Harvesting Risk Hedged Treasury Yield
Ever heard of risk-free rates? Risk free rates are commonly understood to refer to interest rates on 10-year US treasuries. These are considered risk-free as the likelihood of the US government defaulting is considered extremely unlikely.
Treasuries pay out a fixed interest and can be redeemed for their face value at maturity. Fixed returns and negligible default risk make treasuries a critical addition to any decent investment portfolio.
With inflation on the downtrend and Fed’s hiking cycle nearing its apex, long term treasuries provide a fixed income-generating asset with no reinvestment risk.
Little default risk does not mean zero market risk. As highlighted in our previous paper, bond prices are materially exposed to interest rate risk. CME Group’s treasury futures allow investors to hedge that risk.
This paper has been split into two parts – the first provides an overview of treasury futures and their nuances while the second walks through the trade setup required to harness risk-hedged yield.
TREASURY FUTURES
Treasury futures enable investors to express views on a bond’s future price movement. Investors can also hedge against interest rate risk by locking in a coupon rate. CME treasury futures are deliverable with eligible treasury securities which ensures price integrity.
QUOTING
Treasuries are quoted in fractional notation as a percent of their par value. For instance, a bond quoted at 111’272 suggests that it is trading 11 + 27.2/32 (11.85%) above its par value. This allows standardized quotation of bonds with different coupon rates.
Note that notion of quotes in cash markets may be different from futures.
AUCTION SCHEDULE
Treasuries are auctioned periodically depending on their maturity duration.
• Treasury Bills with maturity between 4 to 26 weeks are auctioned every week while T-Bills with maturity of 1-year are auctioned every four weeks.
• Treasury Notes with maturity of 2, 3, 5, and 7 years are auctioned every month while T-Notes with maturity of 10-years are auctioned every quarter.
• Treasury Bonds are auctioned every quarter.
The auctions for each type of security are staggered to reduce their market impact.
CONVERSION FACTOR
It is possible for a large range of “eligible” treasuries to be available for deliveries against standardised futures contract as new treasuries are regularly auctioned at changing rates. The most recently auctioned securities that are eligible for delivery are called “on the run” securities.
To standardize the delivery process for varying securities, a conversion factor unique to each bond is used. The buyer of the futures contract would pay the Principal Invoice Price to the seller. The Principal Invoice Price is the “Clean Price” of the security and is calculated by applying the Conversion Factor to the settlement price.
When the Conversion Factor is less than 1, the buyer pays less than the settlement price and when it is higher than 1 the buyer pays more.
ACCRUED INTEREST
In addition to the adjustment for the quality of the bond being delivered, the buyer must also compensate the seller for any interest the bond would accrue between the last payment and the settlement date.
The final cost to deliver the treasury futures contract would be the Clean Price + Accrued Interest.
CHEAPEST TO DELIVER
Due to the Conversion Factor, which is unique to each bond, some bonds appear to stand out as cheaper alternative for the seller to deliver. So, if a seller has multiple treasury securities, a rational seller will choose to deliver the one that best optimizes the Principal Invoice Price.
As a result, futures price most closely tracks the Cheapest-to-Deliver ("CTD”) securities.
This also provides an arbitrage opportunity for basis traders. In this case, the basis is the relationship between the cash price of the security and its clean price on the futures market. Small discrepancies in these may be profited upon.
Notably, specialized contracts such as CME Ultra 10-year Treasury Note futures with selective eligibility requirements diminish the effects of CTD by reducing the range of deliverable treasuries.
HEDGING BOND PRICE RISK WITH TREASURY FUTURES
Treasury securities are a crucial and substantial addition to any well diversified portfolio, offering income generation, diversification, and safety.
With interest rates elevated and inflation heading lower, coupon rates for long-term US treasuries are yielding positive real returns. Moreover, 10Y yield is hovering at its highest level in 13-years suggesting a strong entry point.
Since the coupon rate of the security is fixed and they can be redeemed at face value upon maturity, the present higher yielding treasuries are a great long-term income generating investment.
Despite the inverted yield curve, which suggests yields on longer-term securities are lower, a position in long-term bonds protects against reinvestment risk. Reinvestment risk refers to the risk that when the bond matures, rates may be lower.
