A guide to trading US and Au bond futures

KEIRAN HORTH & GUY BOWER

PRICING AND CHARTING
YIELD CURVE
SPREADS
Propex Derivatives. Horth & Bower


Contents
1. Basic Definitions
2. Using DV01s
3. Calculating Hedge Ratios
4. Directional Spreading Versus Hedging
5. Changing Slope of the Yield Curve
6. Factors Affecting the Shape of the Yield Curve
7. Charting Your Spread
8. Filtering Data
9. Alternate Method of Charting a Spread
10. Varying the Spread Ratio
11. Trading the Spread
12. When is a Spread Not a Spread
13. Some Spreading Research Ideas
14. Contract Specs and Trading Information


Disclaimer
Trading involves high risks, with potential for profits as well as substantial losses and is not suitable for all persons. No
information in this document or related material should be considered advice or any kind. Propex suggest you seek
advice from an independent investment professional as to the suitability of trading for your personal needs.
Propex Derivatives Pty Ltd. Level 4, 299 Elizabeth Street, Sydney NSW 2000.
Propex Derivatives Pty Ltd (Propex) is a Proprietary Full Participant of the Sydney Futures Exchange.
Propex Derivatives. Horth & Bower
Introduction

OK, lets talk relative value. Spread trading is all about relative value. Spread trading is
all about understanding how two (or more) markets relate to each other and
recognising when there is opportunity based on current levels or a view on the future.

Here we are going to look at some interest rate spreads, how to price them and how to
chart them.

For the newcomer, it is easy to get prices and yields mixed up given their inverse
relationship. When charting spreads, the convention is to use price. When looking at
yield curves the convention is to consider yield not price. As you go through this
document, these things can get a little confusing. One trick to understand is to map out
the concept with a pen and paper.

Basic Definitions

Intermarket Spread - Spreading one market versus another. For example Aussie 3yr
bonds versus Aussie 10yr bonds.

Interexchange Spread Spreading one market versus another from a different
exchange. For example Aussie 10yrs versus the US Tnote.

Steepener Spread Buying the near and selling the far. For example, long 10 Jun
Eurodollar, short 10 Dec Eurodollar.

Flattener Spread Selling the near and buying the far. For example, short 10 Jun
Eurodollar, short 10 Eurodollar Gold.

Butterfly Combination of flattener and a steepener spread that share a common leg.
For example:
Long 5 Mar Eurodollars and short 5 June Eurodollars
Plus
Short 5 June Eurodollars and long 5 Sep Eurodollars = bull

Consolidating the June positions we have
Long 5 Mar + Short 10 June + Long 5 Sep


Using DV01s

Why do we need to know our DV01s? Boiled down, it allows us to compare one interest
rate security with another even if those securities are traded on different exchanges or
in different currencies. The DV01 is used to calculate hedge ratios for spread positions
and derive a standardized format for charting spreads.
Propex Derivatives. Horth & Bower

Firstly, the definition - The DV01 is a dollar value calculated for an interest rate security
that represents the change in price given a one basis point change in yield.

We all know this relationship:


That is prices are inverse to yield, but what is the exact relationship. If we are going to
spread one market versus another, we need to know the exact relationship.

Thats what DV01s tells us. It is the dollar value change in price of a $100,000 security
given a fixed one basis point change in yield.

Aussie Bond DV01s
The SFE bond futures are quoted:
Price = 100 - yield

Therefore the DV01 is simply the same as the value of a 0.01 move. Currently, these are:

Contract DV01 in AUD DV01s in USD
AU 3s: $29.82 $31.01
AU 10s: $91.31 $94.96

The pricing convention for Aussie bond futures is the same as most short-term interest
rate futures around the world such as Eurodollar and Euribor. Therefore the DV01 for
these short term securities is also simply the tick value for a $100,000 equivalent.

US Treasuries
Its a little hard to calculate DV01s for Treasuries given they are quoted in price not
yield. To calculate the DV01s requires the use of the bond pricing formula. The easier
way is to look them up on Bloomberg or directly from the CME site:
http://www.cmegroup.com/trading/interest-rates/duration.html

Currently we have:
Contract DV01 32nds
2yr note: $21.56 0.68992
5yr note: $52.34 1.67488
10yr note: $80.70 2.5824
30yr bond: $159.60 5.1072

These numbers essentially show the change in price of the respective bond futures
contract given a 1 basis point shift in the yield curve.
Propex Derivatives. Horth & Bower

The 32nds column shows the theoretical move in price, expressed in 32nds in the
treasury contract given that 1 basis point move. For example the 30yr bond price would
theoretically move just over five 32nds whereas the 10yr note would move half as much
given a 1bp shift in the curve.


