I have no formal education on bonds.. Just from my own research.. I quickly feel a bit of misunderstanding when it comes to this.. So this paper.. "Understanding the Yield Curve" first starts talking about a par yield curve, spot rate curve, and the forward rate curve.. I don't really understand the differences completely.. first i know that par value means that the bond is being referred to as valued neither at a discount nor a premium.. its at face value.. Obviously no bond trades exactly at face value, so there is the "spot" rate.. that is the rate at which the market is valuing the bond.. i'm just checking to make sure my understanding of this is correct up to this point.. next.. where does the forward curve come in.. and how is it derived?
So i found this as the definition of a forward curve.. "Forward rates can be defined as the way the market is feeling about the future movements of interest rates. They do this by extrapolating from the risk-free theoretical spot rate. For example, it is possible to calculate the one-year forward rate one year from now. Forward rates are also known as implied forward rates. To compute a bond's value using forward rates, you must first calculate this rate. After you have calculated this value, you just plug it into the formula for the prices of a bond where the interest rate or yield would be inserted." so its the one year forward rate of interest.. that is calculated from the spot price in some formula?
Firstly, your previous post was correct about the spot and par curves. Secondly, the forward curve is built out of a set of rates that the mkt expects to prevail in the future at different times. For example, the 1y 1y forward rate is a 1y spot rate that the mkt expects in 1y time. Forwards can be calculated from corresponding spot rates using the "no arbitrage" logic. Specifically, to compute the 1y 1y fwd rate you need the 1y rate and the 2y rate. The generic formula (for zero coupon rates, but roughly OK for others as well) is: (1+r(t2))^t2 = (1+r(t1))^t1 * (1+f(t2-t1))^(t2-t1).
CD, what exactly are you trying to do here? The two bibles we had to read for understanding the curve were: http://www.amazon.com/The-Treasury-...82656&sr=8-1&keywords=the+treasury+bond+basis http://www.amazon.com/Eurodollar-Fu...-Investment/dp/0071418555/ref=pd_bxgy_b_img_y These cover the front and back end of the curve. The emphasis is on trading the cash basis which honestly is the only way to trade these. Yeah you can lay on futures spreads but with what edge? Just curious why you ventured over here from stocks and futures and options.
Good question.. I was asked many times the same thing about options from my friends when i start diving deep into options.. Curiosity i guess.. I know my curiosity teeters on beneficial and detrimental .. i'm interested in futures curves, interest rates, spreading, etc.. Interest Rates sort of seem to be a rather important thing that i know very little about.. What do you mean cash basis? what does Cash basis mean..
so the 1 year rate one year from now.. makes sense.. I'm not sure how that forumla brings you to the future 1 year rate , 1 year from now.. but it seems sensible that you would use the 1 year and 2 year rate to get there..
I would suggest you forget about the basis stuff for now, w/ all due respect to maverick. "Basis" in this context means the spread between a cash bond and the bond futures. It's an entirely different kettle of fish and, as far as I understand it, you want to confine yourself to exchange-traded instruments.
oh i get it.. cash market.. the actual bond market.. meaning going and actually getting the bonds, and selling the futures or something.. i get it.. more to read
The basis trade drives most of the curve activity. The cash is the actual cash bonds and notes. They are bought at treasury auctions and in the open market. The futures markets are "implying an equivalent cash rate" but there are complexities with that which bring opportunities. Unlike most futures, interest rate futures don't really have an underlying product. They have an interest rate implied in the derivative. So futures trade on the principal of cheapest to deliver. This means if you are short the future, you get to make some decisions. As you know from futures 101, the short has to deliver to the long. In most markets, the long has the optionality. In interest rate market, it's the short who does. The short gets to go into the market place and "choose" which basket of cash rates to deliver to the long futures holder. The long does NOT get to choose. Think of it as an option where the short option holder gets stock "put" to him if he is short puts at exp that are ITM. So the short futures trader goes into the market place and determines the most "optimal" and "beneficial" cash to deliver. The difference is known as the basis. It's the basis spread between the rate that the futures market is implying and where the cheapest to deliver is currently at. The basis spread is essentially a synthetic option on the difference. The goal is to sell futures at rate X implied and to deliver cash at rate X-Y with Y being the basis differential you are trying to capture. This can get very complicated but the value of the basis is constantly changing depending on the various duration and convexity of the cash product. In other words, the short future/long cash position is analogous to being long the corresponding option on cash. Where the edge is, is being able to get the cash for a few basis pts in edge either through the auction or the open market. LTCM was notorious doing trades like these. They were better known as "on the run" and "off the run" markets. The off the run treasuries traded at a discount to CTD due to their lack of liquidity. So LTCM bought these at a discount, sold the futures and waited for convergence at expiration to get out. The "on the run" tended to trade at a premium "because" of their extra liquidity and LTCM was generally net sellers of these. There are millions of combinations you can trade here but the key idea is getting edge in the cash market. The futures market didn't have the edge. If anything they traded at negative edge as a by product of their added liquidity. So trading futures to futures was pointless. You are essentially giving up the edge on both sides AND you laid off your optionality on the long side which mean if you held to expiration, you were guaranteed to get the worst priced bond delivered to you (the most expensive). Probably the easiest way to get involved in the game and I've talked about this on my thread is simply using the yield curve as proxy for risk i.e being long steepeners as a surrogate to being long stocks or long the flattener as a surrogate to being short stocks. And I mentioned there is an easy way to do this through the corresponding ETF's. But trying to trade the curve against the big boys with no edge is a recipe for disaster. There is NO retail money here for you to trade against. You are trading against the pros.