December 3, 2011

Bonds: Part 2b - The Reality continued

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Calculating the price of an EGB bond has to be fast. A big bank may have 400 or so European bond obligations and the quotes need to be recalculated quickly when the market moves. It is possible to recover from incorrect prices on D2C markets, with their negotiable RFQs. However, if an executable D2D quote is wrong then the trader will likely lose money.

By fast I mean determining all the actively quoted prices and sending them to the market in around 50 milliseconds. Fast enough that humans can not be involved in the pricing system in any direct manner. Other instruments, like FX and equities have even lower latency requirements (they need to be faster), but they don’t need as much calculation. This is an ever decreasing target, when I started on EGB desks in 2007 the equivalent figure was around 125 milliseconds. It depends entirely on the relative speed of the other banks on the D2D markets. There are three rough categories of EGB pricing speed. The fastest couple of banks can get their prices updated quickly enough that they can make money off the slowest handful – a process known as latency arbitrage. The majority of banks sit safely inbetween these two extremes, neither profiting from the slower banks nor losing money (except to mistakes). Of course over time banks improve their systems and the speeds needed to be safe or profitable only increase. I have worked for banks that at various points have been in all three categories and a significant proportion of my time has been spend analysing and improving EGB pricing speed. At the moment I would guess 50ms pricing would definitely be safe, towards 100ms is danger territory and below 10ms could be profitable.

It is vital to detect when the yield curve moves and reprice appropriately. For EGBs the yield curve is driven by German bond futures traded on the Eurex market in Frankfurt. These futures are derivative contracts to deliver a specified German government bond at a future date. There are a number of them categorised by the maturity of the bond to be delivered. The Schatz delivers a bond with a remaining maturity around 2 years in the future. The Bobl delivers a 5 year bond, while the Bund returns a 10 year and a 30 year bond for the Buxl. The contracts last 9 months and new futures contracts are created every 3 months. So there is always a current contract with the correct tenor. Every quarter the futures used in the yield curve are converted to the current contract. The point every quarter where the new futures take over from the old contracts is known as the “futures roll”.

For example at the moment there are three Bund futures contracts available for trading – expiring in December 2011, March 2012 or June 2012. This month the December contract will expire and be replaced with a September 2012 contract. When the December contract matures those that are short will have to deliver German bonds maturing in roughly 10 years to those with long positions. The contract will list a basket of bonds which may be delivered. The cheapest of these is known as the Cheapest To Deliver (CTD) and is always the one which is actually delivered. Normally the CTD does not change during the length of the contract, but a basket is specified to make it hard to manipulate the futures price.

There are also Italian Government bond futures, but I haven’t heard of these being used for pricing, just hedging. Even if they were used for pricing I can’t imagine it would be for anything other than Italian bonds, whereas the German bond futures affect the entire Euro bond market.

The Schatz, Bobl and Bund futures are the most liquid instruments on the European yield curve and so are used for the 2, 5 and 10 year points. The relatively new Buxl contract is increasingly used as the driving point at the long end of the curve. Although there is some question over its liquidity, so some places may use swaps or a specially computed point instead. Below the 2 year mark Euribor futures are used to drive the curve – although I haven’t dealt much with the short end. I’ve seen curves with other instruments like swaps, but for EGB pricing the German bond futures are always the dominant drivers. If a future changes value then the curve adjusts slightly and the bond prices are recalculated.

Bond prices are determined using a spread off the yield curve at the point corresponding to the bond’s maturity. The size of the spread is determined by credit risk plus liquidity or other terms. Some banks may have a yield curve for each Eurozone country despite them having the same currency and central bank. Visualising these country curves better capture the credit risk of each country and a quant once suggested it also aided pricing. The German curve is the closest to the idealised curve, as it is the safest country. Other countries then spread further away until Greece is reached, clearly worse and separate from the core. As all these curves are based off the same futures, they all move roughly in sync with each other as the futures move. Sometimes they move separately if a country’s perceived risk changes relative to the benchmark – the Bund future.

