Advantage Futures

Cash U.S. Government Securities

Frederick Sturm, Director, CME Group

April 2010

If Bob Dylan were a trader, he’d remind us we don’t need a weatherman to tell which way the wind blows. Now is not too soon to prepare for the eventual day when the foot of the U.S. yield curve is back in play. For many traders CME Group’s suite of short-term interest rate (STIR) contracts – notably CME 3-Month Euro- dollars and CBOT 30-Day Federal Funds – will leap to mind.

A less obvious alternative for taking views on short-term interest rates is the CBOT Treasury futures complex. By no stretch of the imagination are these STIR contracts. They reference Treasury notes and bonds with relatively long terms to maturity. Despite this, they have proven in the past to be a fertile field of opportunity for those willing and able to trade STIR exposure by way of either futures calendar spreads or cash-futures basis spreads —

Treasury Futures Calendar Spreads

…typically capture the attention of market participants for a handful of days each quarter, when commercial and strategic position holders shift their open interest from expiring nearby contracts into the next deferred contracts. Seasoned practitioners will be keenly aware, however, that the quarterly roll is but part of the story. When short-term interest rates get volatile, Treasury calendar spreads serve double duty as a handy means of gaining or shedding money market rate exposure.

To see this, suppose you are long the Jun-Sep calendar spread, i.e., you hold a long position in June futures and an equal size short position in September futures. If you make the simplifying assumption that the same Treasury security is cheapest to deliver into both contracts, then the calendar spread has a clear interpretation as a 3-month money market rate. The return is simply the holding period yield you would earn by taking delivery of the cheapest-to-deliver issue at its June futures invoice price and delivering the same issue three months later at its September futures invoice price.

Treasury Cash-Futures Basis Spreads 

…are increasingly attractive alternatives. Its deep connection to short term interest rates will be familiar to any veteran trader in the habit of monitoring and evaluating implied repo rates on Treasury cash-futures spreads.

For anyone else, it’s useful to recall that the return on a Treasury futures basis position is essentially a money market rate. If you are long the basis, you hold (a) a short position in a Treasury futures contract and (b) a long position in a deliverable-grade Treasury security which you plan to deliver into the contract at expiry. The return on the basis spread is the holding period yield you earn by buying the cash Treasury note or bond and the delivery invoice price implied by the price at which you establish your futures short position. The converse holds if you are short the basis.

How do these two lines of attack compare? For the trader who lacks convenient access to the cash Treasury securities market, the Treasury futures calendar spread is unquestionably the better choice.

Tactical traders who enjoy rapid, efficient, and reliable access to cash Treasuries, however, may prefer the cash-futures basis spread on at least three grounds.

One is clarity. The notional return on the futures calendar spread is straightforward only as long as the same Treasury security is the indisputable cheapest-to-deliver issue for both legs of the spread. As soon as different Treasury issues emerge as cheapest to deliver into each of the spread’s two component futures contracts, the job of reckoning the spread’s notional money market return requires more careful handling, far more work, and various extra side assumptions as to arbitrage relationships. The cash-futures basis spread poses no such difficulties.

Another, surprisingly, is flexibility. In its classic guise, the Treasury cash-futures basis is regarded as a form of strategic arbitrage, in which the trader enters the position with the intention of maintaining it for several days, weeks, or even months. But the classic approach is not the only approach. For the alert trader, tactical intraday trading of basis positions is a means of capitalizing upon tick friction – momentary divergences from fair value – between cash and futures. For nimble relative-value traders, it also opens up an alternative avenue for taking advantage of transi- tory divergences among money market rates – specifically, between the synthetic money market rate captured in the Treasury basis spread position versus the rate exposures reflected in Eurodollar futures, Fed Funds futures, or other CME STIR products.

A third reason is convenience. For traders who prefer not to participate in the market for Treasury repurchase agreements, a purely tactical intraday approach should be appealing for its light touch. Unlike the classic strategic approach to basis trading, intraday cash-futures spread trading entails no overnight or term financing of the spread position’s cash leg.

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