Opportunities in Canadian Fixed Income Derivatives
CFA Ottawa – October 18th, 2012
1
Table of Contents
Description of the Project Yield Curve
Types of strategies and participants active at the Montréal Exchange
Statistical overview of markets with peer benchmarking
Basis Trading
Collateralized Synthetics
Questions
2
Greens
Whites
O
I
S
/
O
N
X
Reds
Building a Sovereign Futures Curve
C
G
Z
C
G
F
C
G
B
Fitch
Moody`s
S&P
AAA
AAA
AAA
1 of 15
1 of 16
1 of 14
Few remaining AAA
rating
US and Germany only
two countries with
full futures curve.
Futures friendly
regulatory reform
(Basel 3, Dodd-Frank)
Demand for
transparency in
Canada
BAX
3
L
G
B
Strategies & Participants
Portfolio
Management
Techniques
Asset Liability
Management
Risk
Management
Rate Locking
Opportunistic
Strategies
Basis Trading
(arbitrage)
Liability Driven
Investing
Cash Flow
Swapping
Duration
Management
Asset
Allocation
(GTAA)
Hedging
purchase/sale
Relative Value
Trading
Monetising
Volatility
Manager
Transitioning
Synthetics
(collateralized)
Institutions
4
Dealers
Treasuries
Pension Funds
Money Managers
Insurance Companies
Central Banks
Credit Unions
Sovereign Wealth Funds
Hedge Funds
Mutual Funds
Three-Month Canadian Bankers' Acceptance Futures (BAX)
BAX 3-Month STIR Futures (1998- 2012 )
600,000
Average Daily Volume
90,000
Average Daily Volume
Open Interest
80,000
70,000
500,000
400,000
60,000
50,000
300,000
40,000
200,000
30,000
20,000
100,000
10,000
-
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
YTD
(Sept)
Source: MX
5
Open Interest (# of contracts)
100,000
Ten-Year Government of Canada Bond Futures (CGB)
CGB 10-year GoC Bond Futures
45 000
400 000
Average Daily Volume
Open interest
40 000
350 000
35 000
300 000
250 000
25 000
200 000
20 000
150 000
15 000
100 000
10 000
50 000
5 000
0
2002
Source: MX
6
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012 YTD
September
Open Interest
Average Daily Volume
30 000
Ten-Year Government of Canada Bond Futures (CGB)
Liquidity Ratio- Ratio of Futures Volume to Cash Market Volume
160%
146%
150%
147%
140%
120%
120%
120%
120%
103%
100%
88%
80%
65%
60%
54%
56%
2002
2003
40%
20%
0%
2004
2005
2006
2007
Source: Montreal Exchange, IIROC - computed with data as of H1 2012
7
2008
2009
2010
2011
2012
Ten-Year Government of Canada Bond Futures (CGB)
10-year Government Bond Futures - Liquidity Ratio
($value traded of futures divided by the $value traded of the cash market)
7
6.51
6
5.26
5
4
3.5
3
2
1.47
1.69
1
0
CGB Bond Futures
US Treasury Futures
UK Gilts Futures
Aussie
Commonwealth
Futures
German Bund Futures
Source: Montreal Exchange, IIROC, CME, NY Federal Reserve, ASX, AFMA, UK Debt Management Office, NYSE Euronext LIFFE
Computed with data as of H1 2012
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Basis Trading
Definition:
A bond`s basis is the difference between the price of a bond and the product of the bond`s
conversion factor and the futures price.
Basis = Bond Price – (Futures Price x Conversion Factor)
Basis Trading:
Basis trading is the simultaneous trading of cash bonds and bond futures to take advantage of
expected changes in the relative prices of bonds and bond futures
Buying the Basis:
To buy the basis, or go long the basis, is to buy the cash bonds and sell a number of futures equal to
the bond`s conversion.
Selling the Basis:
To sell the basis, or go short the basis, is to sell/short the cash bond and buy a number of futures
equivalent to the bond`s conversion factor.