Thus European government bonds generally move in known ways relative to each other and the futures. This can be used for hedging. Traders are constantly aware of the interest rate risk they are taking with their positions (using DV01 as described in Part 1). Generally they are supposed to keep their risk flat – that is close to 0. They will have a set risk limit and every night their positions will be checked against this limit. Regularly or excessively exceeding your limit is a serious offence. Trying to hide being over the risk limit is one of the definitions of a rogue trader. EGB traders generally are not supposed to take risks and so have relatively low risk limits. They are considered flow traders, working to create business with clients and this doesn’t require them to take risks (although some do take small’ish risks). They are not supposed to be trading for the bank’s account (like proprietary or prop trading). Instead they keep their positions small and take a small cut of a large flow of trades with clients (or at least that is the theory). It is supposed to be steady money, without taking any directional bets, just taking the spread difference between the D2D and D2C markets. When I started a quant explained to me that an EGB desk should not make huge amounts of money, but should never lose money either.

When a position is taken, to keep their risk down the EGB traders hedge. That is they trade something else in such a way as to counteract the interest rate risk of the original trade. Thus the two (or more) trades when combined result in flat risk. The obvious way to do this is just to do the reverse trade. That is if a trader buys 10 million of a bond from a client, then immediate turn around and sell the same bonds to someone else. Thus the total position is zero and the risk is zero. However, this is not normally profitable (due to the spread). There was a beginner trader who liked to do this – he constantly lost money in a booming market and was sacked after a few months. Normally it is necessary to hold onto a position for some time before trading out of a position profitably, so other means of hedging are utilised.

Usually hedging means trading the German bond futures. With every futures roll, the proportion of each future that offsets each bond is calculated (usually by the quants). Thus at a point in time a trader may known that for every million in a bond they hold, selling 500,000 Bunds and 200,000 Schatz will offset their risk. This works as the futures are more liquid than any particular bond and the spreads are tighter. Of course the fact that most Euro bonds are hedged with futures is one of the reasons they are so liquid. The Italian bond futures and swaps are also used for hedging on occasion, but the German futures are the most popular. The liquidity in the futures market also means that traders use various strategies to eke out a little extra profit without too much risk. For example a trader may only hedge half of what they need immediately if the market is moving in their favour, hedging the rest a little later at a better price.

Hedging out interest rate risk does not mean there is no risk associated with holding a position. Credit risk is still present. Imagine a Spanish bond is hedged with the German futures. What happens if the Spanish yield curve moves independently of the German curve, because Spain’s credit risk changes relative to the rest of Europe (or at least Germany). At this point the hedge breaks down and the trader either makes or loses money depending on their position. This is what is happening right now in the debt markets. Italy is seen as an increasing risk versus Germany and thus its yields are rising. Anyone long Italian bonds hedged with short German futures is losing money. I know this is happening to some people at the moment.

Theoretically it is possible to hedge away the credit risk with Credit Default Swaps, which is basically just insurance on a bond issuer’s default. However I never saw this used – I’m not sure why, perhaps the cost was too high or it was seen as unnecessary. Instead EGB traders either ignored credit risk (the likelihood a country in the Eurozone defaulting seemed very remote until recently) or just didn’t keep their positions for long.

EGB desks are not like High Frequency Trading (HFT) desks where the length of time a position is held can be counted in milliseconds. Normally it is hours, or often days. If the position was very large the traders may skew the price to encourage others to hit their prices, or ask the salespeople to work away their inventory. In any case, a position is rarely held to maturity. I know of a few bugs in risk systems at large banks related to maturing bonds or futures and which have never been fixed because “that situation never happens” (as a trader once said to me about futures). Holding an instrument to maturity doesn’t involve much profit, but does involve extra bureaucracy and paperwork (especially for futures with the delivery of the relevant underlying bond). It’s easier just to flat the position before maturity.

