Rolling over "Long Gilt Futures"

[bullboy8]

Hi

I am shorting the "long Gilt Futures-March 2012" via spread bet. The expiry is 27th Feb 2012 and was wondering if I roll if over to the next futures contract (the one that expires at the next quarter June 2012), what are the complications in terms of backwardation/contango. WOuld I roll over to a higher price or lower price? Completed new to the futures market.

Also, can anyone can explain how the " conversion factor" is calculated in layman's term. I kinda understand it as converting the "cheapest to delivery" gilt's YTM (maturity being the futures contract maturity date not the gilt's actual maturity date?) to the notional coupon of the futures contract. Many thanks.

 

[Martinghoul]

It's very difficult to explain this in a few words. You really need to read a book on bond futures. Specifically, the "Treasury Bond Basis" by Burghardt, Belton et al.

The gilt roll is an art/science unto itself and has a lot of components to it. At the moment, there's a lot of uncertainty arnd the CTD for the Jun12 contract (due to a variety of factors), which makes things even more difficult.

 

[bullboy8]

It's very difficult to explain this in a few words. You really need to read a book on bond futures. Specifically, the "Treasury Bond Basis" by Burghardt, Belton et al.

The gilt roll is an art/science unto itself and has a lot of components to it. At the moment, there's a lot of uncertainty arnd the CTD for the Jun12 contract (due to a variety of factors), which makes things even more difficult.

THanks for the reply, you've made things even more confusing...hmmm..not sure if i should auto roll over then...

 

[Martinghoul]

THanks for the reply, you've made things even more confusing...hmmm..not sure if i should auto roll over then...

Sorry, but these things are actually confusing... People make money (sometimes very decent money) trading the roll, so if it weren't confusing it would be free money and we can't have that, can we?

 

[bullboy8]

Sorry, but these things are actually confusing... People make money (sometimes very decent money) trading the roll, so if it weren't confusing it would be free money and we can't have that, can we?

after a sleepless night, i think the answer i really need is not how it all works but rather if

A. the long gilt futures market is efficient and has little or no price discrepancies between the cash prices and the futures market (one would think it is as I read it is very liquid market).

B. An the other question is does the usual issues of contangion/backwardation apply to this market like the oil market. If this does, then one should rollover in a backwardation market (assuming you are shorting) and don't rollover in a contango environment (again assuming u are shorting). Is this all correct?......

Thanks........

 

[Martinghoul]

A. Yes and no. While the mkt is very liquid, the spread between cash and futures (aka "the basis") does vary, due to a variety of factors. So price discrepancies do occur, but they are not a symptom of mkt inefficiencies.

B. Not really. The problem is that the underlying for bond futures, such as the long gilt, isn't a single bond, but rather a basket of bonds. As a result, the simple level of the roll doesn't really tell you much, because you're, in effect, comparing apples w/oranges.

Again, I wish I could make it simple, but the reality of it is that I can't. I am happy to help you dig into it, but I am afraid there's really no good simple answer to your questions. Of course, you probably won't go too far wrong if you ignore all the funky complexities and just wait for the roll to settle down (most of the time, there's some volatility initially, but things calm down towards the end; there are exceptions) and just lift/hit the mkt.

 

[bullboy8]

Maringhoul

A. it's interesting to learn that price discrepancies exist in this hugely liquid market where active basis trading takes place....can you share a couple of examples-just a couple wil do so that I can explore them further at a convenient moment.

B. I'll take the advice and hope for the best...when you say wait for the roll to settle down-care to define the duration of wait. these are quarterly contracts that have a trading life of 2 months. Trasding in & out before expire will be hit by the 2 trades hence my initial reasoning to roll them over (as it seems companies allow you to roll them over at half the normal spread-at least city index does).

