Risk Premia Strategies - Interest Rate Markets
The Art of Selectively Harvesting Attractive Risk Premia
- Risk premia on interest rate markets mostly revolve around term premium or carry type strategies (i.e. long positions in major long term interest rate futures). This allows for the monetization of the term premium embedded within the long term yield. We also present a trading system for momentum strategies on interest rate futures based on an option replication argument and we review two models for Alpha generation; a dynamic forward trading strategy which is designed to identify opportunities across G10 rates and a roll-down strategy in rates designed to time movements in the EUR interest rate swap curve, whilst enjoying a positive roll-down.
- Premium strategies in rates are closely related to the understanding drivers of yields in general. Short term yields are classically driven by monetary policies, such as central banks’ main rates. Long term yields are more complex and are classically the sum of short term rate expectations, the credit risk premium and the term or duration premium.
The rate term premium manifests itself whenever curves are steep (namely, long term rates are higher than short term rates). In this case the strategy consists of buying long end instruments (such as US 10y Treasuries or 10y Bunds) and selling short term instruments. It could also be synthetically implemented using interest rate swaps by receiving long term swap rates, paying short term rates and rolling the position over time.
- The main risk in major rate markets over the coming months is the tapering of quantitative easing in the US, with an anchoring of short term rates. This will inevitably lead to a steepening of the USD interest rate curve, which will in turn hurt USD-based term premium strategies. The main risk in other markets is two-fold. Firstly, a solution to the debt issue in certain European countries is far from being resolved and political risk remains high. Secondly, emerging markets remain a risk, with a flood of foreign investment out.
RATE TERM PREMIUM AND MOMENTUM STRATEGIES:
- Momentum strategies are popular strategies in the world of systematic trading generally. The principle of momentum strategy consists of replicating the delta of a call option. This will mechanically increase the leverage in bond bull markets and decrease the leverage in bond bear markets.
We have witnessed a consistent fall in international rates over the past 30 years as central banks have responded to crisis after crisis with ever lower levels of interest rates. Any rate momentum strategy then should be viewed within the context of a 30+ year bull market, with the historical performance of a long position in long term interest rate futures having been very good. A strategy consisting of rolling US Treasury 10y futures returned an average of 4.55% per annum, or a Sharpe ratio of 0.7.
On long maturities and trading less frequently, we found it very difficult to beat the performance of this long position over the past 30 years by using momentum. That said, the long-only strategy would have suffered from sizeable drawdowns. For example, the sell-off between February 1994 and October 1994 caused a drawdown of 15.5% on US Treasuries 10y futures and 11.5% on bund futures. The interest in rates momentum is that it could help reduce drawdowns of long positions in long term futures. Going forward, there’s a clear risk of sharp increases in interest rates globally. However, momentum strategies on long term futures could help enhance returns, thus potentially helping to avoid the full negative consequences if the 30 year bond bull market is indeed over. Resuming trend-following on short term futures will make sense once central banks resume their traditional monetary cycle.
RELATIVE VALUE STRATEGIES:
- Beyond carry, which can be equated to term premium, another source of risk premia comes from rolling-down positions.There have been numerous developments recently in trading strategies searching for positive roll-down, particularly in EUR forward swap rates.
- The concept is straightforward: imagine you hold a contract to receive the 10y swap rate in five years’ time and that you agreed to receive this rate at 3.1%. In one years’ time, the maturity of this contract will be now be only four years. So if nothing changes in the market, the 10y swap rate in four years’ will now be worth 2.9% given its shorter expiry. You can then unwind this contract and monetise this time value. In one year, you would have earned 20bp, just by holding the position for a year.
- The roll-down property of a forward swap rate is linked to the slope of the swap curve: the steeper the curve, the more the roll-down for receiving forward swaps rates. In a previous study, we showed that the roll-down can be traded efficiently in the Euro swap curve by looking at the best combination of forward rates (those which provided the best roll-down and whose deviation to some historical criterion is significant). The table and graph below shows the results of such strategies.
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