Have an Interest in Trading Debt?
The Risks and Potential Rewards of Trading the Interest Rate Complex
Dec 15, 2008
Many years ago bonds were considered boring – not any more. The shape of the interest rate curve changes from positive to negative, the basis between sovereign debt, corporate debt and other forms of debt expands and contracts to create a plethora of opportunities and risks for both the hedge account and the speculator.
The Curve
A "normal" yield curve is what is known as "positive." That means the further out one goes in maturity, the greater the interest rate becomes. In the autumn of 1979, President Jimmy Carter and then Chairman of the Federal Reserve decided to dramatically increase short term interest rates to fight inflation. Overnight rates went to 21% and we had a very negative yield curve.
These days, market participants can take a position in interest rates ranging from 30-day Fed Funds to 30-year U.S. Treasury Bonds. Contracts are also available on 90-day Treasury Bills, two-year, five-year and 10-year U.S. Treasury Notes. In addition, one can take a position in 90-day Eurodollars which is actually LIBOR, an acronym for London Interbank Offered Rate.
Leverage
The leverage in the various forms of interest rate futures is considerable. While short term instruments such as Eurodollars and Ninety Day Treasury Bills is for $1 million (US) the contracts on longer dated maturities is often for $100,000 (US). Please keep in mind maturity is like a giant lever, the further out in maturity the greater the value of a basis point becomes. Volatility equals opportunity and risk.
Strategies
Strategies in the fixed-income market are limited only by one's imagination. From simple hedging and outright speculation, there is a great deal of gray area. Many market participants trade spreads, not only to take a position predicated on an opinion but to reduce the performance bond (or margin) required such as long or short a short maturity and an opposite position in a longer dated maturity.
Still others may want to trade the 90-day Eurodollar vs. the 90-day Treasury Bill, otherwise known as the "TED spread." Another spread might be the Euroyen vs. the Eurodollar. That spreads expands and contracts like any other. Changes in the yield curve can be traded with the Note vs. Bond or "NOB" spread.
Risks and Relevance to Investors
How big is big? The combined cash and derivative market trades approximately $26 trillion per year. Of that, the cash market accounts for about $16 trillion with derivatives the balance.
No surprise, execution tops the list of importance to investors which is comprised of not only price but consistency and speed as well. Other important criteria are macro-economic research, advice on portfolio strategy and access to analysts and economists. One could imagine these criteria are designed to manage systemic risk, credit default risk, liquidity and interest rate volatility.
Participation
Investors and traders alike should realize that these markets demand that you know the factors that affect them like any other market. These markets are no place for an amateur. Investors and traders should also be cognitive of the value of a contract, the price volatility and the required performance bond (margin) before they get involved.
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