I'll quickly share a little background, initially I came across the ishares gilt (epic-IGLT) on the IG platform and was hoping to short it. As i pressed the sell button the platform informed me that due to borrowing restrictions this etf can't be shorted. You see, my strength is within the funds/etf sector as I can see what the spreadbet is trying to mimic. after speaking to a salesadvicer at IG i was pointed to the Long GIlt futures market. However, the complexity of this structure leaves me scratching my head. I can't seem to find the underlying futures price and compare it to the price being offered by SB companies. anyways...going on too much now. THanks for all your input and hope to learn from you more.

 

[bullboy8]

MAringhoul

Do you know what this means:

News And Announcements Preview Manager

 

[Martinghoul]

Yeah, first, in answer to your latest post, yes, I know what the announcement meant. There was a brief period last year when there was some really funny stuff happening with the gilt futures, due to a old high-coupon gilt (8 21s), which would have been the CTD for both Mar and Jun futures. That was undesirable for a variety of reasons (the bond is very old, the BoE owns a chunk of it and it's just not really a good choice for the CTD, 'cause it's a bit of an aberration). So, well in advance, while Dec was the front contract, they decided to adjust the contract spec to make sure that only "representative" bonds can be part of the basket. That was the reason for the temporary suspension.

 

[Martinghoul]

Right, now in answer to your other questions...

A. Well, let me give you a very extreme example. Apart from the more esoteric stuff, like doing basis trades that take advantage of the various optionalities embedded in the contract (e.g. the CTD switch), the main fundamental driver of the basis is availability of capital (balance sheet). When capital becomes scarce, there's an incentive to prefer futures to cash bonds, because the amount of actual capital you need to commit is much lower for futures. So if you look at what occurred at the end of '08, you will find that the basis went properly nuts. If you had capital and funding back then, you could have sold the futures, bot the cash bonds and made out like a bandit. Of course, this was true of pretty much any asset at the end of '08, but that's beside the point. That's an example of a proper move, but it should give you an idea of the main factor involved. If you want examples of a more esoteric sort, let me know.

B. So the gilt roll gets properly active and liquid probably arnd the week before first notice date (for Mar12 contract that's 28th of Feb). By the end of that week things should settle down and you should be able to do your rolls at some sort of a "reasonable" level. Again, this isn't a recommendation to do it, since there are all sorts of exceptions. Best thing to do is to watch carefully and wait for it to "settle down".

So I do see your point. Ultimately it all depends on what your rationale for the trade is, really. If you have a big-picture macro view and expect to make, I dunno, hundreds of basis points, then you really shouldn't worry about small stuff like rolls, etc. Complexity is there primarily for people who trade the various bits of the gilt curve on a relative basis. As to the ETFs etc, I am not familiar w/that mkt at all, but I heard they have complexities of their own and sometimes what you think isn't really what you get.

 

[bullboy8]

MartingHoul

This is good stuff, really fascinated at how futures work. It prob take me years to understand and learn.

is there any way of knowing if a future is trading at a premium/discount to the CTD gilt? like a graph? with ETF's, they have a daily NAV or iNAV which one can compare with the live price to see if it is trading at a premium/discount. surely, it exist as market participants won't know when the arb

Still a little confused with the rollover bit, so in simple terms, do you advise I

A. hold the March 2012 futures and let it expire, then re-buy the June 2012 futures 2nd week of March 2012
B. hold march 2012 futures and let IG roll it over (not sure when they roll it over-would this be the expiry date - 27th Feb)
C. Hold the march 2012 futures and exit a few days before the expiry date

Knowing that bond futures don't suffer the same backwardation/contagion issue the only reason for being so unsure is that I've played the options market before (covered warrants with SG), and seen how they increase their spreads near expiry. On this thought, my guess is that the same will occur in the futures market where the spread in the last couple of days before expiry will shoot up and hit profits (if any) as one rollto the next. And again be hit by big spreads when you enter the new contract (assuming auto rollover) I must admit, this is complex stuff but loving it!

 

[Martinghoul]

I am sure it won't be years. For this stuff I can't recommend the "Treasury Bond Basis" book by Burghardt, Belton et al enough. It's really very good at explaining all the relevant concepts, even though it's focused on US bond futures.

