debt markets macquarie bank group bond futures trading practice paul bide head of debt markets...
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Debt Markets
Macquarie Bank Group
Bond Futures Trading Practice
Paul Bide
Head of Debt Markets Research
Macquarie Bank Limited, Australia
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Debt Markets
Macquarie Bank Group
The Australian Bond Market
Government Bonds A$80bn
State Government Bonds A$35bn
Non-Government Bonds A$35bn (investment grade)
A$150bn
30% of Government bonds are owned by non-residents
Only about 10-15% of Non-Government bonds are held by non-residents
Most futures trading is done by residents of Australia. It is based on trading against bonds and other instruments.
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Debt Markets
Macquarie Bank Group
Who uses futures?
funds managers
insurance companies/pension funds
swap bookrunners
fixed income bookrunners
traders
arbitragers
option books
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Debt Markets
Macquarie Bank Group
What are futures used for?
Portfolio Managementlarge pension funds use futures to alter duration or yield curve exposure without realising taxable gains.
Hedging fixed income bookrunning riskmost fixed income books offset physical bond positions with futures and leave
their portfolios hedged
Bond/futures arbitrage opportunitiesmany traders arbitrage the bond basket to futures relative value differences if
they exist.
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Debt Markets
Macquarie Bank Group
How important are futures to the market?
In Australia, the futures market is the primary market where income exposure is traded
It is important to the liquidity of our financial system
It is liquid, transparent and easily identifiable
It promotes liquidity, enables efficient risk management and allows for an easy price discovery process
Futures have helped the Australian marketplace to mature and gr
ow
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Debt Markets
Macquarie Bank Group
How is a bond futures price calculated?
1. Calculate the forward yield of the bonds in the basket
2. Average the forward yield of the bonds in the basket. (Normally 4 bonds)
3. Deduct that forward yield from 100
Australian futures imply a price but are actually an implied yield of a basket of bonds
US futures are a price
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Debt Markets
Macquarie Bank Group
How is a bond futures contract “cashed out”?
1. On close-out day, the SFE takes market samplings of the bond price of the bonds in the basket.
2. It takes samplings at 3 different times of the day - 9.45am, 10.30am and 11.15am. This is to prevent pricing disto
rtions and manipulations. The times are designed to avoid monetary policy statements (9.30am) and Australian Government statistical releases (11.30am).
3. The SFE ask 8-10 bond market bookrunners for the price of the bonds in the basket, then knocks out the high and
low, then averages the rest. This is also to avoid manipulation and distortion.
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Debt Markets
Macquarie Bank Group
What is an arbitrage?
An arbitrage is an opportunity to profit from buying one instrument / selling another without incurring market risk.
A bond basket - futures arbitrage involves locking in the futures (which is made up of the basket of bonds) to the physical bonds in the basket.
On close out day, these two are equal by definition.
The difference between the future’s price and the forward yields of the bonds is arbitrage profit that can be captured.
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Debt Markets
Macquarie Bank Group
What do you need to do an arbitrage?
Access to the repo market for bonds.
The repo market not only facilitates two way price making in bonds. It also allows you to lock in funding to the futures close out date.
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Debt Markets
Macquarie Bank Group
Why is the repo important?
Because an arbitrage is done by buying or selling bonds forward against a short or long futures position.
The forward bond position must be locked in (via a repo) or it is not an arbitrage. Funding levels may change and what was assumed to be arbitrage profit will turn into a loss if that happens.
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Debt Markets
Macquarie Bank Group
What happens on close out day if you are unwinding an arbitrage?
1. Futures close out price determined
2. Bonds bought or sold against futures position are squared ou
t
3. Futures positions is cashed out against futures close
4. Profit from arbitrage trade is cash
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Debt Markets
Macquarie Bank Group
How does cash settlement work?
Yield of a futures position is used to calculate the implied price of a futures contract ($100,000 face value of bonds) using the Reserve Bank of Australia bond formula.
Implied price of offsetting bond futures position at close out price is calculated in the same manner.
One is settled against the other. Hence the term, cash settlement.
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Debt Markets
Macquarie Bank Group
Appendix - Calculating a forward yield
Australian Government bond 7½ September 2009
Spot yield 6.27%face value $1,000,000cost (spot) $1,091,290repo rate 4.40% (1month)
interest on 1,091,290 x 4.4 x 31 = $4,078100 365
forward price of bond = spot price + repo charge
1,091,2904,078
$1,095,368
implied forward yield 6.29% (calculated by working back from bond formula)
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Debt Markets
Macquarie Bank Group
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