Fixed Income Trading

Strategies
Victor Haghani
&
Gerard Gennotte
General Characteristics
 Securities cash flows easy to replicate using other
securities
 Term structure well explained by limited number
of state variables
 But:
 Fixed costs are high (e.g. modelling, contractual
framework, administration)  Size
 Price anomalies are small, volatility is low  Leverage
Leverage + fat tails Most non-fraud hedge fund
(and IB) crises have involved fixed income
trading strategies
Fixed Income Trading Strategies
 Cash Flow “Arbitrage”
 Term Structure
 Higher Moment (Volatility)
Cash Flow “Arbitrage”
 Instruments with negligible credit risk
 Government bonds
 Fixed rate
 Floating rate
 Inflation indexed
 Interest rate swaps
 Government guaranteed and other AAA+
issuers
Examples of Bond v Bond Trades
 Liquidity/ transactions costs
 Repo “specialness”
 Tax preference- coupon or regime
 Accounting preference
 Age
 Size
On the Run vs Off the Run Bond
 On the run: 5% yield
 Off the run 5.2% yield
 Repo-reverse repo difference: 40bp
 Specialness difference: 30bp
 Duration: 7
 Profit assuming 15% convergence in 3 months:
Carry: (20-30-40)/4=-0.125%
Convergence: 15% of 20bp x 7yr duration=
0.21%
Total = 0.085% of par amount of trade
“That is still a very big number”
On the Run vs Off the Run Bond
 Return on capital:
 Haircut: 1%, thus annual compound return on
working capital:
(1+0.085%/1%)^4-1= 39% very Nice!

 What are the issues?

 What are the risks?
On the Run vs Off the Run Bond
 If the fund were fully invested in this
strategy, leverage would be 100 to 1…
Possibly more if haircuts were netted.
 Stress test: on the run becomes more
expensive by 20bp, loss is 1.4%
 Thus: if fund restricted to have its working
capital and its stress loss to be less than
40% of assets, then capital usage is
2.5*1.4%=3.5%, and the return becomes
10%.
Interest Rate Swaps
 What is LIBOR?
 What is Govt Repo?
 Fair pricing of Interest Rate Swaps
 Long term Repo-Libor Spread
 The arbitrage band

LIBOR – Repo  LIBOR - Reverse Repo
 Basis Points (Govt bond yield - Swap Rate)

