Workshop schedule. Part 1: 4:00 to 5:30 (16:00 to 17:30) Part 2: 6:00 to 7:30 (18:00 to 19:30)

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2 Workshop schedule Part 1: 4:00 to 5:30 (16:00 to 17:30) Brief history of bond futures Why use futures? Challenges to valuation Financial algebra of bond futures Trading Part 2: 6:00 to 7:30 (18:00 to 19:30) Hedging Cash/futures spreads and yield enhancement Special topics 2

3 Brief history of bond futures Introduced in late 1970s in Chicago (first GNMAs, then US Treasurys) Introduced in the 1980s in the UK and Europe Expanded to different maturities Transformation of related markets Breadth of coverage today (14 countries, not counting Russia) 3

4 How to use bond futures In principle, there is nothing you can do in the cash market that you cannot do in the futures market (and the other way round) As a result, you can Speculate Hedge Arbitrage 4

5 So why use futures? Usually cheaper to trade than related cash instruments, often more liquid than related cash markets Accessibility, anonymity Provide efficient access to forward markets (repo link between cash and futures Very low credit risk 5

6 So why use futures? Futures allow you to separate the price from the product Transparency, liquidity, competitively accurate prices 6

7 So why not use futures? Regulatory and legal hurdles Cash management practices Inflexible quantities and forward dates 7

8 A high level of sophistication Trading futures is like playing a guitar (or balalaika) To play the guitar well, you need to understand music better than do other instrumentalists To use futures well, you need to understand financial markets better than do other financial market specialists 8

9 The value of a workshop like this Cannot prevent you from making mistakes Can allow you to recognize your mistakes sooner Can allow you to learn from your mistakes faster 9

10 The starting point Futures contract specifications and mechanics The basic financial algebra of futures Challenges to correct valuation 10

11 Key contract specifications Notional value of 10,000 Rubles Short must deliver 10 (1,000 Ruble) bonds from the deliverable basket Invoice price is determined by the bond s conversion factor Deliverable basket is determined when the contract is listed for delivery 11

12 Contract Specifications OFZ2 Contract Symbol Contract Trading Symbol Contract Description Type Settlement OFZ O2Z1 Delivery futures contract on 2-year Russian Federation government bonds Futures Deliverable Contract size 10 First Trading Day Last Trading Day Delivery Settlement procedure Delivery of bonds by the conclusion of the direct trade on MICEX Government-Backed Securities Section Price tick 1 Cost of price tick 1 Lower limit 9,741 Upper limit 10,039 Settlement price of last clearing session 9,890 Initial Margin (IM, rub) 298 IM value on

13 Baskets of underlying bonds issues and conversion ratios Futures contract on 2-year Russian Federation government bonds Short contract code (settlement date): O2U Bond Maturity date Coupon rate Conversion ratio OFZ % OFZ % OFZ % For the purpose of calculating the conversion ratio the yield is 8.5%. Short contract code (settlement date): O2Z Bond Maturity date Coupon rate Conversion ratio OFZ % OFZ % OFZ % For the purpose of calculating the conversion ratio the yield is 7.0%.

14 Baskets of underlying bonds issues and conversion ratios Futures contract on 4-year Russian Federation government bonds Short contract code (settlement date): O4U Bond Maturity date Coupon rate Conversion ratio OFZ % OFZ % OFZ % For the purpose of calculating the conversion ratio, the bond yield is 8.5%. Short contract code (settlement date): O4Z Bond Maturity date Coupon rate Conversion ratio OFZ % OFZ % OFZ % OFZ % For the purpose of calculating the conversion ratio, the bond yield is 8.7%.

15 Variation margin and offsets Gains and losses on open positions are settled in cash daily You need not carry open positions to delivery instead, you can offset long positions by selling futures, or you can offset short positions by buying futures 15

16 Conversion factors The role of the conversion factor is to convert the futures price into an invoice price The conversion factor is the hypothetical price at which the bond would produce a yield chosen by the exchange The conversion factor is unique both to the bond and to the contract month 16

17 Baskets of underlying bonds issues and conversion ratios Futures contract on 2-year Russian Federation government bonds Short contract code (settlement date): O2U Bond Maturity date Coupon rate Conversion ratio OFZ % OFZ % OFZ % For the purpose of calculating the conversion ratio the yield is 8.5%. Short contract code (settlement date): O2Z Bond Maturity date Coupon rate Conversion ratio OFZ % OFZ % OFZ % For the purpose of calculating the conversion ratio the yield is 7.0%.

