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Chapter 16 - IR Portfolios and Position Taking – 1 933 16.2.5 A Bond/Curve Spread: The NoB Section 16.2.2 discussed calendar or rotation/slope spread in terms of ED futures. Slope spreads may be expressed along any segment of a curve. A very common slope spread trade is between Notes and Bonds. Depending on the country/exchange, the most common variation of this is spreads are: Between 2-year cash bonds (notes) or 2-year bond (note) futures against 10-year bonds (notes) or 10-year bond (note) futures. These are generally referred to as 2’s/10’s Between 5-year cash bonds (notes) or 5-year bond (note) futures against 10-year bonds (notes) or 10-year bond (note) futures. These are generally referred to as 5’s/10’s Between 10-year cash bonds (notes) or 10-year bond (note) futures against 30-year bonds (notes) or 30-year bond (note) futures. These are generally referred to as 10’s/30’s In the US, this type of spread trading is so common that some spreads are traded effectively as single instruments. For example, the so-called Notes-over-Bonds (NoB’s) futures spread trades as a single (spread) instrument 393 . Instruments representing structures, such as spreads or averages, have important practical advantages. Generally, transactions costs are lower since the entire spread is transacted on a single bid/offer spread. Margining is (relativity) lower due to the offsetting nature of the spread’s “internals”. All of the risk associated with legging-in and –out is eliminated. In fact, calendar rolling (when moving from, say, the Dec’s to the March’s) is also of lower relative “roll risk”. Indeed there may be very special advantages for options traders. For example, and spread options on an underlying that trades as a spread is very much easier to price and risk management compared to spread option with an underlying that must be synthesised (more on this in [9]). Unlike the deposit futures calendar spread, the note/bond spreads have added complications. Notably, the depo futures have a linear V01, notes and bonds do not. As discussed previously, this may seem odd at first, since exchanges set the price of note and bond futures to have constant tick value. However, in the case of notes and bonds the constant tick value is in terms of price, not yield. That is, if a bond futures price changes by 1 tick then the P&L impact is known immediately (e.g. for T-Bonds its 31.25/contract per 393 Sometimes, “synthesised” instruments are created explicitly by exchanges. In other cases, the locals/market makers create the synthetic, as with NoB’s.

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Page 1: 16.2.5 A Bond/Curve Spread: The NoB - ARTWeb Home€¦ · 16.2.5 A Bond/Curve Spread: The NoB ... In the US, this type of spread trading is so common that some spreads are traded

Chapter 16 - IR Portfolios and Position Taking – 1 933

16.2.5 A Bond/Curve Spread: The NoB Section 16.2.2 discussed calendar or rotation/slope spread in terms of ED futures. Slope spreads may be expressed along any segment of a curve. A very common slope spread trade is between Notes and Bonds. Depending on the country/exchange, the most common variation of this is spreads are:

• Between 2-year cash bonds (notes) or 2-year bond (note) futures against 10-year bonds (notes) or 10-year bond (note) futures. These are generally referred to as 2’s/10’s

• Between 5-year cash bonds (notes) or 5-year bond (note) futures against 10-year bonds (notes) or 10-year bond (note) futures. These are generally referred to as 5’s/10’s

• Between 10-year cash bonds (notes) or 10-year bond (note) futures against 30-year bonds (notes) or 30-year bond (note) futures. These are generally referred to as 10’s/30’s

In the US, this type of spread trading is so common that some spreads are traded effectively as single instruments. For example, the so-called Notes-over-Bonds (NoB’s) futures spread trades as a single (spread) instrument393.

