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Bond Trading 1999 - Trading the Yield Curve

Bond Trading 1999 - Trading the Yield Curve - Trading the...

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1 Trading the Yield Curve Copyright © 1999-2006 Investment Analytics
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Copyright © 1999-2006 Investment Analytics Trading the Yield Curve Slide: 2 Trading the Yield Curve Repos Riding the Curve Yield Spread Trades Coupon Rolls Yield Curve Steepeners & Flatteners Butterfly Trading
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Copyright © 1999-2006 Investment Analytics Trading the Yield Curve Slide: 3 Repos Firm A Firm A funds itself by doing a repo Pays interest to the buyer at the repo rate Firm B lends money by doing a reverse repo Regarded as a collateralized loan Today T 1 Firm B Firm B Firm A Sale of Security Repurchase of Security
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Copyright © 1999-2006 Investment Analytics Trading the Yield Curve Slide: 4 Repo Trades Repo Master Agreement Term Mainly short term: overnight (70%) to 1 week (20%) Long term up to one year (‘Term repos’) Repo Rate Can be paid as interest or by setting repurchase price above sale price Simple add-on interest, 360 day year: (1 + r x n/360) Overnight repo rate typically spread below Fed Funds
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Copyright © 1999-2006 Investment Analytics Trading the Yield Curve Slide: 5 Repo Trades Securities (“Collateral”) Mainly Treasuries & Agency securities, but also CD’s BA’s, CP, MBS Credit risk: applies to both parties Margin (“Haircut”) Good faith deposit paid by borrower to lender Sells securities worth $100, borrows $98 Right of substitution Borrow may pay extra 2-3 bp for right to offer lender other collateral
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Copyright © 1999-2006 Investment Analytics Trading the Yield Curve Slide: 6 Repo Markets Borrowers of collateral (reverses) Mainly dealers wanting to short specific issues The “specials” market Lenders of collateral (repos) Banks, S&L’s Munis Brokers Garvin, Prebon, Tullet
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Copyright © 1999-2006 Investment Analytics Trading the Yield Curve Slide: 7 Trading Applications Customer Arbs Reverses to maturity Tails
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Copyright © 1999-2006 Investment Analytics Trading the Yield Curve Slide: 8 Customer Arbs Reverses to maturity Yields have risen, customer portfolios are underwater Portfolio managers can’t take a loss Carrying securities at book value, rather than current lower market value Choice: Sell securities, book loss, & reinvest proceeds at higher yields Hang onto underwater securities, avoid booking a loss, earn a lower yield
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Copyright © 1999-2006 Investment Analytics Trading the Yield Curve Slide: 9 Reverses to Maturity Dealer offers to reverse in underwater securities for remaining term Sells securities in market Invests proceeds in securities of equal maturity at yield spread above break-even reverse rate Customer gets funds at repo rate, re-invests in higher yield securities at e.g. X% + 50bp At maturity dealer offsets amount lent to customer (plus interest) against face value of securities he has reversed in (plus final coupon)
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Copyright © 1999-2006 Investment Analytics Trading the Yield Curve Slide: 10 Reverse to Maturity Sell underwater securities “Underwater” securities, Customer Dealer Loan at x% Invest proceeds at x% + 50bp Invest proceeds at > x% + 50bp
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Copyright © 1999-2006 Investment Analytics Trading the Yield Curve Slide: 11 Tails Purchase 90-day bill 0 Discount rate 5.95%
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