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Opportunities in Canadian Fixed Income Derivatives CFA Ottawa – October 18th, 2012

Opportunities in Canadian Fixed Income Derivatives CFA Ottawa – October 18th, 2012. Table of Contents. Building a Sovereign Futures Curve. CGB. LGB. CGZ. CGF. Reds. Greens. Whites. O I S / ON X. BAX. Strategies & Participants.

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Opportunities in Canadian Fixed Income Derivatives CFA Ottawa – October 18th, 2012

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  1. Opportunities in Canadian FixedIncomeDerivatives CFA Ottawa – October 18th, 2012

  2. Table of Contents

  3. Building a Sovereign Futures Curve CGB LGB CGZ CGF Reds Greens Whites O I S / ON X BAX

  4. Strategies & Participants

  5. Three-Month Canadian Bankers' Acceptance Futures (BAX) Source: MX

  6. Ten-YearGovernment of Canada Bond Futures (CGB) Source: MX

  7. Ten-YearGovernment of Canada Bond Futures (CGB) Source: Montreal Exchange, IIROC - computedwith data as of H1 2012

  8. Ten-YearGovernment 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) Source: Montreal Exchange, IIROC, CME, NY Federal Reserve, ASX, AFMA, UK Debt Management Office, NYSE Euronext LIFFE Computedwith data as of H1 2012

  9. Basis Trading Definition: A bond`s basis is the differencebetween 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 tradingis the simultaneoustrading of cash bonds and bond futures to takeadvantage 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.

  10. Basis Trading SampleCalculation: Gross Basis = Bond Price – (Futures Price x Conversion Factor) Carry: Carry is the differencebetween coupon incomeearned on the bond and the cost of financing the bond Delivery Option Value: The Delivery Option Value is the value associatedwith the short’s right to choosewhat bond to deliver, and when to deliverit. The value of this option depends on the likelihood of shifts in the cheapest to deliver, which in turnsdepends on the interest rate volatility.

  11. Basis Trading - Carry Coupon Income = (3/2) x (112/183) = 91.8 cents FinancingCost = 107.143 x .01422 x (112/365) = 46.8 cents

  12. Basis Trading – Option Value/Net Basis

  13. Basis - Optionality • Rule of Thumbs for Cheapest-to-Deliver Bonds: • whenyields are low, the lowestduration bond is the CTD • whenyields are high, the highestduration bond is the CTD

  14. Basis Trading - recap • Gross • Basis • Carry • Net Basis/Option Value Source: Bloomberg LP

  15. 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-of-line. The trader’s observation is supported by the following information: 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.

  16. 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.

  17. Reverse Cash and carry trade (basis trade)

  18. HedgingTool Objective: To hedge 11 mm Canadian 10-year bonds Solution: Short 84 CGB`s (Bloomberg PDH1) Source: Bloomberg LP

  19. HedgingTool Source: Bloomberg LP

  20. CollateralizedSynthetics  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.

  21. CollateralizedSynthetics  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.

  22. CollateralizedSynthetics 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 50CGZ contracts and invested the surplus (after initial margin deposited at the CDCC) in a general collateral repo transaction.

  23. CollateralizedSynthetics • 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.

  24. CollateralizedSynthetics • Conclusion • By substitutingsome bonds for futures and money market instruments, an investoris able to takeadvantage of a yieldenhancingopportunitieswhilemaintaining 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.

  25. 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 recommendsthatyouconsultyourownadvisors in accordance withyourneeds. Jason Taylor Senior Manager, FixedIncomeDerivatives (514) 871-3519 jtaylor@m-x.ca

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