With Fed at the apex of its hiking cycle, rates will likely not go any higher. So, a position in long term T-bond, locked in at the current decade-high rates, offers a lucrative opportunity. The position also benefits in the uncertain scenario of a recession as bond prices rise during recessions.
This investment fundamentally represents a long treasury bond position which profits in two ways: (a) Rising bond prices when interest rates decline, and (b) Coupon payments.
If the coupon payout is unimportant, fluctuations in the bond price can be profited upon in a margin efficient manner using CME futures. This does not require owning treasuries as the majority of the treasury futures are cash settled with just 5% reaching delivery.
In the fixed income case, the bond is held until maturity which leads to opportunity costs from bond price fluctuations.
CME futures can be used to harvest a fixed yield from treasuries and remain agnostic to rate changes, by hedging the long treasury position with a short treasury futures position.
This position is directionally neutral as losses on one of the legs are offset by profits on the other. The payoff can be improved by entering the short leg after bond prices are higher.
To hedge treasury exposure using CME futures the Basis Point Value (BPV) needs to be calculated. BPV, also known as DV01, measures the dollar value of a one basis point (0.01%) change in bond yield. BPV depends upon the bond’s yield to maturity, coupon rate, credit rating and face value.
Notably, BPV for longer maturity bonds is higher as their future cashflows are affected more by changes in yield.
Another commonly used term is modified duration which determines the changes in a bond’s duration or price basis of a 1% change in yield. Importantly, the modified duration of the bond is lower than 100 BPV’s since the bond price relationship to yield is non-linear.
BPV can be calculated by averaging the absolute change in the bond’s yield-to-maturity, its value when held until maturity, from a 0.01% increase and decrease in yield. Where there are multiple bonds in a portfolio, the BPV for a unit exposure will have to be multiplied by the number of units.
On the futures side, BPV can be calculated as the BPV of the cheapest to deliver security for that contract divided by its conversion factor.
By matching the BPV’s on both legs, the hedge ratio can be calculated. This represents the number of contracts needed to entirely hedge the cash position.
SUMMARY OVERVIEW OF CME TREASURY FUTURES
CME suite of treasury futures allow investors to gain exposure to treasury securities across a range of expiries in a deeply liquid market.
Each futures contract provides exposure to face value of USD 100,000.
The 2-Year, 5-Year, and 10-Year contract are particularly liquid.
Micro Treasury Futures are more intuitive as they are quoted in yields and are cash settled. Each basis point change in yield represents a USD 10 change in notional value.
These products reference yields of on-the-run treasuries and settled daily to BrokerTec US Treasury benchmarks ensuring price integrity and consistency.
Micro Treasury Futures are available for 2Y, 5Y, 10Y, and 30Y maturities enabling traders to take positions across the yield curve with low margin requirements.
TRADE SETUP TO HARVEST RISK HEDGED TREASURY YIELDS
A long position in the on-the-run 10Y treasury notes and a short position in CME Ultra 10Y futures allows investors to benefit from the treasury bond’s high coupon payment while remaining hedged against interest rate risk.
Hedge ratios can be calculated using analytical information from CME’s Treasury Analytics Tool to obtain the BPV of each of the legs:
The on-the-run treasury pays a coupon rate of 3.375% pa. and its last quoted cash price was USD 98.04. It has a DV01 of USD 76.8.
Since, each contract of CME Treasury Futures represents face value of USD 100,000, the long-treasury position would need to be in multiples of USD 100,000.
For a face value of USD 500,000 (USD 100,000 x 5) this represents a notional value of USD 490,000 (Face Value x Cash Price).
The long-treasury position's DV01 = USD 76.8 x 5 = USD 385.
The cheapest-to-deliver security has a DV01 of USD 92.2 and a conversion factor of 0.8244.
The futures leg thus has a BPV = Cash DV01/Conversion Factor = USD 92.2/0.8244 = USD 111.8.
The hedge ratio = BPV of Long Treasury/BPV of Short Futures = USD 385/USD 111 = ~4 (3.4)
So, four (4) lots of futures would be required to hedge the cash position which would require a margin of USD 2,800 x 4 = USD 11,200.
