The Treasury Bond Basis: An in-Depth Analysis for Hedgers, Speculators, and Arbitrageurs

Contents
List of Exhibits
Preface to the Third Edition
Preface to the Second Edition
Preface to the First Edition
1. Basic Concepts
Treasury Bond and Note Futures Contract Specifications
Definition of the Bond Basis
Units
Conversion Factors
Characteristics of Conversion Factors
Futures Invoice Price
Carry : Profit or Loss of Holding Bonds
Theoretical Bond Basis
Implied Repo Rate
Buying and Selling the Basis
Sources of Profit in a Basis Trade
Altemative Summary P/L
RP versus Reverse RP Rates
2. What Drives the Basis?
The Short's Alternatives
Search for the Cheapest Bond to Deliver
The Best Time to Deliver a Bond
Rules of Thumb
The Bond Basis Is Like an Option
Shifts in the Cheapest to Deliver
History of the Most Delivered Bond
Examples of Buying and Selling the Cheapest to Deliver Basis
The Importance of Embedded Options
3. The Short's Strategic Delivery Options
Structure of the Delivery Process
Delivery Process
Delivery Month
The Switch Option
Parallel Changes in Yield Levels
Changes in Yield Spreads
The End-of-Month Option
Timing Options
4. The Option-Adjusted Basis
An Outline for Pricing the Short's Delivery Options
Option Structures
Valuing the Switch and End-of-Month Options
Expected Basis Net of Carry
A Word about the Value of Early Delivery
Practical Considerations
Volatility and Distribution of Yield Levels
Yield Betas
Volatility and Distribution of Yield Spreads
Consistency between Forward Prices and Expected Forward Prices
Consistency between Delivery Option Values and Futures Options Values
Term Repo Specials
Anticipated New Issues
The Option-Adjusted Basis in Practice
If the Basis Is Cheap, Futures Are Rich
The CTD's BNOC Is Pure Option Value
5. Approaches to Hedging
DV01 Hedge Ratios and Competing Objectives
Standard Industry Rules of Thumb
Rule of Thumb #1
Rule of Thumb #2
The Rules of Thumb in Practice
Shortcomings of the Rules of Thumb
Spot and Repo DV01s
Forward Prices as a Function of Spot Yields and Repo Rates
The Short-Term Independence of Spot Yields and Term Repo Rates
Creating Synthetic Bonds with Forwards and Futures
Handling Repo Stub Risk
Option-Adjusted DV01s
Yield Betas
Putting It All Together
Reckoning the P/L of a Hedge
Evaluating Hedge Performance
Working with Durations
Duration of a Futures Contract
Appendix to Chapter 5: Better Hedges with Yield Betas?
Using Yield Betas to Improve Hedges
Estimating Yield Betas for Treasury Bonds and Notes
Using Yield Betas to Improve Hedges
Hedging Something Other Than the Current Long Bond
When Yield Betas Can Get You into Trouble
Unstable Yield Betas
Competing Hedge Ratios When Correlations Are Less Than 1.0
Competing Hedge Ratios
Sample Calculations
6. Trading the Basis
Selling the Basis When It Is Expensive
Selling the CTD Basis
Selling the Basis of Non-Cheap Bonds
Buying the Basis When It Is Cheap
Trading the Basis of "Hot-Run" Bonds
Basis Trading When the CTD Is in Short Supply
Trading the Calendar Spread
Fair Values for Treasury Note Calendar Spreads
Profiting from Mispricings in Calendar Spreads
Patterns in Calendar Spreads
Practical Considerations in Trading the Basis
RP Specials
Term Financing versus Overnight Financing
Short Squeezes
The Short Squeeze of 1986
Taking a Basis Trade into the Delivery Month
7. Volatility Arbitrage in the Treasury Bond Basis
Overview
The Options Embedded in Bond Futures
Calls, Puts, and Straddles
Two Arenas for Trading Volatility
The Option-Adjusted Bond Basis
History of Mispricings
Volatility Arbitrage
Report Card
Examples of Yield Enhancement
Leverage
Words of Caution
Other Applications
8. Nine Eras of the Bond Basis
The Birth and Maturation of Bond Futures
Volatility of Yields Since 1977
Nine Eras of Trading
First Era: Cash and Carry (1977 and 1978)
Second Era: Negative Yield curve (1979 through 1981)
Third Era: Positive Carry (1982 through 1984)
Fourth Era: The Golden Age of Yield Enhancement (1985 through 1989)
Fifth Era: Volatility Arbitrage (1990 through 1991)
Sixth Era: The Death of Gamma (June 1991 through June 1993)
Seventh Era: The Callables' Last Hurrah (July 1993 through 1994)
Eighth Era: The Long Dry Spell of the 11-1/4% (1995 through 1999)
Ninth Era: 6% Factors and the Rebirth of Bond Basis Trading (2000 to ?)
Changing of the Guard-The Rise of Notes and Fall of Bonds
Where Do We Go from Here?
9. Non-Dollar Government Bond Futures
Active Non-Dollar Government Bond and Note Futures
The Transition to Electronic Trading
Portfolio Equivalent Value
Contract Specifications
Maturities, Settlement Windows, and Last Trading Days
Cash Settlement of SFE's CGB Contracts
Up-to-Date Informdtion
Cash/Futures Relationships
Key Cash Market Features
Auction Cycles and Deliverable Sets
Basis Reference Sheets for Germany, Japan, and the United Kingdom
Optionality and Futures Mispricings
Trading Themes in European Bond Bases
Squeezes of CTD Bonds
Bonds Exiting the Basket Trades
New Issuance
A Word of Caution
10. Applications for Portfolio Managers
Hedging and Asset Allocation
Advantages of Using Futures for Hedging and Asset Allocation
Managing a Portfolio's Duration with Futures
Calculating the Duration of a Portfolio That Contains Futures
Example of Targeting Portfolio Duration When Futures Are in the Mix
Example of Solving for Hedge Ratios Using Target Durations
Synthetic Assets
Trade Construction
How Well Has the Synthetic Asset Strategy Worked?
Historical Record on Yield Enhancement
Variations on a Theme
Caveats
Appendix A. Calculating Conversion Factors
Appendix B. Calculating Carry
Appendix C. Conventions in Major Government Bond Markets
Appendix D. German Federal Bonds and Notes (Bubills, Schatze, Bobls, and Bunds)
Appendix E. Japanese Government Bonds (JGBs)
Appendix F. Government Bonds of the United Kingdom of Great Britain and Northem Ireland (Gilts)
Appendix G. Glossary
Index