Calculating Hedge Ratios

You can think of a DV01 as a measure of volatility. With that in mind we use DV01s of
related securities (eg 10s and 30s) to calculate the ideal ratio of contracts to use when
spreading the two as a hedge or speculative position.

So staying within the same currency, the hedge ratio for one Treasury versus another is
simply the ratio of one DV01 versus the other.

Consider this table:
2yrs 5yrs 10yrs 30yrs
2yrs 1.00 0.41 0.27 0.14
5yrs 2.43 1.00 0.65 0.33
10yrs 3.74 1.54 1.00 0.51
30yrs 7.40 3.05 1.98 1.00

This shows the theoretical hedge ratios for any combination of Treasury contracts. For
example to trade the 2:5 spread, you would trade 2.43 2yr contracts for every 5yr. To
trade the 10:30 spread, you would trade 1.98 10yrs for every one 30yr.

For spreading interest rate products, this is the place to start.

Now lets add the Aussie bonds. Again, these are simply the ratios of one DV01 to the
next. For the Aussie bonds, we will use the USD converted DV01s.

Au3yrs Au10yrs
Au3yrs 1.00 0.33
Au10yrs 3.06 1.00
2yrs 0.70 0.23
5yrs 1.69 0.55
10yrs 2.60 0.85
30yrs 5.15 1.68

This table says we need to trade 3.06 Au3yrs for every Au one 10yr for example, or 0.85
Au10yrs for every 1 US 10yr note. Using the above data and with the help of rounding,
here are the ratios for some popular spreads:


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US Spreads Nickname
5yrs 3 2 10yrs "Fight" Spread
5yrs 3 1 30yrs "Fob" Spread
10yrs 2 1 30yrs "Nob" Spread
Aussie Spread
Au3yrs 3 1 Au10yrs "3s, 10s"
US - Aussie Spread
10yrs 6 5 Au10yrs "10,10s"


Directional Spreading Versus Hedging

Given the ratios are based on the dollar value of a basis point move, a perfect hedge
would require an equal movement in yield in the two contracts. On a yield curve, this
would mean a parallel shift in the curve, not a change in slope.

One could argue, the purpose of spreading is to remove outright yield risk and take a
position on a change in the slope of the curve.

If we see anything but a parallel shift in the yield curve, these spread ratios create a
position that is in some way directional which is many respects is the purpose of a
speculative spread position.



Propex Derivatives. Horth & Bower
Changing Slope of the Yield Curve

Non-parallel changes in the yield curve are categorized as steepeners and flatteners.
Both have bullish and bearish scenarios.

Steepeners are where the difference between the long end and short ends increases.
The terms bullish or bearish refers to the direction of prices.

Yields fall = bullish = lower rates

Yields rise = bearish = higher rates

Bull Steepener this is where rates are falling (prices rising) and short term rates are
falling faster than longer term rates.

















Bear Steepener this is where rates are rising (prices falling) and long end rates are
rising faster than short end rates.














Propex Derivatives. Horth & Bower


Flatteners are where the difference between the long end and short ends decreases.
The terms bullish or bearish refers to the direction of prices.

Yields fall = bullish = lower rates

Yields rise = bearish = higher rates

Bull Flattener is when yields are falling (prices rising) and the long end is moving further
than the short.

















Bear Flattener is when yields are rallying (prices falling) and the short end is falling
harder than the long end.

















Propex Derivatives. Horth & Bower
Factors Affecting the Shape of the Yield Curve

Economic cycle. During strong economic expansion, short term yields will often move
higher than longer term rates and the yield curve will be inverted. As the economic
conditions turn negative, shorter term rates will go back below long term rates and the
yield curve takes on a normal shape. As rates move lower still, the curve will steepen.
As the recovery gets underway, the curve can flatten as short term rates rise.

Another scenario that may cause an inverted yield curve is the perceive risk of default of
government debt (eg Greece).



Inflation. The yield curve will be steep when expectations for short-term inflation are
low. Expectations of strong inflationary pressures will flatten the yield curve.

Monetary Policy. The yield curve will steepen when the Central Bank moves towards a
loose monetary policy. The curve will flatten and can gradually move inverted when
policy is tightened.

