Has anybody ever hedged an ARM by selling Treasury fututes?

Discussion in 'Trading' started by ralph00, May 16, 2005.

  1. Just wondering. It seems to me it would be possible to create some kind of hedge to do this. ... Thus locking in a rate well below that of whatever the 30 year fixed rate happened to be going for.
     
  2. Exploiter

    Exploiter

    Well, it's a nice idea, but there's a few reasons that it would be expensive to do this.

    First of all, a short position in Treasury futures will essentially require you to pay interest. Why is that? The interest charge is built into the futures price. If you look at the term structure of the futures market you will see that your futures price is at a discount to the spot -- as time passes the future price will converge with the spot with the economic effect of you paying interest on your short T-note position.

    Second of all, because many professional money managers think the same way you do -- and are compelled to looked to the futures markets because structural inefficiencies in the cash market make it difficult to short treasuries there -- the price of Treasury futures are pushed excessively low, giving futures roughly 50 bp more yield than the cash. This means that you will sell your futures contract at a really low price and the interest you are charged will be that much more.

    Third of all, you'll need to roll your position 4 times a year, which can add up.

    I think the best thing to do might be to sell at-the-money Treasury call options and roll out of them to the next month before they expire, every month.