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The Trading Mesh

Using the GMEX IRS CMF to Hedge a Bond Position

Fri, 07 Aug 2015 06:17:49 GMT           

By VJ Angelo, Chief Strategy Officer of GMEX Exchange
This article was originally published at The OTC Space and is reproduced here with permission   

Introduction

With the launch of the GMEX Interest Rate Swap Constant Maturity Future (IRS CMF) on GMEX Exchange as of 7thAugust 2015, this article provides an example of how the contract can be used by an asset manager to hedge a physical bond position.

This is the first in a series of articles providing a range of worked examples of how the IRS CMF can be used as an interest-rate hedging tool.

The GMEX IRS CMF

The concept behind the GMEX IRS CMF is to create a futures contract that closely replicates the hedging properties of a vanilla Spot interest rate swap (IRS), while leveraging the advantages of a listed derivative.

From a hedging perspective, the contract contains a number of unique features. For example, it is settled daily to GMEX’s proprietary Interest Rate Swap Constant Maturity Index (IRS CMI), which is calculated in real time using tradable IRS prices from the interbank market. Also, it has no time decay and does not mature; the daily maturity calibration process (which incorporates carry of an IRS, fed back in on a daily basis) ensures positions are kept in the same maturity from one day to the next. This feature, along with the full curve of maturities available from two to thirty years, means that the IRS CMF is not subject to the position changes and recalculations that a quarterly roll entails . Additionally, unlike many other similar contracts, the CMF offers the convexity of the IRS market through the use of a variable tick value, using the present value of the notional swap of the CMF entered into.

As a Eurex listed and cleared derivative, there are a number of advantages that the IRS CMF offers. The contract is traded on a central limit order book and offers a single centralised liquidity pool for clean price discovery, but at a substantially lower margin cost base than over the counter (OTC) IRSs, being subject to 2-day as opposed to 5-day VAR, with planned margin offsets against other Eurex products such as Schatz, Bobl, Bund and Buxl.

(Full product specifications of the IRS CMF are available at the GMEX website - www.gmex-group.com).

Sovereign or Corporate Bond Hedging

The key aspects of hedging a physical bond position are to reduce the risks caused by market volatility and price moves by locking in, as much as possible, the fixed coupon of the bond.

In the past, firms have used IRSs to hedge the fixed coupon of the bond, leaving only the floating leg (LIBOR) of the IRS to hedge or manage. This has traditionally been achieved through the use of Forward Rate Agreements (FRAs) or the use of Short Term Interest Rate (STIR) Futures contracts. However, the demise of the deposit market and the ongoing LIBOR scandal has left many firms questioning the use of these markets. The use of STIRs adds both the roll risk and further difficulties stemming from the fact that they do not represent the true economic value of the floating rate risk.

Additionally, the use of IRSs has now become increasingly expensive.  Firms are suffering constrained balance sheets, along with the cost of margining as well as decreasing liquidity and increasing bid/offer spreads, which means that the cost of this hedge method is rapidly becoming prohibitive for many firms.

Alternatively, firms could try to use Sovereign Debt futures to hedge their bond positions, but this approach also has challenges such as the influence on pricing from the cheapest-to-deliver (CTD), the cost of quarterly rolls when holding a long term position, and the large gaps in the futures curve that make delta management intensive.

Fortunately, the IRS CMF offers a third way, combining the flexibility of the IRS markets with the cost advantages of the futures markets.

Linear Duration Hedge Using IRS CMF

The following trade example is of a simple linear duration hedge using the GMEX IRS CMF to hedge a physical bond position. This method (the simplest and easiest hedge method to manage, requiring little in the way of calculation) takes into account the time decay of the underlying bond against the constant maturity of the futures contract.

In this example, a 10-year bond at issuance is hedged on day one with a 10-year IRS CMF, so on trade date (T) the bond and the CMF are perfectly matched. On T+1, the bond has decayed to a 9y 364d maturity whereas the CMF maturity is still 10 years, so the position will need to be adjusted.

The hedging method below explains how to maintain as close a hedge as possible during the lifetime of the trade using the CMF curve of contracts.


Trade date T

Bank A purchases $50 Million of the 10-year bond issuance and purchases 50 Million equivalent of the 10-year CMF = 1000 Contracts (each of $50,000 notional):

 

Bond

IRS CMF

Overall

Position

Long $50m

Long 1000 ($50m notional)

Netted

Maturity

10 years

10 years

Netted

Cash Position

Lender

Notional borrower

Netted

Rate Position

Receiver of Fixed

Notional payer of fixed

Netted


T + 1

 

Bond

IRS CMF

Overall

Position

Long $50m

Long 1000 ($50m notional)

Netted

Maturity

9 years 364 days

10 years

Mismatched

Cash Position

Lender

Notional borrower

Notionally matched

Rate Position

Receiver of Fixed

Notional payer of fixed

Notionally mismatched

The challenge for the trader is to keep mismatches to a minimum and keep the hedge as close as possible. To this end, the CMF position must synthetically mature along with the bond.

As the CMF contracts are available at every annual point on the curve, the ability to do this with fairly tight deltas is relatively easy using a simple linear hedge.

Assuming there are exactly 250 business days between 9 years and 10 years, the trader would simply roll four contracts (1000 contracts / 250 business days = 4) out of the 10-year maturity and into the 9-year, each business day that the position is held.

Thus, as the point the Bond reaches 9y in maturity the entire CMF position would also be in the 9y contract.

The following diagrams show how the hedge is re-balanced daily over the first year:


Trade Date T

 

 

 

Bank A’s position at trade date T:

 

 

 

 

T + 1

 

The bond maturity is now 9 years 364 days (because the 10-year maturity has decayed by 1 business day). The CMF maturity is still 10 years (because the CMF maintains its maturity).

As there is now a mismatch between the two positions, Bank A needs to rebalance its position with a trade roll in the CMF, whereby 4 contracts of the 10-year CMF are sold and 4 contracts of the 9-year CMF are bought:

 

This results in the following hedged position:

 

 

 

 

With the trade roll conducted each day, after the first year, the position is as follows:

 

 

 

Conclusion

This article has demonstrated how easy it is to hedge a bond position accurately using the GMEX IRS CMF. We look forward to sharing more examples of how the CMF can be used to hedge interest rate exposures, and would welcome feedback from readers.

About GMEX

Global Markets Exchange Group Limited (GMEX) is authorised and regulated by the UK Financial Conduct Authority (FCA) to operate GMEX Exchange. GMEX is a wholly-owned subsidiary of GMEX Group.

About GMEX Group

GMEX Group is a group of companies that offer sustainable and innovative solutions for the new era of global financial markets, encompassing:

  • Operation of an exchange for the trading of a Constant Maturity Future for Interest Rate Swaps
  • Development of related new tradable market and product indices
  • Creation and operation of low cost electronic exchanges in equities, debt, FX, derivatives and commodities in developing and, in a targeted way, developed markets
  • Interconnectivity of exchanges to each other creating a global network of liquidity
  • Business development to enhance liquidity in partner exchange products
  • Consultancy on exchange strategy, product development, clearing and regulation
  • Provision of exchange, clearing house and depository platform technology

GMEX Group stakeholders include Deutsche Börse AG, Société Générale Corporate & Investment Banking and Forum Trading Solutions Limited through its investment vehicle.

For more information. visit www.gmex-group.com

or follow us on Twitter @GMEX_Group

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