BTP Futures at Eurex

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1 BTP Futures at Eurex September 10, 2009 Webinar Lecture notes available in PDF from Eurex Presented by Kevin Baldwin, director of education THE INSTITUTE FOR FINANCIAL MARKETS 2001 Pennsylvania Ave NW Suite 600 Washington DC tel: This presentation has been compiled for general information purposes. Examples are hypothetical, used for explanatory purposes only. Although every attempt has been made to ensure the accuracy of the information, the instructor and the IFM assume no responsibility for any errors or omissions.

2 About the IFM The Institute for Financial Markets, founded in 1989, is a Section 501(c)(3) nonprofit industry-sponsored educational foundation. The IFM is dedicated to providing quality and unbiased information,research data and instruction. The Institute offers independent-study and exam preparatory materials in print and computer-based formats; instructor-led seminars and customized, in-house training; research data; desktop reference tools; and consultancy on industry standards and best practices. Institute for Financial Markets 2001 Pennsylvania Ave. NW Suite 600 Washington DC Tel: Fax: info@theifm.org

3 Risk Disclosure The risk of loss in trading commodities can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. The information contained herein is derived from sources believed to be reliable. The audience should practice their own due diligence.

4 Maastricht Treaty, 1991 Treaty called for a common unit of exchange, the euro, and set strict criteria for conversion to the euro and participation in EMU, European Monetary Union. Criteria: Annual budget deficits not exceeding 3% of GDP Total public debt < 60% of GDP Exchange rate stability Inflation rates within 1 ½ % of the three lowest inflation States in the EU, and long term inflation within 2% of the lowest three members

5 The Euro Zone

6 Beyond 60% Debt/GDP Some states had public debt/gdp ratio s exceeding the 60% maxium. Indeed, both Italy and Belgium topped 120%. The EC (European Commission = executive branch of the EU) recommended Italy & Belgium each be admitted despite their deficiency, citing the significant steps each country had taken to reduce its debt ratio

7 world factbook

8 After Monetary Union in Europe Sovereign fixed income futures markets in Europe consolidated to use the German yield curve futures as the proxy for sovereign European debt OAT, BONO s, and BTP s Between 1997 and 2007, credit spreads between German benchmark govt yield spreads and other EU states was narrow, and relatively stable.

9 Sovereign Spreads Blowing Out Deteriorating economic performance, along with burgeoning fiscal deficits, have led to significant widening of European sovereign spreads vs. Germany Financial system turmoil in 2007 and 2008 exacerbated the widening, as sovereign German securities benefited from the influence of the flight-to-quality trade.

10 Greece Italy Spain France

11 Fiscal Fortunes Diverge Prior to the diverging fiscal fortunes of member EU states, the Eurex complex of bund related futures (euro-schatz, eurobobl, euro-bund, and buxl) were an effective hedging instrument for the majority of EU debt. The widening spreads among member states has created enormous basis risk in hedging/modifying exposure to non- German EU debt.

12 BTP Future Solution In response to the problems created by widening EU member states government bond yields to German yields, Eurex is launching futures on ten year Italian government bonds, complimenting their existing benchmark Euro Zone instruments BTP futures are back on September 14, 2009!

13 Plenty of Paper: 8-12 Years

14 Volume in Mio

15 GBTPGR10 {index} is a 10 Year Generic Italian Govt Bond

16 GDBR10 {index} as a 10 Year Generic German Govt Bond Sept 3, 2009 Italian 10 yr: 4.14% German 10 yr: 3.24% Sovereign Spread: 0.90%

17 Correlation Between the Two Benchmarks Looks Pretty Strong Through Early 2008

18 Period 2: Feb 2008-Feb 2009 Period 1: Feb 2006-Feb 2008 Period 3: Since Feb 09

19 Feb.2006-Feb.2008 Daily, n=522 y i = α i + β i (x i ) + ε i

20 Feb.2006-Feb.2008 Weekly, n=104

21 For Comparison, R 2 on SPY vs. SPX is 96.8%

22 Feb.2008-Feb.2009 Daily, n=260

23 Feb.2008-Feb.2009 Weekly, n=52

24 Feb.2009-Aug.2009 Daily, n=150

25 Feb.2009-Aug.2009 Weekly, n=29

26 Massively Increased Basis Risk R 2 Std.Error of Beta Feb.2006-Feb.2008 daily Feb.2006-Feb.2008 weekly Feb.2008-Feb.2009 daily Feb.2008-Feb.2009 weekly Feb.2009-Aug.2009 daily Feb.2009-Aug.2009 weekly