Though the notional on the two legs does not match, the position is hedged against interest rate risk and pays out 3.375% per annum in coupon payments.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Treasuries pay out a fixed interest and can be redeemed for their face value at maturity. Fixed returns and negligible default risk make treasuries a critical addition to any decent investment portfolio.
With inflation on the downtrend and Fed’s hiking cycle nearing its apex, long term treasuries provide a fixed income-generating asset with no reinvestment risk.
Little default risk does not mean zero market risk. As highlighted in our previous paper, bond prices are materially exposed to interest rate risk. CME Group’s treasury futures allow investors to hedge that risk.
This paper has been split into two parts – the first provides an overview of treasury futures and their nuances while the second walks through the trade setup required to harness risk-hedged yield.
TREASURY FUTURES
Treasury futures enable investors to express views on a bond’s future price movement. Investors can also hedge against interest rate risk by locking in a coupon rate. CME treasury futures are deliverable with eligible treasury securities which ensures price integrity.
QUOTING
Treasuries are quoted in fractional notation as a percent of their par value. For instance, a bond quoted at 111’272 suggests that it is trading 11 + 27.2/32 (11.85%) above its par value. This allows standardized quotation of bonds with different coupon rates.
Note that notion of quotes in cash markets may be different from futures.
AUCTION SCHEDULE
Treasuries are auctioned periodically depending on their maturity duration.
• Treasury Bills with maturity between 4 to 26 weeks are auctioned every week while T-Bills with maturity of 1-year are auctioned every four weeks.
• Treasury Notes with maturity of 2, 3, 5, and 7 years are auctioned every month while T-Notes with maturity of 10-years are auctioned every quarter.
• Treasury Bonds are auctioned every quarter.
The auctions for each type of security are staggered to reduce their market impact.
CONVERSION FACTOR
It is possible for a large range of “eligible” treasuries to be available for deliveries against standardised futures contract as new treasuries are regularly auctioned at changing rates. The most recently auctioned securities that are eligible for delivery are called “on the run” securities.
To standardize the delivery process for varying securities, a conversion factor unique to each bond is used. The buyer of the futures contract would pay the Principal Invoice Price to the seller. The Principal Invoice Price is the “Clean Price” of the security and is calculated by applying the Conversion Factor to the settlement price.
When the Conversion Factor is less than 1, the buyer pays less than the settlement price and when it is higher than 1 the buyer pays more.
ACCRUED INTEREST
In addition to the adjustment for the quality of the bond being delivered, the buyer must also compensate the seller for any interest the bond would accrue between the last payment and the settlement date.
The final cost to deliver the treasury futures contract would be the Clean Price + Accrued Interest.
CHEAPEST TO DELIVER
Due to the Conversion Factor, which is unique to each bond, some bonds appear to stand out as cheaper alternative for the seller to deliver. So, if a seller has multiple treasury securities, a rational seller will choose to deliver the one that best optimizes the Principal Invoice Price.
As a result, futures price most closely tracks the Cheapest-to-Deliver ("CTD”) securities.
This also provides an arbitrage opportunity for basis traders. In this case, the basis is the relationship between the cash price of the security and its clean price on the futures market. Small discrepancies in these may be profited upon.
Notably, specialized contracts such as CME Ultra 10-year Treasury Note futures with selective eligibility requirements diminish the effects of CTD by reducing the range of deliverable treasuries.
HEDGING BOND PRICE RISK WITH TREASURY FUTURES
Treasury securities are a crucial and substantial addition to any well diversified portfolio, offering income generation, diversification, and safety.
With interest rates elevated and inflation heading lower, coupon rates for long-term US treasuries are yielding positive real returns. Moreover, 10Y yield is hovering at its highest level in 13-years suggesting a strong entry point.
Since the coupon rate of the security is fixed and they can be redeemed at face value upon maturity, the present higher yielding treasuries are a great long-term income generating investment.
Despite the inverted yield curve, which suggests yields on longer-term securities are lower, a position in long-term bonds protects against reinvestment risk. Reinvestment risk refers to the risk that when the bond matures, rates may be lower.
