Introduction to Interest Rate Trading. Andrew Wilkinson

Transcription

1 Introduction to Interest Rate Trading Andrew Wilkinson

2 Risk Disclosure Futures are not suitable for all investors. The amount you may lose may be greater than your initial investment. Before trading futures, please read the CFTC Risk Disclosure. For a copy, call (203) Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. Past performance is not a guarantee of future results. Interactive Brokers LLC is a member of NYSE, FINRA, SIPC

3 Monetary Policy Central banks set monetary policy Includes level of interest rates Provision of liquidity Money supply The outright benchmark or key rate is important So to is the yield curve

4 Factors Influencing Monetary Policy Growth Inflation Employment Retail Sales Housing market Business and consumer confidence Exchange rate For a full discussion see Introduction to FX

5 The Yield Curve The shape depicting the time horizon of money Key to understanding this is that interest rates are market determined outside of central bank Look at the price of money from one-to to-12 months Yield curve can be positive or negative

6 A Normal Yield Curve 6.20% 6.00% 5.80% 5.60% 5.40% 5.20% 5.00% 4.80% 4.60% 4.40% Jun- 07 Jul-07 Aug- 07 Sep- 07 Oct-07 Nov- 07 Dec- 07 Jan- 08 Feb- 08 Mar- 08 Apr- 08 May- 08 Jun- 08

7 Short & Long Term Rates Short end of the curve out to two years Long term rates would be two-to to-30 years Short term price of money is found at banks in cash deposit rates, CD rates etc. Long term rates are synonymous with five-plus year auto loans, mortgages etc. and priced off government debt prices

8 What Instruments Reflect Interest Rates? Investors use cash yields, CDs, notes and bonds as safe places for keeping liquid funds Speculators look at the price of money differently Short-term term interest rate futures (three month duration) Two, five and 10-year notes Cash Futures Options on the above

9 Products and Trading Each country (economic area) has its own short term rate of interest Of interest to us is the price of money and its relationship with current futures pricing We are also interested in the relationship between one price-point point on the chart and other price points on the chart We are interested in the relationship over time between one market and another

10 Summary Money market rates versus central bank policy Intra-market spreads Inter-market spreads AT ALL TIMES: Shape of the curve

11 United States Symbol 3 month eurodollar GE 2 year note ZT 5 year note ZF 10 year note ZN CME CBOT CBOT CBOT

12 United Kingdom Symbol 3 mth short sterling Long gilt L R London International Financial Futures & Options Exchange LIFFE

13 European Currency Symbol 3 mth Euribor Euro Schatz (2yr) Euro BOBL Euro Bund (5yr) (10yr) EU3 GBS GBM GBL LIFFE EUREX EUREX EUREX

14 Canada 3 mth BA s Symbol BAX CGB Cad 10yr Govt Bond CGB Montreal Exchange

15 Australia Symbol 90-day bills Aus10yr Govt Bond IR XT Sydney Futures Exchange

16 Short Interest Rate Futures A contract settled against a benchmark rate (LIBOR) London Interbank Offered Rate A contract covers a nominal $1 million (approx in others) Represents the price of 3-month 3 money Proxy for current national benchmark rate Futures represent traders best estimates of where 3-3 month money will be across a time horizon Predictions of futures pricing are what makes for a moving market

17 Short Interest Rate Futures Price is quoted as minus the rate of interest If current fed funds rate is 5.25% the implied futures price is: = So interest rate futures BUYERS are bulls and want rates to fall Futures SELLERS are bears and expect interest rates to rise What implied futures price if the Fed raised rates to 6%?

18 Short Interest Rate Futures Contract Months Current Year September 07 December 07 March 08 June 08 Settlement is usually third Wednesday of expiring month Next Year (2008) September 08 December 08 March 09 June 09 Following Year (2009) September 09 December 09 March 10 June 10

19 Current Futures Strips Euro$ Sterling Euro Euro$ Sterling Euro Sep Sep Dec Dec Mar Mar Jun Jun Sep Sep Dec Dec Mar Mar Jun Jun Sep Sep Dec Dec

20 Nov-09 Jul-09 Sep-09 May Euro$ Yield Curve Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 Jan-08 Nov-07 Sep-07

21 Eurodollars December 2007 eurodollar future = Implies 3-month 3 LIBOR will be 5.28% in December Q> What would one do if you believed the Fed would RAISE interest rates by a half percent before then?