Operation Twist in 2011 was a good example of the US Feds policy changing the yield
curve. In September the Fed announced they would sell short term bonds and buy long
term bonds in an effort to reduce longer term rates. The effect of such policy is to
flatten the curve by increasing short term rates and reducing long term rates.

The curve trade to make is this scenario would to be to get long the 30yr bond and
spread off with shorter term notes such as the 2yrs. In two days the long end rallied
Propex Derivatives. Horth & Bower
over 5 handles whereas the short end hardly moved (nobody expected much of a
change in short end rates given the Feds commitment to keeping short end rates low).

Supply of and Demand for Treasury Bonds. Activity in treasury financing (supply) and
large managed funds (demand) can also have an effect on the yield curve. Specifically
supply or demand constraints in particular maturities can lead to changes in the relative
prices of certain points along the curve.


Charting Your Spread

Wouldnt it be easy if every contract we look at is traded in the same currency and
quoted the same way? Unfortunately they are not. So to chart these spreads, we have
to make a few calculations.

The easiest to chart these spreads is to bring them back to yield. CQG has a function
where it can turn an fixed interest security price into a yield chart. From there, we
simply calculate the spread price and chart.


So to chart any of the US Treasury spreads for example, the following codes would be
used:
US Spreads Code Nickname
2s/5s TUA-FVA "Tuf" Spread
2s/10s TUA-TYA "Tut" Spread
5s/10s FVA-TYA "Fight" Spread
5s/30s FVA-USA "Fob" Spread
10s/30s TYA-USA "Nob" Spread

Then right click the title bar, select More, then Yield as the above image shows.

Propex Derivatives. Horth & Bower
The same goes for the US-Aussie spreads. We do not need to convert the currency of
one to the other as we already did this when calculating the hedge ratios earlier. With
the yield function on CQG, it is comparing apples with apples.

The codes are:
Aussie Spread Code Nickname
3rs-10yr HTS-HXS "3s, 10s"
US - Aussie Spread
10yrs TYA-HXS "10,10s"

Note, this method of charting looks at the futures yields, not cash note/bond yields.
There is often a difference between futures and cash (known as basis).


Filtering Data

When trading a cross-border spread, it can be useful to filter the display to show only
certain trading hours. You might do this if you are trading the US-Au spreads during the
night session only.



Alternate Method of Charting a Spread

On CQG there is a function called SHAREDSCALE. It takes one market and puts in on the
same price scale as another. US Treasuries are quoted in 32nds and fractions thereof.
The SHAREDSCALE function allows you to change that back to decimal therefore making
Propex Derivatives. Horth & Bower
it easier to either chart a spread or overlay one or more markets. For these charts, we
will convert Treasuries to decimal using the Eurodollar (code:EDA) market.

This approach to charting spreads adjusts the price of the securities by its DV01 so the
dollar value of an up or down tick on the chart is constant. Note, the DV01s change
regularly and therefore so does these numbers.


The CQG formulas for his approach are:

Two-legged US Spreads:
2s/5s SHARESCALE((TUA?1*.464-FVA?1*.191),EDA)
2s/10s SHARESCALE((TUA?1*.464-TYA?1*.124),EDA)
5s/10s SHARESCALE((FVAH2*.191-TYAH2*.124),EDA)
5s/30s SHARESCALE((FVAH2*.191-USAH2*.063),EDA)
10s/30s SHARESCALE(TYAH2*.124-USAH2*.063,EDA)

Butterflies:
2s/5s/10s: SHARESCALE((TUA?1*.464-FVA?1*.191)-
(FVA?1*.191-TYA?1*.124),EDA)
5s/10s/30s: SHARESCALE((FVAH2*.191-TYAH2*.124)-
(TYAH2*.124-USAH2*.063),EDA)

US-Aussie Spread:
US10-AU10: (TYA?1*.124-HXS?1)


Varying the Spread Ratio

Ok, the hedge ratios calculated a few pages back assume a
parallel shift in the yield to maintain the perfect hedge. Given
a change in the slope of the curve is far more common than
parallel shifts. This is evidenced simply by the fact that the
spread chart does not remain constant it moves up and
down.

So even with a theoretically perfect hedge ratio we are taking
a directional position with any spread. The short cut to
working out the directional position is to overlay the spread
with the outright and look for the correlation.





