I was recently posed the following question and am thinking about retorting with the following answer. However, I really don't know what the f* I'm talking about. Can someone either answer this question or let me know if my answer makes any sense at all? I would greatly appreciate the help. Thanks!
The following question was posed to me:
Q: 'We would like to know what the relationship is between a bond portfolio (say consisting of long term US Government Bonds) and the 30-Year Treasury Bond Futures Contract traded on the CBOT. Although it would make sense that these two markets are strongly correlated, the relationship is not obvious. For instance, the USZ3 Futures contract (30 Y Treasury Bond December) has been quite volatile last month with swings of up to +/- 6% in price level. During this same time, most of the bond funds investing in long term US Government bonds have exhibited much less voltility and very often with weak correlation on a day to day basis. We are trying to understand the exact relationship between these two markets and how would one go about using the USZ3 futures contract to hedge a bond portfolio? On a broader scope, we would also be interested to see the most suitable way to use interest rate futures to hedge a bond portfolio. Any explainations, articles, books or comments would be helpful.'
My answer is as follows:
First of all, since the December contract has expired, I will discuss the issue with respect to the March futures contract. The March future trades in accordance with the 'Cheapest-to-deliver' which is the 6 7/8 Coupon expiring in 8/15/25. This Bond has a duration of 11.9 years. However, the on-the-run (active 30 year) is the 5 3/8 of 2/15/31 which has a duration of 14.1 years. As such, the difference in duration plus the yield curve effects probably explains much of the variation in returns. There is also some convexity issues whereas the Bond Future is negatively convex and the cash bond is positively convex. Furthermore, the Government has stopped the issuance of long-term 30 year Securities and as such, the more active futures contract is the Ten Year Note Future (TYH4). Due to the less active trading of the USH4 (illiquidity) it is subject to more volatile swings than the cash bonds. Nonetheless, to more effectively answer this question, one would need to know the average duration of the bonds being held by the Bond Funds. As far as a reference, the definative book is the Treasury Bond Basis Revised Edition, By Burghardt and Belton. However, you can also contact the CBOT Marketing Division (312-435-3500 general number) for some hedging info.
The following question was posed to me:
Q: 'We would like to know what the relationship is between a bond portfolio (say consisting of long term US Government Bonds) and the 30-Year Treasury Bond Futures Contract traded on the CBOT. Although it would make sense that these two markets are strongly correlated, the relationship is not obvious. For instance, the USZ3 Futures contract (30 Y Treasury Bond December) has been quite volatile last month with swings of up to +/- 6% in price level. During this same time, most of the bond funds investing in long term US Government bonds have exhibited much less voltility and very often with weak correlation on a day to day basis. We are trying to understand the exact relationship between these two markets and how would one go about using the USZ3 futures contract to hedge a bond portfolio? On a broader scope, we would also be interested to see the most suitable way to use interest rate futures to hedge a bond portfolio. Any explainations, articles, books or comments would be helpful.'
My answer is as follows:
First of all, since the December contract has expired, I will discuss the issue with respect to the March futures contract. The March future trades in accordance with the 'Cheapest-to-deliver' which is the 6 7/8 Coupon expiring in 8/15/25. This Bond has a duration of 11.9 years. However, the on-the-run (active 30 year) is the 5 3/8 of 2/15/31 which has a duration of 14.1 years. As such, the difference in duration plus the yield curve effects probably explains much of the variation in returns. There is also some convexity issues whereas the Bond Future is negatively convex and the cash bond is positively convex. Furthermore, the Government has stopped the issuance of long-term 30 year Securities and as such, the more active futures contract is the Ten Year Note Future (TYH4). Due to the less active trading of the USH4 (illiquidity) it is subject to more volatile swings than the cash bonds. Nonetheless, to more effectively answer this question, one would need to know the average duration of the bonds being held by the Bond Funds. As far as a reference, the definative book is the Treasury Bond Basis Revised Edition, By Burghardt and Belton. However, you can also contact the CBOT Marketing Division (312-435-3500 general number) for some hedging info.