9
Basis Trading
Sample Calculation:
Gross Basis = Bond Price – (Futures Price x Conversion Factor)
Gross
Basis
Carry
Option
Value/Net
Basis
Carry:
Carry is the difference between coupon income earned on the bond and the cost of financing the
bond
Delivery Option Value:
The Delivery Option Value is the value associated with the short’s right to choose what bond to
deliver, and when to deliver it. The value of this option depends on the likelihood of shifts in the
cheapest to deliver, which in turns depends on the interest rate volatility.
10
Basis Trading - Carry
Carry
Coupon
Income
Coupon Income = (3/2) x (112/183) = 91.8 cents
45.05
11
91.8
Financing
Cost
Financing Cost = 107.143 x .01422 x (112/365) = 46.8 cents
46.8
Basis Trading – Option Value/Net Basis
12
Option
Value/Net
Basis
Gross
Basis
Carry
19.25
64.3
45.05
Basis - Optionality
Switch Options
• Parallel curve
movements
Timing Options
• Carry (positive/negative)
• Wild card
• Yield spread changes
• End-of-month
• New Issues
Rule of Thumbs for Cheapest-to-Deliver Bonds:
•when yields are low, the lowest duration bond is the CTD
•when yields are high, the highest duration bond is the CTD
13
Basis Trading - recap
Bond Price
Carry
Forward
Price
Gross
Basis
Futures Price
Bond Price x
Conversion
Factor
Net
Basis/Option
Value
Source: Bloomberg LP
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Reverse Cash and carry trade (basis trade)
 SITUATION
A bond trader notes that the price relationship between the cheapest-to-deliver 3% December
2015 Government of Canada (GoC) bond and the 5-year GoC bond (CGF) futures contract is out-ofline. The trader’s observation is supported by the following information:
CGF futures contract details:
CGF futures expiry
Last delivery day
June 2015
29-Jun-2015
CGF futures price
116,55
CGF futures implied repo rate 0.834%
Net Basis
0.193
Cheapest-to-deliver bond details:
Coupon
3%
Maturity
01-Dec-2015
Bond price
Conversion factor
Actual repo rate
106.296
0,9065
1,422%
The trader realizes that the current pricing offers an arbitrage opportunity. The implied repo rate
from the futures is less than the actual repo rate, which suggests that the CGF contract is cheap.
Consequently, he initiates a reverse cash-and-carry trade, consisting of selling of the cheapest-to-
deliver bond in the cash market and buying the CGF futures, to lock-in a profit.
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Reverse Cash and carry trade (basis trade)
 STRATEGY
The trader initiates a reverse cash-and-carry trade that involves the following steps:
1. Short the cheapest-to-deliver bond. Receive the bond price + accrued interest.
2. Buy the futures contract.
3. Lend the proceeds received at the current short-term financing rate.
4. Pay any intervening coupon during the life of the futures contract.
5. Pay the futures invoice price + accrued interest to the seller.
6. Cover the short sell with the bond received from the futures seller.
7. Calculate arbitrage profit.
Initial data
Price of the cheapest-to-deliver bond
Accrued interest
(99 days = December 1 to March 9 settlement date)
Financing rate (actual repo rate)
Conversion factor
Price of the CGF futures
Days from settlement to futures delivery (March 9 to June 29)
Days from next coupon to futures delivery (June 1 to June 29)
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106,296
814
1,422%
0,9065
116,55
112
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Reverse Cash and carry trade (basis trade)
Reverse Cash-sand-Carry Transaction
Amount (per $100,000 notional amount)
Remarks
Short the CTD bond
$106,296 + $814 = $107,110
Price of bond + Accrued interest
Lend the proceeds until CGF futures
delivery
$107,110 x 0.01422 x 112/365 = $467
Amount received from selling the bond x
Short-term financing rate x Number of
days/365
Income to pay during the life of the CGF
futures (coupon for June 1 to June 30)
Total income of the bond position
$1,500
Coupon income
$107,110 + $467 - $1,500 = $106,075
Proceeds + Lending - Income to pay
Delivery price of the deliverable bond at
CGF futures delivery
($116,55 x 0.9065) + $230* = $105,883
Futures invoice price x Conversion factor
+ Accrued interest received by the seller
from the bond buyer
* $100,000 x 3% coupon x 28/365
Arbitrage profit (per CGF futures)
17
$106,076 – $105,883 = $193
Total income from the bond position Delivery price of the deliverable bond
Hedging Tool
Objective: To hedge 11 mm Canadian 10-year bonds
Solution: Short 84 CGB`s (Bloomberg PDH1)
Source: Bloomberg LP
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Hedging Tool
Source: Bloomberg LP
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Collateralized Synthetics
 SITUATION
An investor would like to construct a synthetic bond portfolio to take advantage of a yield enhancing
opportunity. In addition to seeking this opportunity, the investor would also like to improve the
liquidity of her portfolio, and make it more operationally efficient by reducing the number of bonds
held in it.