22 Eurodollars A> You d d sell a December 2007 eurodollar future at in the expectation that it would trade towards Current fed funds of 5.25% up to 5.75% minus 5.75% = The 2500 multiplier times the increment of yields a tick value of $12.5 Value of this movement would be $12.50 * 94 = $1,175

23 Eurodollars Conversely, if your expectation is for the Fed to reduce rates by ¼ point by year end BUY December 07 eurodollar future From the three month contract should rise to around (since minus 5.00 = 95.00)

24 Trade Size Warning! Warning: Interest rates are less volatile than they used to be thanks to: Controlled global inflation Tendency towards inverted yield curve Global savings glut U.S. trade imbalance Wealth of oil exporters and dollar recycling Check Margin And Trade Enough Size

25 Eurodollar Summary Interest rate markets are very active and react to daily data Don t t think that since official rates may only change several times per year that no action exists! More than anything, remember that here we are trading: Expectations Perceptions Sometimes, one step away from reality A good trader will piece it all together and be ahead of the curve

26 Eurodollar Spread Trading A single eurodollar contract is one piece of the jigsaw Represents just one point in time Yield curves shift up or down Outright directional movement They also behave like a piece of elastic Relative movement Let s s consider the relationship between two points in time December 2007 future December 2008 future

27 Eurodollar Spreads December 2007 future = (5.28%) December 2008 future = (5.25%) At present, very little between them (curve is flat) But the history reveals vastly different picture Two aspects to this type of trade: Forces the trader to watch the yield curve Requires some relative out performance and therefore precision Long versus short combination also requires less margin

28 Eurodollar Spreads Spread loosely defined is the current best guess of what shape the t yield curve will have between two future timeframes (future versus future) Concept: Use buy and sell to refer to the furthest contract Order: Sell spread (buy near contract) and (sell far contract ) Buy spread (sell near contract) and (buy far contract ) Spread seller looks for out performance of front month relative to far month curve steepening trade Spread buyer looks for out performance of far month relative to front month - curve flattening trade

29 Eurodollar Spreads Consider a yield curve across Dec 07 and Dec 08 contracts where both are priced at (5.25%) Trader expects one Fed hike soon to ice the rate rising cycle Thereafter expects rate market to discount half percent easing over the course of 12 months Sees Dec 07 falling to (5.50%) Sees Dec 08 rising to (5.00%)

30 Eurodollar Spreads Market Implied Trader's Expectation 6.20% 6.00% 5.80% 5.60% 5.40% 5.20% 5.00% 4.80% 4.60% 4.40% Dec- 07 Jan-08 Feb- 08 Mar- 08 Apr-08 May- 08 Jun- 08 Jul-08 Aug- 08 Sep- 08 Oct-08 Nov- 08 Dec- 08

31 Eurodollar Spreads Trader buys the spread at zero (both futures prices same) Sell Dec Buy Dec Thereafter the Fed does raise rates sending current rates to 5.50% (94.50) Market anticipates no more and begins to price in a 50 basis point cut sending Dec 08 future to (5.00%)

32 Eurodollar Spreads Profit and loss on trade Trade established at zero Trade closed at (95.00 minus 94.50) Short Dec Cover = +0.25/0.005* $12.5 = $625 Long Dec Sell = +0.25/0.005*$12.5 = $625 Total gain = $625 + $625 = $1,250

33 Inter-Market Spreads In review: buy/sell eurodollar futures hoping to profit from anticipating interest rate market developments Monitor the yield curve Position spread trades to benefit from anticipated curve movements over time (intra-market spreads) But how to trade American interest rate expectations versus rate expectations in any other country? Inter-Market spreads!

34 Inter-Market Spreads Theory is similar to intra-market spreads Buy one currency curve and sell another Why? Anticipate market specific development in one nation Expect excessive change in inflation profile Notice a central bank in/out of control Currency related strengthening/weakening impact economy hard

35 Inter-Market Spreads Example: U.S. versus U.K. Trader expect British rates to keep on rising while U.S. rates stay on hold due to: Stronger inflation in U.K. Housing price pressures in U.K. versus weakness in U.S. Faster economic growth in Europe versus U.S. Current British base rate = 5.50% (94.50) Current U.S. rate = 5.25% (94.75) Where will year-end end rates be by Dec 07?

36 Inter-Market Spreads More important question is, where are futures now? Dec 07 3-month 3 short (= 6.25%) Dec 07 eurodollar (= 5.25%) Official rates are just 0.25% apart in favor of U.K. Expectations are that by year end they will widen to 1% What could the trader do?

37 8/23/07 7/24/ Inter-Market Spreads Spread UK over US (bps) 12/26/06 1/25/07 2/24/07 3/26/07 4/25/07 5/25/07 6/24/07 11/26/06 10/27/06 9/27/06 8/28/06

38 Inter-Market Spreads Higher inflation rate in U.K. and legacy of weak currency Traditionally higher interest rate economy Fed prepared to move aggressively But look at historic differential between official rates

39 7/11/00 7/11/01 7/11/02 7/11/03 7/11/04 7/11/05 7/11/99 7/11/ UK-US Benchmark Spread A A- B Fed raises rates B 7/11/06 7/11/97

40 Bond Trading Same principles apply to government debt trading Very liquid markets Outright trading and directional trading Spread trading Can be divorced from CB policy

41 Cash Bond Trading Focus on futures, but cash bonds are also common More for medium-long term positioning Focus on income Consider: Coupon Yield Maturity Cheapest-to to-deliver concept

42 Locating Ticker Symbols on the Website Look up icon on TWS toolbar Product listing under website Futures

43 Conclusions Money markets actually more integral to investing than the stock markets Plenty to keep your eye on if you want to venture into interest rate trading

44 Questions?