Debt Markets Macquarie Bank Group Bond Futures Trading Practice Paul Bide Head of Debt Markets Research Macquarie Bank Limited, Australia 1

Debt Markets Macquarie Bank Group The Australian Bond Market Government BondsA$80bn State Government BondsA$35bn Non-Government BondsA$35bn(investment grade) A$150bn 30% of Government bonds are owned by non-residents Only about 10-15% of Non-Government bonds are held by non-residents Most futures trading is done by residents of Australia. It is based on trading against bonds and other instruments. 2

Debt Markets Macquarie Bank Group Who uses futures? funds managers insurance companies/pension funds swap bookrunners fixed income bookrunners traders arbitragers option books 3

Debt Markets Macquarie Bank Group What are futures used for? Portfolio Management large pension funds use futures to alter duration or yield curve exposure without realising taxable gains. Hedging fixed income bookrunning risk most fixed income books offset physical bond positions with futures and leave their portfolios hedged Bond/futures arbitrage opportunities many traders arbitrage the bond basket to futures relative value differences if they exist. 4

Debt Markets Macquarie Bank Group How important are futures to the market? In Australia, the futures market is the primary market where income exposure is traded It is important to the liquidity of our financial system It is liquid, transparent and easily identifiable It promotes liquidity, enables efficient risk management and allows for an easy price discovery process Futures have helped the Australian marketplace to mature and grow 5

Debt Markets Macquarie Bank Group How is a bond futures price calculated? 1.Calculate the forward yield of the bonds in the basket 2.Average the forward yield of the bonds in the basket. (Normally 4 bonds) 3.Deduct that forward yield from 100 Australian futures imply a price but are actually an implied yield of a basket of bonds US futures are a price 6

Debt Markets Macquarie Bank Group How is a bond futures contract “cashed out”? 1.On close-out day, the SFE takes market samplings of the bond price of the bonds in the basket. 2.It takes samplings at 3 different times of the day am, 10.30am and 11.15am. This is to prevent pricing distortions and manipulations. The times are designed to avoid monetary policy statements (9.30am) and Australian Government statistical releases (11.30am). 3.The SFE ask 8-10 bond market bookrunners for the price of the bonds in the basket, then knocks out the high and low, then averages the rest. This is also to avoid manipulation and distortion. 7

Debt Markets Macquarie Bank Group What is an arbitrage? An arbitrage is an opportunity to profit from buying one instrument / selling another without incurring market risk. A bond basket - futures arbitrage involves locking in the futures (which is made up of the basket of bonds) to the physical bonds in the basket. On close out day, these two are equal by definition. The difference between the future’s price and the forward yields of the bonds is arbitrage profit that can be captured. 8

Debt Markets Macquarie Bank Group What do you need to do an arbitrage? Access to the repo market for bonds. The repo market not only facilitates two way price making in bonds. It also allows you to lock in funding to the futures close out date. 9

Debt Markets Macquarie Bank Group Why is the repo important? Because an arbitrage is done by buying or selling bonds forward against a short or long futures position. The forward bond position must be locked in (via a repo) or it is not an arbitrage. Funding levels may change and what was assumed to be arbitrage profit will turn into a loss if that happens. 10

Debt Markets Macquarie Bank Group What happens on close out day if you are unwinding an arbitrage? 1.Futures close out price determined 2.Bonds bought or sold against futures position are squared out 3.Futures positions is cashed out against futures close 4.Profit from arbitrage trade is cash 11

Debt Markets Macquarie Bank Group How does cash settlement work? Yield of a futures position is used to calculate the implied price of a futures contract ($100,000 face value of bonds) using the Reserve Bank of Australia bond formula. Implied price of offsetting bond futures position at close out price is calculated in the same manner. One is settled against the other. Hence the term, cash settlement. 12

Debt Markets Macquarie Bank Group Appendix - Calculating a forward yield Australian Government bond 7½ September 2009 Spot yield6.27% face value$1,000,000 cost (spot)$1,091,290 repo rate4.40% (1month) interest on1,091,290x4.4x31=$4, forward price of bond=spot price + repo charge 1,091,290 4,078 $1,095,368 implied forward yield 6.29% (calculated by working back from bond formula) 13

Debt Markets Macquarie Bank Group 14