Propex Derivatives. Horth & Bower
Trading the Spread

There are three ways to enter a spread:

Exchange Traded Spreads. The simplest way to transact in a spread is when the
exchange offers that spread as an exchange traded product. The CME offer the NoB (10-
30) as an exchange spread pictured here.

The thing to note here is that a one lot trade in the spread equates to a traded amount
in each contract equivalent to the ratio set by the exchange.

At the time of writing, the NoB spread trades at a ratio of five 10yrs and three 30yrs (as
opposed to what we calculated at 2:1 in the previous pages close, but not exact).

Autospreader. Trading platforms such as CQG have a spreader feature where you can
program a tradable synthetic spread. The end result is the ladder is tradable much like
an exchange traded spread.

Legging. The good old fashioned method to enter a spread is roll up your sleeves and
enter each leg manually.

A tip for the best entry is to identify which market is most volatile and work a limit order
entry in this market. After getting a decent price in the choppy market, go to the second
market and either work best bid/offer or hit market.

Legging in a spread can be a tricky method to get used to, but youll get the hang of it
with a little practice.


When is a Spread not a Spread

1. Bad Timing - A spread should not be used to cover up a bad trade.

Consider this scenario: Trader Ted gets long the Tbond at 142-26 after what he sees as a
decent rally and one he expects will continue (exhibit A).
Propex Derivatives. Horth & Bower


The market then falls away, down to 142-00 before Ted decides to act. Rather than
stopping out the trade and admitting the trade was simply a bad one, Ted sells some
10yr notes against it, thinking he will spread it off and watch it come back (exhibit B).

Think about the logic here. Ted is 26/32nds offside and then enters into a position that
will require the bonds to rally well beyond his original buy price just for that spread to
make a decent advance. Pure logic suggests he has a far better chance of simply holding
the outright bonds in anticipation of a bounce.

Admittedly the trade would reduce the downside if the market kept falling, but it
virtually gives away any chance of making back the ticks already lost.

As a rough estimate, the bond would have to rally by twice as much as the fall for that
spread to make back the lost ticks.

Turning an outright losing trade into a spread is not a spread strategy.

Propex Derivatives. Horth & Bower
Admittedly the example above shows a trade that was off side by a large amount before
spreading. However the exactly the same logic applies to smaller moves. Spreading
something off makes it harder for you to make money.

2. Bad Correlations A spread involves opposing positions in correlated markets
and the same positions in inversely correlated markets.

Most of the time, stocks and bonds are inversely correlated. It is not unprecedented for
a trader to spread these markets, perhaps trading relative values or extremes in one
versus another.

So what does a spread in say the S&P versus the Tnote look like? Are you long one and
short the other? If you think about it, that is a double directional trade. If they are
inversely correlated (stocks go up bonds go down), then being long one and short the
other is taking an even bigger directional position that you would be trading just one of
the markets outright.

The correct spread trade to make in inversely correlated markets is to be long both or
short both. That is a spread.

3. Bad Ratios

If we look at the Aussie 3s:10s spread as being a 3:1 ratio, then are you spreading when
you are long 30 threes and short 30 tens?

The answer is yes and no. One way to look at it is you have a spread of 30 threes and 10
tens PLUS another 20 tens. You are essentially overweight in one leg of the trade and
therefore adding a directional bias.

There is nothing wrong with doing this if it fits into your view, but its not a simple
spread trade in the strict definition. Placing these trades requires a directional view as
well as a relative value or spread view. In many cases you may simply be better off
placing a smaller directional trade.


Some Spreading Research Ideas

All of these may seem like leading questions. That is because they are. However, a little
bit of homework here can teach you how spreads behave in certain scenarios. Know
your market!

Propex Derivatives. Horth & Bower
1. How does a move in the currency affect a spread between the Aussie 10s and
the US 10ys Note? Is it worth tracking the Aussie when looking at this spread?

2. At different times of the day, a spread between two markets in different time
zones (e.g. Australia and the US) will behave differently. At certain times of the
day such as the open, close and when data is released, traders will look at one
market more than another. As such spread relationships can break down, albeit
temporarily. Does this provide an opportunity?

3. How is a data release going to affect the short end of the curve versus the long
end (i.e. a slope change)? Run some scenarios where the change in slope is affect
by stronger or weaker data.

4. In reacting to data, is the change in the slope instantaneous or can you find
examples where the change takes hours or even days? Does the market give you
time to get in the spread and require patience when holding?