In order to construct the synthetic bond portfolio, the investor would need to sell the bonds in his
portfolio, and replace them with a long futures position paired with a short-term money-market
instrument. The goal would be to construct a portfolio that reacts in the same way to the difference
market conditions, and interest rate fluctuations as one consisting of cash bonds only. In order to the
achieve this, the investor would use the same technique to determine a hedge ratio, but in this case
would create a position that replicates the price changes, as opposed to one that offsets them.
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Collateralized Synthetics
In this example we will demonstrate this strategy using the CGZ (Two-Year Government of
Canada Bond Futures) contract with a portfolio value of $10,000,000.
 DATA
Initial data as of October 15th, 2012.
Total capital to invest: $10,000,000
Targeted modified duration of portfolio 2.00
Conversion factor of the OTR
Average yield:
1.25%
Modified duration of the CGZ contract:
Average coupon:
1.00%
Value of a basis point:
Value of a basis point:
0.02
Repo rate:
Current On-the-run 2-year:
CAN 1% Nov 1, 2012 December CGZ contract price:
21
.9413
1.75
0.019
1.20%
108.05
Collateralized Synthetics
Computing the hedge ratio:
HR = BPVPortfolio  Conversion factorOTR
BPVFutures
HR = 0.020  .9413
0.019
HR = 0.9908
Number of contracts needed:
10,000,000  0.9908 = 49.54 or 50 contracts
200,000
The strategy consists of buying 50 CGZ contracts and invested the surplus (after initial margin
deposited at the CDCC) in a general collateral repo transaction.
22
Collateralized Synthetics
 RESULTS
We assume that on December 18th 2012 the yield curve experienced a parallel shift of + 25bps.
We can forecast the following P&L for each scenario (synthetic and bond portfolio) using the
duration DV01 figures.
Synthetic Portfolio
Gain/Loss on futures position
(0.019 x -25 x 2,000 contract multiplier x 50)
-$47,500
Interest on repo transaction
(0.012 x 64/365 x $10,000,000)
$21,041
Total - -$26,459
Bond Portfolio
Gain/Loss on bond portfolio
(2 x -0.0025 x $10,000,000)
-$50,000
Accrued interest
(1% x 64/365 x $10,000,000)
$17,534
Total - -$32,465
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Collateralized Synthetics
 Conclusion
By substituting some bonds for futures and money market instruments, an investor is able to take
advantage of a yield enhancing opportunities while maintaining the characteristics of his portfolio.
In order to demonstrate this example, many variables were simplified. For example, the
performance of the synthetic is dependent of the cheapness of the futures contract acquired. Due
to varying market conditions, the relative cheapness of the futures contract can vary. In addition,
although we demonstrated the strategy utilizing risk free collateralization, it isn`t uncommon for
institutions to substitute T-bills and repo transactions for better yielding AAA asset-back securities.
Coupling these two effects can significantly influence the outcome of the strategy.
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The information presented is for educational purposes only
and is not intended for trading purposes and shall not be
interpreted in any jurisdiction as constituting a
recommendation, advice, opinion or endorsement
concerning the purchase or sale of derivative instruments,
underlying securities or any other financial instrument or
as constituting legal, accounting, tax, financial, investment
or other advice. Past performance is not necessarily
indicative of future performance. Therefore, the Bourse
recommends that you consult your own advisors in
accordance with your needs.
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Jason Taylor
Senior Manager, Fixed Income Derivatives
(514) 871-3519
jtaylor@m-x.ca