As to the richness/cheapness of the futures vs cash bonds, gross basis and net basis are the two relevant metrics. Unfortunately, I don't know of an easy way to generate a history of these things (since you need a whole bunch of somewhat esoteric data). Otherwise, you're correct, people do look at net basis, for example, to get an idea of value. For example, at the end of 2008 gilt net basis went heavily negative.

As to my "recommendation", I would say it's C, although I am not entirely sure what IG normally does.

So the roll dynamic in gilts is a bit different. It's not entirely true that it just shoots up near expiry. What happens is that there's a lot of volatility when large accounts decide to roll. Unlike the ETF schlubs (e.g. USO) there is no real constraint arnd when the rolls have to happen, so it's all very uncertain. There will be periods when the spread spikes or collapses, because someone has decided to either roll or front-run someone who is going to roll. In fact, this time arnd it's likely to be extra special and volatile, because the whole mkt has to guess what the new 10y gilt is going to look like. So it's hard to even establish "fair value" for the roll properly. Anyways, I will try to keep you updated, but it's fun times in the gilt mkt at the moment.

 

[bullboy8]

net basis data....hmmm...where can one find that info?

I think you're right on the rolling process being super complicated. I've read that when you short and roll over to the next contract, you buy the current contract and sell the new contract. i.e. sell March buy June and The march contract is more expensive than June. hahaha, when you think there's not much more.........I just can't think why the march contract will be more than the june contract-surely this is only true if the market expects the yield to be higher in June than march.

My logic is this (albeit simple one). The market assumes:

March contract £100,000
June contract £95,000 (because yields will rise and push down the CTD gilt price)

Am i right to say that if the market expects the yield to be lower in june than march then one will gain during rollover?

 

[Martinghoul]

Nah, you're incorrect... The whole point with bonds is that there's a very significant time dimension to everything you do. So think of it this way... Suppose you buy the Mar12 gilt futures at 100 today. For simplicity, let's assume that this is equivalent to buying the CTD for 28th of Feb delivery at 100. Let's then say that at the same exact time you buy the the Jun12 futures at price x. That is equivalent to buying the very same CTD for 1st of Jun delivery at price x. What do you think should be a relationship between x and 100? Hint: remember, this is a bond and it accrues a coupon.

 

[bullboy8]

My answer/best guess: one would buy the March 12 futures at 100 (expiry price) and sell the June futures at x. The difference between the two futures is irrelevant because you have exited one contract and opened a new, so you close your old price by buying it since you sold at that old price and sold at a new price in a new contract with no bearing in price to the old.
Ok, bouncing all around the place but starting to piece it all together now. Another one if you don’t mind. Is this statement or shall i say paragraph correct?
“When one shorts a long gilt future, he/she sell a future. Assuming the CTD is priced at £100 the shorter will receive the cost of carry, in this case assumed to be £5, so the future will be priced at say £105. This is to compensate the shorter having to keep his £100 in the market (i.e. he can’t leave it in the bank to accrual interest whereas the long person can). Assuming a static gilt price all the way to expiry, the £105 futures price should theoretically go down to £100 (i.e. spot price of the CTD gilt)
So, if on the slight chance that the above is true, this “long gilt futures” market is a sure win for shorters should the price of gilts stay static as he will gain on receiving the cost of carry.
Heheh....as always, what is the formula for the cost of carry? I recall it being yield on the CTD gilt - 3 mon LIBOR?

 

[bullboy8]

is there anyway you can see the profit/loss of holding the long gilt future (assuming auto rollover) over a time period say 5 yrs? It's hard to gauge the historic profit and loss for training. Thanks.