5. How would a surprise rate cut/hike affect the yield curve?

6. There is a general assumption that yield curve spreads are mean reverting. While
mean reversion is certainly possible most if not all spread driven by fundamental
factors are directional not mean reverting. This is why it is important to think
about how general fundamental affect one part of the curve versus another.

Run some of these ideas through your head and go back through charts and data
releases. You might just find a pattern.





















Propex Derivatives. Horth & Bower
Yield Curves at the time of writing
Aussie Bonds

US Treasuries







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Contract Specs
Name: Aussie Bond Futures (3yrs and 10yrs)

Name: Aussie Bond Futures (3yrs and 10yrs)
Exchange: Exchange code: Tick Value: Daily Volatility:
SFE 3: YB
10: XB
3: 0.01 = ~a$29.82
10: 0.005 = ~a$45.655
$331
$940
Comment: Like all markets, Aussie bonds have gone through cycles of volatility and lack thereof.
For the day trader, it means adapting to what is in front of you. It means trading what the
market is saying, not sticking to inflexible and outdated rules. In the 1990s, the 10yr bond was
the market more suitable for active day trading. Large daily ranges made for great short and
sharp trend trades. These days, interest rates are lower and the government bond market is
smaller. This has caused a volume shift to the shorter end of the curve. As such the 3yrs are now
the leading market. Lower intraday ranges now mean fewer opportunities compared with say
the S&P.

Intraday volatility tends to be small and as such larger traders use either a long term strategy or
one of market making where queue position is of utmost importance.

Correlations these markets are tied to global bond markets such as the Bund or the US 10yr
Tnote. Because the Aussie market is smaller, there are good opportunities for lag trades.

Spreading Spreading 3s versus 10s or bank bills versus 3s is common as well as spreading the
Australian bonds versus the US Treasuries (Au 3yrs against US 5yr note or tens versus tens).
More information: www.sfe.com.au
Daily Volatility = ATR * tick value. Note this will change every day. ~ = Approximately

Propex Derivatives. Horth & Bower

Name: US Treasuries (5yr bond, 10yr note and 30yr bond)

Name: US Treasuries (5yr bond, 10yr note and 30yr bond)
Exchange: Exchange code: Tick Value: Daily Volatility:
CBOT 5: ZF
10: ZN
30: ZB
5: 0.0025 = us$7.8125
10: 0.005 = us$15.625
30: 0.01 = us$31.25
5: us$350
10: us$790
30: us$1,740
Comment: The 10yr note or just the Tnote is the primary market among these three. They all
have good liquidity. They can be traded as outrights or as spreads between each other or
related markets. There are good correlations here with international bond markets such as
Australia and Germany as well as stock and commodity prices. The markets still trade open
outcry in Chicago, but have side-by-side electronic trading on Globex.

5yr Note: The small tick size makes it a good market for learning to size up when you are just
starting out. It can also be a good market for ladder stacking without risking too much. One
thing to watch in this market is for new intraday highs and lows triggering a similar move in the
30yrs. Normally we see the long end lead the short, but this can reverse in quiet ranging
markets.

Spreading: These are great markets for spreading. There is the 5s versus 30s (the fab); the 10s
versus 30s (the NoB) and the 5s versus 10s (the fight). If you are new to spreading and want to
get involved, pick one spread and just watch it.

More information: www.cmegroup.com

Propex Derivatives. Horth & Bower



More Reading

Book: Trading STIR Futures by Stephen Aikin
http://www.amazon.com/gp/product/1897597819/ref=as_li_ss_tl?ie=UTF8&tag=mrrnk
-20&linkCode=as2&camp=1789&creative=390957&creativeASIN=1897597819

CME Treasury Futures General Info:
http://www.cmegroup.com/trading/interest-rates/yield-center.html

CME Treasury Futures Duration and DV01 Tool:
http://www.cmegroup.com/trading/i nterest-rates/durati on.html

Measuring the price sensitivity of U.S. Treasury Futures doco:
http://www.cmegroup.com/trading/interest-rates/files/Empirical_Duration.pdf

Calculating the Dollar Value of a Basis Point doco:
http://www.cmegroup.com/trading/interest-rates/calculating-the-dollar-value-of-a-
basis-point.html




Links
Propex main website: www.Propex.net.au
Propex training site: www.PropexTraining.com

Contact
Guy Bower
Training Manager
Guy.Bower@Propex.net.au