27 Period 2: Feb 2008-Feb.2009 Daily R 2 =64.5% Period 1: Daily R 2 = 94% Period 3: Since Feb 09 Daily R 2 = 39%

28 BTP = α i + β i (Bund future) + e i Feb 2006-Feb 2008

29 BTP = α i + β i (Bund future) + e i Feb 1, 2008 Jan 30, 2009

30 BTP = α i + β i (Bund future) + e i Jan 2, Aug 31, 2009 R 2 Std.Error Beta Feb 06-Feb Feb 08-Feb Jan 09 Aug

31 Flight-to-quality, investors seek the safety of the highest rated securities, while selling lower rated sovereign bonds; blowing out the spreads amid rising volatility. Source: Maria Cannata Liquidity 2009, Volterra, 4, Aprile 2009

32 Relative to ASW, 10 & 30 yr BTP also widened substantially amid rising vol. This also demonstrates that sovereign spreads are also impacted by movements in the Euro-Swap curve. Source: Maria Cannata Liquidity 2009, Volterra, 4, Aprile 2009

33 Financial crisis substantially reduced liquidity, widening the bid/ask spread across the BTP curve Source: Maria Cannata Liquidity 2009, Volterra, 4, Aprile 2009

34 Not Just for Italians! German sovereign debt is AAA Italian sovereign debt is AA BTP futures should remove the excess basis risk from using German fixed income futures to manage Italian govt rates Traders in other EU state debt, should also benefit by using BTP future as a proxy for other non-aaa rated Euro denominated debt: ie. France, Spain, Greek, etc.

35 Other Benefits of Using BTP Allows asset managers an opportunity to generate alpha by trading the spread between member countries on exchange, with the benefit of central counterparty mitigating credit risk Traders will also take advantage of margin offsets against existing positions of Eurex listed fixed-income future positions

36 BTP Contract Specifications Contract Standard Notional long-term debt instrument issued by Italy with an original maturity not longer than 16 years and a remaining term of 8.5 to 11 years and a six percent coupon. Contract Value EUR 100,000 Fee and Pricing Price Quotation Tick Size / Value Settlement (via CBL) Delivery Day Last Trading Day Trading Hours Market Making Block Trade Size EUR 0.20 per contract; OTC: EUR 0.30 per contract In percentage of the par value, with two decimal places 0.01% / EUR 10 Italian government bonds that have an original maturity of not more than 16 years and remaining term of 8.5 to 11 years on the Delivery Day. Such debt securities must have a minimal issue amount of EUR 10 billion and a nominal fixed payment. Tenth calendar day of the respective quarterly month (Mar, Jun, Sep, and Dec) Two exchange trading days prior to the Delivery Day of the relevant delivery month. Trading in the maturing delivery month ceases at 12:30am CET 8:00am to 7:00pm CET 9:00am to 5:30pm CET for the first six months 250 contracts

37 A Bond is a Sequence of Cash Flows Bond Price = I I =1 Coupons ( 1 + r n ) nt + Corpus r nt ( 1 + n ) The price of a bond is just the present value of its cash flows discounted at an appropriate rate of interest. **Interest rates and inflation are usually correlated; higher inflation implies higher interest rates and lower prices. r = yield to maturity, n=2 payments/year, t = time in decimal

38 Conversion Factor, Reconciles Quality Calculated using gross true yield ; cash flow scheduled for payment on holidays and weekends are moved to next trading day. CF i = Bond Price = 100 I i=1 Coupons nt ( 1 + ) 6% n + Corpus 6% nt ( 1 + ) To find the CF, discount the bond s cash flows at 6% on the delivery day (10 th ) and divide by 100. This process reconciles all deliverable Italian BTP s to the 6% nominal yield the Eurex contract calls for. BTP Conversion Factors have six digits. n

39 Eligible Cash BTP for Delivery

40 Conversion Factor Implications Conversion Factor December 2009 = Suggests that the 4.25s Sept 2019 bond is % as VALUABLE as the nominal 6.00% futures contract. Suggests that the 4.25s Sept 2019 bond is % as VOLATILE as the nominal 6.00% futures contract.