18 Invoice prices In a cash market trade, Full (dirty) price = Net (clean) price + accrued interest In a futures market delivery, Futures invoice price = Futures price x conversion factor + accrued interest The converted futures price takes the place of the net or clean market price 18

19 Futures are not forwards You buy and sell forwards, but go long and short futures (even so, we talk about buying and selling futures contracts) The short decides which bond to deliver Futures prices in general are lower than forward prices because of the short s delivery options Consider the deliverable basket 19

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21 Create a riskless asset Creating a synthetic money market instrument Today Futures delivery Buy the bond here at its market price plus today's accrued interest and sell futures at today's market futures price Sell the bond here at today's futures price times the bond's conversion factor plus accrued interest at futures delivery 21

22 Which bond is cheapest to deliver? Before expiration, the cheapest to deliver bond from the short s perspective is the bond with the highest implied repo rate* (I ve used a US money market day-count convention) At expiration, the bond with the lowest converted spot price is cheapest to deliver 22

23 March year bond basket 23

24 Spot/futures price spread The spread between a bond s spot price and its converted futures price is generally known as the basis This spread matters because its behavior affects the performance of everything you do with futures speculating, hedging, or arbitraging You need someone who knows how to value the spread correctly 24

25 Spot/futures price relationship for the cheapest to deliver 25

26 Challenges to correct valuation Access to market data Bond prices Term repo rates including repo specials for both buying and selling A complete understanding of the rules that govern delivery and invoicing (including the delivery schedule) 26

27 Repo rates 27

28 Yield levels and the ctd At expiry, the futures price is the lowest converted spot price. This chart assumes the hypothetical yield for calculating conversion factors is 6%. 28

29 Yield spreads and the ctd 29

30 Futures price before expiry 30

31 Shifts in the cheapest bond 31

32 March year bond basket 32

33 The value of the shift option: synthetic calls and puts 4-year bond prices as of March 2012 contract expiration Series Name RFBL 7 RFBL 6.88 RFBL 7.35 RFBL /03/15 07/15/15 01/20/16 08/03/16 Factor Yield Shift Converted prices at delivery CTD series Futures price at delivery Assign some probabilities to these shifts Basis net of carry at delivery/factor Shift

34 Synthetic options In this example, a long position in the March 12 basis of issue would be like a put option on bonds rising in value as yield rise and bond prices fall A long position in the basis of issue would be like a call A long position in the basis of issue would be like a straddle 34

35 Scenario analysis and the value of the short s delivery option How are yield (changes) distributed? How volatile are yields? How variable is the slope of the curve? Typically, a shift and twist analysis with a reasonable number of scenarios will do a good job of handling the variables that matter 35

36 Are futures rich or cheap? 36

37 Looking for cash/futures trades Looking for cash/futures trades Implied repo rates Actual Spread Trade date 2-year 4-year O/N 2-year 4-year 11/18/2011 0: % 3.22% 5.49% 0.25% -2.27% 11/17/2011 0: % 7.91% 5.42% -0.57% 2.49% 11/16/2011 0: % 8.66% 5.60% 0.45% 3.06% 11/15/2011 0: % 5.95% 5.65% 1.12% 0.30% 11/14/2011 0: % 8.93% 5.57% 0.78% 3.36% 11/11/2011 0: % 5.99% 5.38% 0.03% 0.61% 11/10/2011 0: % 6.23% 5.28% -0.76% 0.95% 11/9/2011 0: % 5.55% 5.36% -0.37% 0.19% 11/8/2011 0: % 5.45% 5.33% -0.96% 0.12% 11/7/2011 0: % 5.37% 5.44% -2.11% -0.07% 11/3/2011 0: % 4.05% 5.37% -1.27% -1.32% 11/2/2011 0: % 5.57% 5.56% -1.35% 0.01% 11/1/2011 0: % 3.56% 5.77% -0.68% -2.21% 10/31/2011 0: % 7.52% 5.74% 0.40% 1.78% 10/28/2011 0: % 11.23% 5.61% 1.34% 5.62% 10/27/2011 0: % 9.10% 5.75% 1.53% 3.35% 10/26/2011 0: % 6.84% 5.84% -0.15% 1.00% 10/25/2011 0: % 6.22% 5.71% 1.26% 0.51% 10/24/2011 0: % 6.43% 5.60% 1.42% 0.83% 10/21/2011 0: % 4.89% 5.57% -0.01% -0.68% 10/20/2011 0: % 4.32% 5.54% 0.11% -1.22% 10/19/2011 0: % 5.06% 5.49% 0.86% -0.43% 10/18/2011 0: % 6.61% 5.52% 0.37% 1.09% An implied repo rate higher than the actual repo rate suggests a cheap cash/futures spread. Cautions: Risk in O/N repo. Implied repo rates become increasingly sensitive to small price difference as you approach contract expiration. 37