-180
-160
-140
-120
-100
-80
-60
-40
-20
0
20

2/28/1995
5/28/1995
8/28/1995

11/28/1995

2/28/1996
5/28/1996
8/28/1996

11/28/1996

UKT 8 2021
2/28/1997

JGB 2.2 12/20/07

FRTR 6 10/25/25
5/28/1997

UST 6.625 5/15/07

8/28/1997
11/28/1997

2/28/1998
5/28/1998

8/28/1998

11/28/1998
2/28/1999
5/28/1999
8/28/1999
Swap Spreads of G4 Govt Bonds

11/28/1999

2/28/2000
5/28/2000
8/28/2000

11/28/2000
2/28/2001
5/28/2001

8/28/2001
End Users of Interest Rate Swaps
 The original “Swap”
 Borrowers want floating rate liabilities and investors want fixed
rate bonds
 High risk companies use to create long term liabilities from
short term floating rate debt
 Financial Institution ALM:
 Banks and insurance companies fixed as synthetic assets
 Real Estate and other project finance:
 Property investors use to create fixed rate mortgages
 U.S. mortgage agencies use as hedge of fixed rate mortgage
portfolio
 Governments to alter debt duration
 Hedging fixed rate issuance
What Drives Swap
Spreads
 Historical regressions:
 Changes in Govt and high grade corporate
bond issuance
 Slope of yield curve
 Change in short term rates
 Change in AA corporate spreads
 Bank credit crisis (Japan?)
Equilibrium when outside of Arbitrage
Bands
 Spread increases or decreases with
duration
 Return on capital example:
 10 year swap spread at 80bp
 Libor – Reverse Repo = 35bp
 Initial margin = 2%
 Stress loss = 60bp (5%) Risk capital  20%
 Carry  0.45%/20%= 2.25% excess return on
capital
 To allocate risk capital, must believe in
convergence of spread
Swap Spreads Today
10 years
 UK Gilts 30bp
 Bund 8
 JGB 8
 US Treasury 30
 Inflation Linked Bonds
 Recent rapid growth- UK (govt and corp),
US, France, Italy, Sweden, Japan,
Australia, New Zealand, Iceland
 Complex and non-standard structures
 Indices
 Cash flows
 seasonality
Term Structure “Arbitrage”
 Fundamental problem- bonds age and
therefore cannot enforce convergence
 Arb free models- many choices
 Parsimony in factors
 Mean reversion in residuals
 Statistical vs structural approach- PCA
 The model as a measurement tool not a
forecasting tool
 Model choice depends on application
Simple 2-Factor TS Model
 Level of yield curve
 Slope of yield curve
A Broader Set of Possible Term
Structure Factors
 Overnight rate
 Near term trajectory of overnight rate
 Objective
 Speed of adjustment
 Long term expectation of short term rate
 Speed of convergence to long term expectation
 Risk premium
 Volatility
Fitting Term Structure Factors
 R0  Overnight rate
 Near term trajectory of overnight rate
 R3month :  Objective
 R1year  Speed of adjustment
 R10year  Long term expectation of short term rate
 R5year  Speed of convergence to long term
expectation
 R30year  Risk premium
 Interest rate options Volatility and other
distributional properties
Trading Strategies
In increasing order of speculativeness
 Betting on residuals
 Very narrow trades- 5-7-10-12-15
 Not much margin
 Betting on inter-market factors
 Government bond risk premium vs interest
rate swap risk premium
 Betting on factors
 MFR- risk premium
 Japan- speed of convergence to long term rate
Example 1: Japanese Yen
Interest Rate Swap Rates
Slow Convergence to Long Term Rate

Date 11-Jun-03
1 Year 0.07%
2 Year 0.09%
3 Year 0.11%
4 Year 0.15%
5 Year 0.18%
7 Year 0.27%
10 Year 0.44%
15 Year 0.70%
20 Year 0.88%
30 Year 1.09%
Example 2: UK Gilt Rates
Low Risk Premium
Date 8-Feb-05
2-Year 4.52%
3-Year 4.50%
4-Year 4.48%
5-Year 4.46%
7-Year 4.44%
8-Year 4.43%
10-Year 4.44%
15-Year 4.40%
20-Year 4.35%
30-Year 4.25%
Fixed Income Volatility
 Realized versus implied
 Term Structure of Volatility
 Skew
 Smile
 Caps vs swap options vs bond options
 Spread options, barrier options,
correlation etc.
 Mortgage prepayment options
Fixed Income Volatility: A Difficult Game
 Many degrees of freedom
 Supply-demand pressures
 High transactions costs
US Mortgages- Highly Complex and
Very Large Market
 Description of market
 $3000BB of mortgage backed bonds
 FNMA/FHLMC own more than ½ of outstanding
 Prepay Modeling
 Prepay efficiency
 Ramp up
 Burnout
 Dumbo
 Home equity
 Pool idiosyncrasies
 Yield curve
 Very big forecasting errors
Mortgage Derivatives
 IO/PO
 CMO tranching
 Inverse floaters
 ARMs
Return on Capital in FI Trading Business
 Pre-fee post-trx costs Sharpe ratio of 1
 How much risk?
 Capitalized such that a 5σ 1 month event results in a
10% loss
 How much alpha?
 σmonthly = 2%  σannual = 7%
 1 x 7% = 7% gross alpha
 7% gross alpha  4% net alpha
Fees being 2% Mgmt Fees, 20% Incentive Fees
(Sharpe ratio of 2  9% net alpha)