With Fed at the apex of its hiking cycle, rates will likely not go any higher. So, a position in long term T-bond, locked in at the current decade-high rates, offers a lucrative opportunity. The position also benefits in the uncertain scenario of a recession as bond prices rise during recessions.
This investment fundamentally represents a long treasury bond position which profits in two ways: (a) Rising bond prices when interest rates decline, and (b) Coupon payments.
If the coupon payout is unimportant, fluctuations in the bond price can be profited upon in a margin efficient manner using CME futures. This does not require owning treasuries as the majority of the treasury futures are cash settled with just 5% reaching delivery.
In the fixed income case, the bond is held until maturity which leads to opportunity costs from bond price fluctuations.
CME futures can be used to harvest a fixed yield from treasuries and remain agnostic to rate changes, by hedging the long treasury position with a short treasury futures position.
This position is directionally neutral as losses on one of the legs are offset by profits on the other. The payoff can be improved by entering the short leg after bond prices are higher.
To hedge treasury exposure using CME futures the Basis Point Value (BPV) needs to be calculated. BPV, also known as DV01, measures the dollar value of a one basis point (0.01%) change in bond yield. BPV depends upon the bond’s yield to maturity, coupon rate, credit rating and face value.
Notably, BPV for longer maturity bonds is higher as their future cashflows are affected more by changes in yield.
Another commonly used term is modified duration which determines the changes in a bond’s duration or price basis of a 1% change in yield. Importantly, the modified duration of the bond is lower than 100 BPV’s since the bond price relationship to yield is non-linear.
BPV can be calculated by averaging the absolute change in the bond’s yield-to-maturity, its value when held until maturity, from a 0.01% increase and decrease in yield. Where there are multiple bonds in a portfolio, the BPV for a unit exposure will have to be multiplied by the number of units.
On the futures side, BPV can be calculated as the BPV of the cheapest to deliver security for that contract divided by its conversion factor.
By matching the BPV’s on both legs, the hedge ratio can be calculated. This represents the number of contracts needed to entirely hedge the cash position.
SUMMARY OVERVIEW OF CME TREASURY FUTURES
CME suite of treasury futures allow investors to gain exposure to treasury securities across a range of expiries in a deeply liquid market.
Each futures contract provides exposure to face value of USD 100,000.
The 2-Year, 5-Year, and 10-Year contract are particularly liquid.
Micro Treasury Futures are more intuitive as they are quoted in yields and are cash settled. Each basis point change in yield represents a USD 10 change in notional value.
These products reference yields of on-the-run treasuries and settled daily to BrokerTec US Treasury benchmarks ensuring price integrity and consistency.
Micro Treasury Futures are available for 2Y, 5Y, 10Y, and 30Y maturities enabling traders to take positions across the yield curve with low margin requirements.
TRADE SETUP TO HARVEST RISK HEDGED TREASURY YIELDS
A long position in the on-the-run 10Y treasury notes and a short position in CME Ultra 10Y futures allows investors to benefit from the treasury bond’s high coupon payment while remaining hedged against interest rate risk.
Hedge ratios can be calculated using analytical information from CME’s Treasury Analytics Tool to obtain the BPV of each of the legs:
The on-the-run treasury pays a coupon rate of 3.375% pa. and its last quoted cash price was USD 98.04. It has a DV01 of USD 76.8.
Since, each contract of CME Treasury Futures represents face value of USD 100,000, the long-treasury position would need to be in multiples of USD 100,000.
For a face value of USD 500,000 (USD 100,000 x 5) this represents a notional value of USD 490,000 (Face Value x Cash Price).
The long-treasury position's DV01 = USD 76.8 x 5 = USD 385.
The cheapest-to-deliver security has a DV01 of USD 92.2 and a conversion factor of 0.8244.
The futures leg thus has a BPV = Cash DV01/Conversion Factor = USD 92.2/0.8244 = USD 111.8.
The hedge ratio = BPV of Long Treasury/BPV of Short Futures = USD 385/USD 111 = ~4 (3.4)
So, four (4) lots of futures would be required to hedge the cash position which would require a margin of USD 2,800 x 4 = USD 11,200.
Though the notional on the two legs does not match, the position is hedged against interest rate risk and pays out 3.375% per annum in coupon payments.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
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