38 Synthetic bonds A synthetic government bond can be created by combining Duration (or PV01) equivalent futures position Term money market instrument with a maturity equal to the futures contract s expiration date Possible opportunities for 1-way arbitrage by bank funding desks 38

39 Futures risk and return algebra Futures + cash = real bond Futures = real bond cash (i.e., a fully leveraged or geared position in the bond) Real bond futures = cash Futures profit/loss is the result of futures price change only Bond profit/loss is the result of bond price change, accrued coupon income, and actual or implied financing cost 39

40 Synthetic and real bonds The payoff on a synthetic bond is the sum of Changes in the value of the futures position Interest income on the term money market instrument The payoff on a real bond is the sum of Changes in the value of the bond Coupon income on the bond 40

41 Synthetic and real bonds (2) If futures are fairly priced, the total return to the real bond will equal the total return to the synthetic bond except for the cost of and payoff to any embedded delivery options 41

42 Uses of futures The RTS excellent summary of strategies includes uses that fall into three categories Directional/speculative (outright buys and sells and spreads) Hedging (actual and anticipatory, duration management) Arbitrage (cash/futures spreads, yield enhancement) 42

43 Directional strategies Buy futures in lieu of buying cash bonds to bet on a fall in interest rates Sell futures in lieu of shorting cash bonds to bet on a rise in interest rates Buy futures on one part of the curve (e.g., 2 years) and sell futures on another part of the curve (e.g., 4 years) to bet on a steepening of the yield curve 43

44 2-year and 4-year zero coupon yields

45 Comments on outrights Futures provide efficient access to the government bond market Relative richness or cheapness of the contracts may be relatively unimportant Comparing a futures trader s gains and losses with those of a cash bond trader s requires you to keep track of coupon income and financing costs 45

46 Comments on spreads You are trading the forward yield spread, not the spot yield spread Important to use the right contract ratios to isolate a trade on the slope (or shape) of the curve from a trade on the level of the curve (see next slide) Tricky to compare gain or loss on futures trade with gain or loss on equivalent spread trade done in the cash market 46

47 Constructing a yield curve trade Ruble values of a basis point (December 2011 contracts Date 2-year 4-year 11/18/ /17/ /16/ /15/ /14/ /11/ /10/ /9/ /8/ /7/ /3/ /2/ /1/ The notional or face value of a single contract is 10,000 rubles Each contract calls for the delivery of 10 bonds, each with a face value of 1,000 rubles To bet on a steepening of the yield curve, you would buy 2-year contracts and sell 4-year contracts If you use a ratio of 1:1, your net rv01 would be 1.84 rubles using the values for 11/18/11. To be rv01 or duration neutral, you would buy year contracts for each 2-year contract you sell 47

48 Workshop: Part 2 Hedging Cash/futures spreads Special topics 48

49 Hedging strategies Hedge a position against a rise in interest rates (great for dealers) Manage a portfolio s duration Manage a portfolio s exposure to a change in the slope of the curve Asset allocation Anticipatory hedges Expected bond issuance Expected cash inflow to be invested 49

50 Comments on hedging Why hedge? Why not sell the actual bond? If you do hedge, you can Sell the bond forward Sell a different bond in the spot market Sell a different bond forward Sell a bond futures contract 50

51 Hedges turn bonds into term money market instruments Convergence of the spot and futures prices reduces the bond s yield to a money market yield and may cost you the price of the delivery options 51

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54 Hedges never work perfectly The only perfect hedge is to sell the position All other hedges produce unexpected gains and losses Repo Changes in yield spreads Changes in cheapest to deliver bond Changes in the value of short s delivery options 54

55 Competing Hedge Ratios 55

56 Hedge a spot position Excellent for dealers who want to underwrite a large cash position while in the process of sales and distribution Experience shows the cash markets are always more liquid when futures markets are open than when they are closed (or only lightly traded) 56

57 Manage a portfolio s duration One great advantage of futures is that you can control exposure to a change in the general level of interest rates without undoing a well constructed portfolio Another is that you can extend the duration of the portfolio beyond what is available in conventional bond markets 57