 

[Martinghoul]

Right, so it is all about the cost of carry, as you have correctly pointed out. The problem is that I think you have the direction backwards. If you're long the bond, you receive coupons (or dividends, if you're more comfortable w/equities terminology). If you're short the bond, you must pay these coupons/dividends. Let's assume for the moment that the coupons/dividends are higher than the prevailing funding rate (as is the case at the moment). What does this mean? This means that, generally speaking, being long gilts/gilt futures is a positive carry position, whereas being short gilts/gilt futures is a negative carry position. This, in turn, implies that if the price of the CTD today is 100, the price of the futures has to be X, where X is lower than 100. Reason being that the fair price of the futures is one that makes you indifferent between being long/short the CTD today at 100 and being long/short the CTD out of some future date at X. Does that make sense? That is the reason why you will see the price of the Jun12 contract lower than the price of the Mar12 contract, all else being equal.

And yes, roughly, you can estimate the cost of carry as the yield - 3M LIBOR. Currently, that's arnd 220bps per annum.

Yes, it's very difficult to see the history of this. Basically, what you need is the historical total return from being long 10y gilts (cash bonds is fine for a rough proxy). I don't know how to get that off the top of my head, but I imagine it should be possible to do this using the total return of smth like one of the FTSE gilt indices. See here for the list: Values - FTSE I am not sure how to actually get the historical data, but let me dig arnd.

 

[bullboy8]

Is this index suitable? FTSE British Government Index (Over 15 years)-I got data since 2000 and it shows approx 90% bull market over the period, there's little negative 12 months rolling returns-here's the data (*100 to convert to %). but assuming I need to minus 3 mon LIBOR for each 12 months rolling period?

07/2000 0.06483
08/2000 0.02747
09/2000 0.06633
10/2000 0.03860
11/2000 0.04861
12/2000 0.07989
01/2001 0.09347
02/2001 0.06839
03/2001 0.03680
04/2001 -0.01234
05/2001 -0.02557
06/2001 -0.02135
07/2001 0.01835
08/2001 0.05226
09/2001 0.03111
10/2001 0.07611
11/2001 0.03016
12/2001 -0.00912
01/2002 0.01578
02/2002 0.00158
03/2002 -0.01429
04/2002 0.03346
05/2002 0.03709
06/2002 0.07966
07/2002 0.05211
08/2002 0.07249
09/2002 0.11445
10/2002 0.03356
11/2002 0.02712
12/2002 0.09920
01/2003 0.09315
02/2003 0.10630
03/2003 0.13047
04/2003 0.11105
05/2003 0.15931
06/2003 0.09136
07/2003 0.04734
08/2003 0.01893
09/2003 0.00612
10/2003 -0.00279
11/2003 0.01222
12/2003 0.01187
01/2004 -0.00814
02/2004 0.00359
03/2004 0.02840
04/2004 0.01077
05/2004 -0.03146
06/2004 -0.00108
07/2004 0.03854
08/2004 0.04597
09/2004 0.04508
10/2004 0.08809
11/2004 0.10847
12/2004 0.08416
01/2005 0.07944
02/2005 0.06784
03/2005 0.05423
04/2005 0.10247
05/2005 0.13374
06/2005 0.14424
07/2005 0.12100
08/2005 0.12033
09/2005 0.10432
10/2005 0.09274
11/2005 0.09571
12/2005 0.11003
01/2006 0.13852
02/2006 0.14032
03/2006 0.10691
04/2006 0.05589
05/2006 0.04534
06/2006 0.00976
07/2006 0.04581
08/2006 0.04269
09/2006 0.05572
10/2006 0.07322
11/2006 0.04569
12/2006 0.00033

