for hedging with Eurodollars involve stacking and stripping futures contracts as well as products called packs and bundles, which are packaged strips.

Assume that it is March 2017 and a corporation assumes a two-year bank loan repayable in March 2019 for $100 million. The loan rate is reset every three months at LIBOR plus a fixed premium. As such, the loan may be deconstructed into a series, or strip, of eight successively deferred three-month periods. Note: If the loan is secured currently, the effective rate may be fixed at the current rate for the first three months. Thus, there is no risk over the first three-month period between March and June 2017. However, the corporation remains exposed to the risk that rates advance by each of the seven subsequent loan rate reset dates.

Considering that the floating rate loan may be decomposed into seven successively deferred 90-day loans. The BPV associated with each of those seven loans equals $2,500.

BPV = $100,000,000 x (90÷360) x 0.01% = $2,500

The corporation might sell 100 Eurodollar futures in successive quarterly contract months to match the seven successive quarterly loan reset dates. Therefore, one might effectively hedge each of the seven loan periods independently. This transaction is often referred to as a strip hedge, or a series of short (or long) Eurodollar futures in successively deferred contract months to hedge the risk of rising (or declining) rates, respectively.

Reset Date	Action to Hedge Rate Reset
June 2017	Sell 100 Jun-17 futures
September 2017	Sell 100 Sep-17 futures
December 2017	Sell 100 Dec-17 futures
March 2018	Sell 100 Mar-18 futures
June 2018	Sell 100 Jun-18 futures
September 2018	Sell 100 Sep-18 futures
December 2018	Sell 100 Dec-18 futures

Conclusion

If rates climb higher over the term of the loan, the short Eurodollar futures contracts would be profitable as the futures decline as rates rise. The profit on the strip of Eurodollar futures would offset the increase borrowing costs effectively locking in a lower rate.

Corporate treasurers and bank asset liability mangers are particularly aware of fluctuations in interest rates as borrowing and lending rates directly influence profitability. They have many tools available to hedge their interest rate exposure and on the Eurodollar or LIBOR side of the business, there is no better instrument.

Indeed, the hedging community has embraced strip hedging so enthusiastically that CME Group has launched a variety of pre-packaged strips that are called packs and bundles.

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

Regards,
Peter Knight Advisor

—————————————————————-