58 Manage exposure to the curve In many cases, an investor cares about his exposure to a change in the slope of the yield curve The availability of bond futures at three points on the Russian government bond yield curve makes it possible to take a more nuanced approach to controlling interest rate risk 58

59 2-year and 4-year zero coupon yields

60 Asset allocation An extension of the duration management argument is that one can use futures to change the exposure of an entire portfolio to stocks and bonds (and to commodities and, possibly, foreign currencies) without touching the actual portfolio Futures overlay programs also allow you to create portable alpha products 60

61 Anticipatory: Expected issue The sale of futures can provide protection against a rise in interest rates between now and when you plan to do a bond offering Comment: the futures sale will protect you against a change in the government bond rate but not against a widening of your spread against government bond yields 61

62 Anticipatory: Expected cash inflow The flip side of the expected issue problem is the expected investment problem that is, an inflow of cash that you intend to invest at a fixed rate 62

63 Cash/futures spreads Creating synthetic term cash Buying or selling mispriced cash/futures spreads Using synthetic bonds to enhance portfolio yields 63

64 Synthetic term cash Buying bonds and selling bond futures creates a synthetic short-term bond with a maturity coinciding with the futures settlement date Similar to a reverse repo trade where cash is lent against a pledge of securities Reverse the trade to borrow synthetically 64

65 Looking for cash/futures trades Looking for cash/futures trades Implied repo rates Actual Spread Trade date 2-year 4-year O/N 2-year 4-year 11/18/2011 0: % 3.22% 5.49% 0.25% -2.27% 11/17/2011 0: % 7.91% 5.42% -0.57% 2.49% 11/16/2011 0: % 8.66% 5.60% 0.45% 3.06% 11/15/2011 0: % 5.95% 5.65% 1.12% 0.30% 11/14/2011 0: % 8.93% 5.57% 0.78% 3.36% 11/11/2011 0: % 5.99% 5.38% 0.03% 0.61% 11/10/2011 0: % 6.23% 5.28% -0.76% 0.95% 11/9/2011 0: % 5.55% 5.36% -0.37% 0.19% 11/8/2011 0: % 5.45% 5.33% -0.96% 0.12% 11/7/2011 0: % 5.37% 5.44% -2.11% -0.07% 11/3/2011 0: % 4.05% 5.37% -1.27% -1.32% 11/2/2011 0: % 5.57% 5.56% -1.35% 0.01% 11/1/2011 0: % 3.56% 5.77% -0.68% -2.21% 10/31/2011 0: % 7.52% 5.74% 0.40% 1.78% 10/28/2011 0: % 11.23% 5.61% 1.34% 5.62% 10/27/2011 0: % 9.10% 5.75% 1.53% 3.35% 10/26/2011 0: % 6.84% 5.84% -0.15% 1.00% 10/25/2011 0: % 6.22% 5.71% 1.26% 0.51% 10/24/2011 0: % 6.43% 5.60% 1.42% 0.83% 10/21/2011 0: % 4.89% 5.57% -0.01% -0.68% 10/20/2011 0: % 4.32% 5.54% 0.11% -1.22% 10/19/2011 0: % 5.06% 5.49% 0.86% -0.43% 10/18/2011 0: % 6.61% 5.52% 0.37% 1.09% An implied repo rate higher than the actual repo rate suggests a cheap cash/futures spread. Cautions: Risk in O/N repo. Implied repo rates become increasingly sensitive to small price difference as you approach contract expiration. 65

66 Strategy: Buy or sell cash/futures spread Cash and Carry (if futures are rich) Purchase bonds and sell futures If income exceeds the funding cost (or, if losses from convergence are less than your positive carry), an arbitrage profit is realized Sell the spread (if futures are cheap) Sell bonds and buy futures If gains from convergence exceed your negative carry, an arbitrage profit is realized 66

67 Trades when futures are cheap Sell bonds/buy futures (i.e., sell the basis) Replace expensive bonds with synthetic bonds (yield enhancement) Treasury bond futures cheap in late 1980s Treasury note futures and Bund futures cheap in early 1990s Treasury note futures cheap in early 2000s 67

68 Government Securities Positions in Bonds and Bond Futures 68

69 Selling the cash/futures spread Sell the bond short (overnight or term repo) Buy an appropriate number of futures Experience selling the 10-year Treasury note basis during the early 2000s The problem with selling the bond basis in the spring of 1986 (and other squeezes) 69