42 Once BTP Futures Begin Trading, We ll Have a Basis Table Too! Euro-bund Sept Basis Table

43 Conversion Factor s Are Unique to Each Security and Serial Expiration Each deliverable cash BTP security will have a unique conversion factor for each serial expiration future contract listed. The CF tells you the price of the bond at 6% yield on the delivery date, usually the 10 th of the expiring contract month.

44 BTPS 4.5% Aug.2018 Description BTP= Buoni del Tesoro Poliennali

45 BTPS 4.5% Aug.2018 Volatility Statistics BPV cash = 75.32/ 100,000 face value BPV future = BPV CTD /CF CTD

46 BTPS 4.25% Feb.2019 Volatility Statistics Modified Duration: 7.54 BPV = 77.77/ 100,000 face

47 BTPS 4.5% Mar.2019 Volatility Statistics Modified Duration: BPV = 78.64/ 100,000 face

48 BTPS 4.25% Sept.2019 Volatility Statistics Modified Duration: BPV = 80.30/ 100,000 face

49 BTPS 4.5% Feb.2020 Volatility Statistics Modified Duration: BPV = 83.80/ 100,000 face

50 Volatility Properties of Deliverables 4.5% August 2018, mod.dur.7.158, BPV % Feb.2019, mod.dur. 7.54, BPV % March 2019, mod.dur 7.551, BPV % Sept.2019, mod.dur 7.919, BPV % Feb.2020, mod.dur , BPV 83.80

51 Invoicing Protocol Principal Invoice = Conversion Factor x Futures Settlement x 1,000 Total Invoice = Principal Invoice + Accrued Interest

52 Anticipating Cross-over s in the CTD P x CF i Relative medium duration bond 4.5% March 2019 Relative high duration bond 4.5% Feb.2020 = inflection point, aka cross-over Relative low duration bond 4.5% Aug % 5% 6% 7% 8% Market Yield

53 Systemic Bias When Yields 6% 4% 6% 8% Rally, Prices up Futures like the bond that rallies least: favors higher coupon, shorter maturity. Price σ falls, HR should rise You make more long cash than you lose short futures Sell-off, Prices down Futures like the bond that sells off fastest: favors smaller coupon longer maturity, longer duration. Price σ rises, HR should fall. You make more being short futures than you lose being long cash.

54 Kevin Baldwin Director, Education Thank You Institute for Financial Markets 2001 Pennsylvania Ave. NW Suite 600 Washington DC Tel: Fax:

55 About the Instructor Kevin Baldwin began his career in the futures and options industry in 1990 within the largest non-bank FCM s institutional training department. He taught their six week futures and options course in Chicago for six years. In addition to the six week Chicago program, he provided shorter term derivatives seminars for client institutions in Buenos Aires, Rio de Janeiro, Tokyo, Seoul, London, Mumbai, and Moscow on behalf of the British government's Know How fund. Mr. Baldwin also taught futures & options courses for the Illinois Institute of Technology's Master Program in Financial Markets. In 1996, Kevin Baldwin joined an innovative Introducing Broker in New York City as managing director and had held various securities and futures registrations including Series 3, 4, 7, 24, 30 and 63. In addition to his professional responsibilities, Kevin became an adjunct faculty member for New York University's School of Continuing Education where he taught both Intermediate Securities Analysis and Futures and Options courses. In 2000, Kevin returned to Chicago and developed a portfolio of websites aimed at different segments of the futures and options community. In the summer of 2006, Mr. Baldwin became the director of education for the Institute for Financial Markets in Washington DC. Since joining the IFM, he has worked to broaden the IFM s course curriculum offerings to include a Strategies & Tactics course aimed at speculators, a Managing Exposure to Financial Instruments course, a Credit Derivatives-OTC & Exchange-Traded, a Algorithmic Trading course, as well as our well known Series 3 preparation course. Mr. Baldwin earned a Bachelor of Science degree from San Jose State University in California. He also holds an MBA from the University of Chicago, Booth School of Business.

FINANCING IN INTERNATIONAL MARKETS

FINANCING IN INTERNATIONAL MARKETS 3. BOND RISK MANAGEMENT Forward Price of a Coupon Bond Consider the following transactions at time T=0: i. Borrow for T 2 days at an interest rate r 2. ii. Buy a coupon