01/2007 -0.04276
02/2007 -0.01833
03/2007 -0.01081
04/2007 0.00494

05/2007 -0.02149
06/2007 -0.03260
07/2007 -0.01581
08/2007 -0.01692
09/2007 -0.03572
10/2007 -0.04178
11/2007 -0.02274
12/2007 0.02667
01/2008 0.05346
02/2008 0.02407
03/2008 0.05058
04/2008 0.04337
05/2008 0.04459
06/2008 0.05968
07/2008 0.04829
08/2008 0.05606
09/2008 0.05428
10/2008 0.03378
11/2008 0.08170
12/2008 0.13648
01/2009 0.02942
02/2009 0.04486
03/2009 0.08575
04/2009 0.07801
05/2009 0.07096
06/2009 0.11271
07/2009 0.06288
08/2009 0.11282
09/2009 0.13253
10/2009 0.13225
11/2009 0.07786
12/2009 -0.04836
01/2010 0.06100
02/2010 0.02490
03/2010 -0.00151
04/2010 0.03044
05/2010 0.08730
06/2010 0.07956
07/2010 0.08367
08/2010 0.09496
09/2010 0.07825
10/2010 0.04858
11/2010 0.02674
12/2010 0.08780
01/2011 0.03754
02/2011 0.07808
03/2011 0.06938
04/2011 0.09259
05/2011 0.07206
06/2011 0.02813
07/2011 0.09180
08/2011 0.03164
09/2011 0.11221
10/2011 0.18466
11/2011 0.25066
12/2011 0.26257

In 2011 it is up 26% !!!!!!

CAn you define the yield in the cost of carry calc (yield - 3 mon LIBOR). Current libor is 1.1% approx so would suggeset a yield of 3.3% according to your calc of 2.2% approx cost of carry. is this YTM? If so, i souced from:

YieldCurve.com - the site dedicated to fixed income and the global debt capital markets

and for a 10 yr gilt it shows 2.18%.

If my index is correct and this shows a pretty accurate P/L for the "long gilt futures" market then this suggest shorters are doomed, right, as 90% of the time they wll lose money. many thanks.

 

[bullboy8]

Please allow me to have one final stab before giving up.

The long buys a future priced at £100 (assuming a £5 margin requirement) he borrows £95 at LIBOR (0.5%). This £100 is paid over to the shorter . The CTD price at this point should be greater than £100 because the shorter has to pay the coupon to the long.

At expiry, the short goes out to buy the CTD gilt and delivies this to the long. The long repays the £95 plus interest at LIBOR.

feel like giving up-this is quite difficult.

 

[Martinghoul]

Is this index suitable? FTSE British Government Index (Over 15 years)-I got data since 2000 and it shows approx 90% bull market over the period, there's little negative 12 months rolling returns-here's the data (*100 to convert to %). but assuming I need to minus 3 mon LIBOR for each 12 months rolling period?

07/2000 0.06483
..
12/2011 0.26257

In 2011 it is up 26% !!!!!!

CAn you define the yield in the cost of carry calc (yield - 3 mon LIBOR). Current libor is 1.1% approx so would suggeset a yield of 3.3% according to your calc of 2.2% approx cost of carry. is this YTM? If so, i souced from:

YieldCurve.com - the site dedicated to fixed income and the global debt capital markets

and for a 10 yr gilt it shows 2.18%.

If my index is correct and this shows a pretty accurate P/L for the "long gilt futures" market then this suggest shorters are doomed, right, as 90% of the time they wll lose money. many thanks.

Yeah, 15+ FTSE should be a roughly OK proxy. And yes, if you assume you're funding yourself at LIBOR, you should take the total return of the gilt index and subtract LIBOR, which should sort of give you the return net of funding (very roughly). And yes, in general, we've been in a secular bull mkt for bonds for a long time now (some say from well before 2000 and suggest that it has to do w/demographics; who knows). And yes, since the crisis, the bond mkt has been on a tear and especially so recently w/all the European developments (any non-EUR denominated safe asset is desperately wanted).

As to my figure for the carry, pls forgive me, that was a total brain fart. I gave you just the 10y gilt yield number and forgot to subtract the LIBOR bit. Very sorry.

And yes, this trade is either doom or it's the trade of the century, right? Who knows which one it is. BTW, there's nothing special about gilts, in that sense. You can look at US treasuries or Japanese JGBs, the overall story is the same. So take your pick: you're either short at pretty much close to all-time best levels ever, but you have to pay to hold the position; or you're long at a really horrible level, but you get paid for it. IMHO, being short bonds is a trade that will work, but it's all about the timing. Lots and lots of people have tried to be short, but got the timing wrong and stopped out.