70 Example of selling the basis 70

71 Selling the 10-year basis,

72 Selling the 10-year basis:

73 Selling the 10-year basis:

74 Yield enhancement (1) 74

75 Yield enhancement (2) 75

76 Additional topics Power of forward pricing Squeezes Importance of financing Absence of a term repo market Managing the rolls Fails 76

77 The power of forward pricing Forward yield curves are better behaved than spot yield curves Forward prices are breakeven prices Forward price relationships reveal opportunities that are not apparent in the spot market (when a friend bought the forward TED for 0 basis points) 77

78 Spot and forward curves 78

79 Buying the forward ted for free To buy the ted spread, you buy Treasuries and sell Eurodollar futures You can trade the spread forward by using term repo to buy the Treasuries How could the spread have been free? 79

80 Squeezes Short squeezes are the most common Long squeezes are possible 80

81 Financing is half the battle Easily half the difference between a spot trade and an equivalent futures trade can be explained by financing Have someone on the team who knows repo markets inside and out Know where the collateral is The repo desk will be the last profitable desk in the financial world 81

82 Absence of a term repo market Absence of a term repo market makes it difficult to value futures properly On the other hand, one might create a synthetic term money market instrument (buy bond/sell futures), finance it in the overnight market with an eye to profiting from the spread between the implied term rate and the sequence of overnight rates 82

83 Managing the rolls Anyone who maintains long or short futures positions for extended periods of time will need to deal with contract rolls that is, the replacement of an expiring position in one contract month with an open position in the next contract month Managing these rolls correctly can, depending on how the market treats them, either save you or make you a great deal 83

84 Fails Fails in the futures market are penalized heavily while fails in the spot market can be normal practice It is extremely important to know the rules governing deliveries in the futures market if you intend to take positions to delivery 84

85 Special topics in short-term rates Riding the yield curve Stub risk 85

86 Insights into cash and carry Money market futures (e.g., Eurodollar futures) allow one to disaggregate the deposit curve to understand how standard banking trades makes money The following slide shows the payoff to borrowing short and lending long This payoff, in turn, would be a cost of maintaining a short position 86

87 Riding the yield curve 87

88 Stub risk Stub risk is the risk associated with term financing from today until contract expiration Changes in repo rates are largely unrelated to changes in bond yields Useful to know when deciding how to construct your hedge 88

89 Sources of interest rate risk 89

90 Level and changes, 5-years 90

91 Eras of the US Treasury bond basis Cash and carry ( ) Negative yield curve ( ) Positive yield curve ( ) Golden age of yield enhancement ( ) Volatility arbitrage ( ) 91

92 Eras of the US Treasury bond basis Death of gamma ( ) Callables last hurrah ( ) The long dry spell of the 11-1/4s ( ) 6% factors and the rebirth of bond basis trading (2000 -?) 92

93 More eras? The ultra bond contract A new dry spell? 93

94 Conclusion For more information, see Burghardt, Belton, Lane, and Papa, The Treasury Bond Basis, 3 rd edition (McGraw-Hill) Questions? 94

95 Disclaimer Global Promotional Material Disclaimer This document has been produced for information purposes only and is not to be construed as an offer to buy or sell any financial instrument or security. All information, prices or projections are subject to change without notice. Newedge makes no representation or warranty that the information contained herein is accurate, complete, fair or correct or that any transaction is appropriate for any person and it should not be relied on as such. The opinions, views and forecasts expressed herein reflect the personal views of the author(s) and do not necessarily reflect the views of Newedge. Some financial products and investments are subject to fluctuations in price and or value and investors may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large declines in value that could equal or exceed the amount invested. Futures and options, as well as certain other financial instruments, are speculative products and the risk of loss can be substantial. Consequently only risk capital should be used to trade futures and options and other speculative products. Investors should fully understand the risks and potential losses and seek their own independent investment and trading advice having regard to their objectives, financial situation and needs. This information is not intended to be construed as investment advice. We do not accept any liability or loss or damage arising from any inaccuracy or omission in or the use of or reliance on the information in this document. Due to international regulations not all financial instruments/services may be available to all clients. You should be aware of and observe any such restrictions when considering a potential investment decision. THE DISTRIBUTION OF THIS DOCUMENT IN OTHER JURISDICTIONS MAY BE PROHIBITED OR RESTRICTED BY LAW, AND PERSONS INTO WHOSE POSSESSION THIS REPORT COMES SHOULD INFORM THEMSELVES ABOUT AND OBSERVE ANY SUCH PROHIBITION OR RESTRICTIONS. BY ACCEPTING THIS REPORT YOU AGREE TO BE BOUND BY THE FOREGOING. 95