As previously stated, the two main components of a European government bond’s price are interest rates and credit risk. Credit risk is basically the risk of the country defaulting. This risk is driving European bond prices at the moment. Prices rising for this reason is often called the result of “bond vigilantes” – traders punishing a government for its poor finances and worsening position. It is claimed that austerity will save us from these vigilantes. Although such claims from politicians ignore the other factor driving bond prices. A country heading towards a recession will likely lower its interest rates in the near future to stimulate its economy. Alternatively, in a booming economy interest rates tend to rise. So other things being equal, if a country’s economy is slowing then the yield of its bonds is likely to decrease in the expectation of lower interest rates from the central bank. This is what we are seeing in the UK, credit risk hasn’t changed much but with a recession likely or at least a weak economy, bond yields are at historic lows.

EGB traders keep an eye out for any news that may affect these factors. Millisecond to millisecond pricing is done by the futures driving the yield curve. So traders instead use expectations to adjust spreads, grow or shrink positions for a little profit (within their limits) or turn off quoting in advance of expected volatility. If a large or step change in futures’ pricing is possible, then turning off quotes until the market has settled lessens the likelihood of making a trade which is bad a few milliseconds later (and thus meaning the hedge is done at the wrong level). This often occurred around big economic announcements which could quickly change views of an economy’s direction.

Quoting was always turned off for the largest economic news – monthly US non-farm payrolls (often abbreviated to just “non-farm”), announced on the first Friday of each month at 8:30am New York time (usually 1:30pm London time). The payroll figure describes the number of jobs created (or lost) in the US economy over the previous month along with average pay rises and hours worked. This gives an indication of where the US economy is heading, and thus the world as the US is still the largest component of the world economy. If the US is booming, it is more likely the rest of the world will be too – and vice-versa. The neutral payroll figure is around 200,000 jobs created in a month, as this matches the monthly workforce increase in the US (it is a big country!). Thus lower jobs figures suggest lower bond yields and higher job figures imply higher bond yields.

As always with such economic indicators, it is the difference in expectations that has an effect. In the days leading up to the announcement analysts try to predict the figure and the consensus of these expectations are built into bond prices. When the real figure is announced the prices are adjusted relative to the expected figure. Thus if the market expects a payroll gain of 20K and the announced figure is 80K gained, then yields will rise despite the small gain suggesting a slowing economy.

Resolving the difference between reality and expectation can cause bond prices to jump. This creates lots of noise on the trading floor. Someone junior normally has the job of shouting out the figure as it is released. The more surprising the announcement, the louder the shouting afterward. When the series of bad payroll numbers came out during the financial crisis, the traders cheered loudly. It seems perverse to cheer US job destruction, but as previously stated traders only look at their personal PnL, not the wider picture. In this case the traders had permission to build up a long position and so the falling yields after a bad number made them money.

The noisiest I have heard a trading floor was immediately after non-farms during the start of the financial crisis and the day after Lehman’s went bust. On these occasions it got close to the levels seen in movies when there is a panic. Trading floors are generally noisy places with lots of desks packed together. There are always people shouting instructions, conversing or talking on phones. TVs are constantly on but with the sound turned off unless something big is happening (terrorist attack, Lehman’s collapse, the Ashes). The most annoying noise is the computers. Traders often have their PCs set up to play a noise on various events: a trade done, RFQ received, large price move, etc. So there are constant laser blasts, ka-chings, buzzers, animal sounds, movie quotes and more. It can be hard to concentrate with these intentionally attention grabbing noises. Traders don’t seem to mind too much, they are constantly focussed on the present – though not so good for programming. Strangely one noise almost never heard on a trading floor is a mobile phone ring. Banks like to record all communication for compliance reasons, so personal mobiles are banned or discouraged as they can’t be recorded.

There is probably more to EGB trading than the above – but this is what I have seen and had explained to me.


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