Instruments representing structures, such as spreads or averages, have important practical advantages. Generally, transactions costs are lower since the entire spread is transacted on a single bid/offer spread. Margining is (relativity) lower due to the offsetting nature of the spread’s “internals”. All of the risk associated with legging-in and –out is eliminated. In fact, calendar rolling (when moving from, say, the Dec’s to the March’s) is also of lower relative “roll risk”. Indeed there may be very special advantages for options traders. For example, and spread options on an underlying that trades as a spread is very much easier to price and risk management compared to spread option with an underlying that must be synthesised (more on this in [9]). Unlike the deposit futures calendar spread, the note/bond spreads have added complications. Notably, the depo futures have a linear V01, notes and bonds do not. As discussed previously, this may seem odd at first, since exchanges set the price of note and bond futures to have constant tick value. However, in the case of notes and bonds the constant tick value is in terms of price, not yield. That is, if a bond futures price changes by 1 tick then the P&L impact is known immediately (e.g. for T-Bonds its 31.25/contract per

393 Sometimes, “synthesised” instruments are created explicitly by exchanges. In other cases, the locals/market makers create the synthetic, as with NoB’s.

Page 2: 16.2.5 A Bond/Curve Spread: The NoB - ARTWeb Home€¦ · 16.2.5 A Bond/Curve Spread: The NoB ... In the US, this type of spread trading is so common that some spreads are traded

934 A Trader’s Guide to: Bonds Swaps & IR Instruments – Vol 1

tick, where a tick 1/32nd). Crucially, this in not the V01 in the usual sense. To obtain a bond future’s V01, one must shift the underlying (cash) bond’s IRR by 1 bps, and then re-calculate the futures price (and only then apply the tick-value formula). This matters are detailed in Chapter 11. A notable consequence of this is that, say, a 10-year notes of note future’s V01 will not equal a, say, 30-year bond’s V01. This now raises the question of the “correct weighting” of the spread. For example, should a NoB be composed of an equal number of long (short) T-Note futures to short (long) T-Bond futures, or should some other weighting scheme be used. The answer to this depends on the ultimate objective of the trade. For example, a hedger or market maker may have a bucket report showing the need to reduce rotation risk between the 10-year and 30-year buckets. Here, the weighting must precisely the hedge ratio as implied by the usual sensitivity ratio calculations. An investor, or perhaps a hedger “anticipating” risk394, may be taking a view on the rotation of the curve. For example, suppose that current 10’s/30’s yield spread is 12 bps. Suppose that the trader has the view that this spread will widen, say to 20 bps. How can this view be exploited? The image below shows a position composed of 10-year and a 30year bond (cash bonds used for clarity, as this avoid extra layer of futures calculation, but the results are comparable).

Traded Instrument 1 Traded Instrument 2 SpreadIssue Date 23-Mar-07 Issue Date 23-Mar-07

Settlement/Trade 21-Jun-07 DPY 365 Settlement/Trade 21-Jun-07 DPY 365Maturity 20-Mar-17 10 years Maturity 15-Mar-37 30 yearsCoupon 7.00% Coupon 7.50%

IRR (B/O) 7.53% 7.51% IRR (B/O) 7.65% 7.63%Frequency 2 Frequency 2

Basis 0 Basis 0

Accrued Int 1.711 Accrued Int 1.833Clean Price (B/O) 96.370 96.503 Clean Price (B/O) 98.232 98.463Dirty Price (B/O) 98.081 98.214 Dirty Price (B/O) 99.943 100.174

"Risk Capital" 10,000,000"Captial Limit/Trade" 5.00% 47,500.28

0.6 Notional 300,000 Within Market Risk 1 0.6 Notional 300,000 Within Market Risk

Traded Yield 7.52% Traded Yield 7.64% 0.12%Traded Price 96.436 Traded Price 98.347

J21+L25Duration 7.0460 Duration 11.9241V01 (Up) -0.0667 96.370 0.0001 V01 (Up) -0.1151 98.232 0.0001

M2M Yield 7.53% M2M Yield 7.63% 0.10%M2M Price 96.370 M2M Price 98.463M2M P&L -199.98 M2M P&L 346.09

Equal

394 As always, at what point is a hedger a punter? This is not to say that hedgers should not take views, and indeed, in some cases it is not possible to avoid taking “some” view. However, it should be clear when risk is being taken, the extent to which it is being taken, and that it is consistent with the risk/return and mandate parameters.