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The 10-Year Treasury Note Market Christopher G. Lamoureux & George Theocharides December 2 nd, 2010 Cyprus University of Technology.

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Presentation on theme: "The 10-Year Treasury Note Market Christopher G. Lamoureux & George Theocharides December 2 nd, 2010 Cyprus University of Technology."— Presentation transcript:

1 The 10-Year Treasury Note Market Christopher G. Lamoureux & George Theocharides December 2 nd, 2010 Cyprus University of Technology

2 Motivation 10-year T-Note market provides a unique laboratory to explore effects of various nonconvexities on financial asset prices. Why? –Securities have no default risk so that future cash flows are certain. –There exist stripped securities (redundant) in the market that can replicate the cash flows of each note, and allow us to benchmark these notes to their fundamental value. –Derivatives are actively traded on the notes. –There have been important technological enhancements in the trading process during our period that allow us to isolate an exogenous change in liquidity.

3 Evolution of Open Interest & Volume in the Futures Market

4 Pricing Deviations

5 Aim of Project Examine apparent violations of the law of one price in the market for 10-year Treasury notes. Examine the relationship between price premia, repo specialness, and liquidity. Examine the impact of the futures market on the underlying spot market.

6 Preview of Results Markets are becoming more closely integrated (less segmented) over time. The OTR premium is not idiosyncratic, but is related to a factor that affects most notes and is diminishing with the age of the note: – Since 2005, 80% of the variation in the price deviations in all outstanding notes is explained by a single factor. Despite the fact that the distinction in liquidity between the OTR note and older notes has increased with the proliferation of electronic trading in the former, the relative pricing deviations between the on-the-run note and its predecessors has shrunk. This casts doubt on the notion that the on-the-run price premium is solely the result of this note being more liquid than older notes.

7 Preview of Results…Contd. As in previous studies, we show though that the pricing deviations we document may not imply that an arbitrage opportunity exists: - Consistent with previous findings, we show that the deviations between the note and the replicating portfolio of coupon STRIPS cannot be exploited by stripping and reconstituting, as the principal strip-necessary to reconstitute the note-inherits the price premium of the note itself. - Consistent with previous findings, we find a strong correlation between the pricing deviation and specialness, i.e. an arbitrageur seeking to short the overpriced security will earn a lower rate on the cash collateral than she would on general collateral. Nevertheless, our analysis suggests that, similar to liquidity, expected future specialness is not the only non-convexity affecting prices, i.e. price premia, repo specialness, and liquidity are at least partially distinct phenomena. We show that being deliverable against the 10-year note futures contract is valuable as well: -All the deliverable securities exhibit a deliverability premium that is increasing in recent years. -Notes that are no longer available for delivery against the futures contracts have a price deviation from the underlying STRIPS that bounces around zero.

8 Related Literature Related Literature : – Limits of Arbitrage: Shleifer and Vishny (JF, 1997), Gromb and Vayanos (JFE, 2002), Brunnermeier and Pedersen (RFS, 2009), Xu, Pan, and Wang (WP, 2010), Gromb and Vayanos (Annual Review of Financial Economics, 2010). – Deliverability Premium : Simpson and Ireland (JFQA, 1985), Garbade (1985), Kuipers (JFM, 2008). – On-the-Run Premium : Babbel et al. (WP, 2001), Cherian et al. (Review of Derivatives Research, 2004), Graveline and McBrady (WP, 2005). Pasquariello and Vega ( JFE, 2008), Vayanos and Weill (JF, 2008). -Securities Shorting/Repo Specialness: Duffie (JF, 1996), Jordan and Jordan (JF, 1997), Duffie, Garleanu, and Pedersen (JFE, 2002), Krishnamurthy (JFE, 2002), Nashikkar (WP, 2007), Nashikkar and Pedersen (WP, 2007). -Idiosyncratic/Systematic Variation of the Markets: Duffee (JF, 1996).

9 Institutional Background Treasury Market: – Auction of 10-year note every 3 months. (February, May, August, December). – In certain periods, re-issuance every 1 or 3 months. – Announcement/Auction/Issue Date – This 2-week period is considered the When-Issued market. – On-the-Run premium: Believed to be due to notes higher liquidity. – Trading volume is concentrated in the OTR issues. (Barclay, Hendershott, Kotz (JF, 2006)]. – Transition to electronic communications networks has enhanced liquidity. [Mizrach and Neely (Fed Reserve Bank of St. Louis Review, 2006)].

10 Institutional Background Treasury Futures Market: – Trade on the old CBOT, now part of CME Group. – Expire on a quarterly cycle (March, June, September, December). – Several options for the short side (delivery, timing, end-of-month, and wild-card options). – Deliverable basket includes any note (excluding TIPS) with a remaining time to maturity of 6.5 to 10 years, on the first day of the delivery month. – Each contract is for $100,000 face value of the Treasury note. – Usually one note from this basket is considered the CTD. – CME Group uses a standardization procedure through a conversion factor for each note [price the note would have on the first day of the delivery month, were its yield to maturity equal to the specified notional yield (6% since 2000), on a $1 par]. – If market yields are lower than 6%, then the shortest-term note is considered the CTD, otherwise its the one with the longest time to maturity.

11 Repo Market Private Market : – Cash vs. bond lending. – Regular securities are traded at the general collateral rate. – Securities in high demand are traded at a special rate (lower than the general collateral rate, ex. OTR, CTD). – Majority are overnight transactions. Federal Reserves Securities Lending Program: – Lender of last resort. – Securities traded here are considered to be on special. – Bond vs. bond lending. – Minimum loan fee (only at 5 basis point since April 7, 2009).

12 Private Repo Market Dealer Lender Money lent Securities (collateral) Money lent + Repo interest Securities Beginning of term End of term

13 Feds Securities Lending Program Fed Investor Security (collateral) Security in demand Security (collateral) Security in demand + interest rate Beginning of term End of term

14 Data Treasury Note Market: – Provided through Bloomberg. – Daily pricing on the 10-year and 7-year notes. – Sample starts on June 3, 1991, until June 30, – Pricing on STRIPS to create an intrinsic value for each note (due to lack of availability through Bloomberg, sample starts between May 15, 1997, until June 30, 2008). – In cases of missing STRIPS information, we searched for the data through Wall Street Journal archives. Treasury Futures Market: – Obtained from CBOT until Sept contract, and remainder through Bloomberg. – Sample spans 68 contracts. – Since 2003, we have data from both the auction and electronic platform.

15 Data Repurchase and Lending Rates: – Daily general collateral rates through Bloomberg from May 15, 1997, to June 30, – Federal Reserves Securities Lending program – through the New York Feds website. Sample spans from April 29, 1999 to June 30, – OTR special rates through Wells-Fargo, Inc. (comparison sample to the Fed data) Daily sample spans from 1/2/2004 – 8/28/2007.

16 Empirical Methodology Examine the pattern of pricing deviations through time for different sub-samples (deviations constructed using an ALL fungible coupon STRIPS portfolio as well as a principal/coupon STRIPS portfolio). Examine the specialness/lending rates for identical sub-samples. Conduct regressions to isolate causes of the pricing deviations for different sub-samples (all observations, deliverable/non-deliverable notes, cheapest-to-deliver (CTD) note, OTR note). Examine the determinants of the specialness of the OTR security. Explore the principal components structure of the pricing deviations, and conduct formal inference on this structure using a posterior simulator. Examine 2 cases studies – The June 2005 squeeze episode, and the Summer & Fall 2003 Delivery Fails episode.

17 Table 2 Deviations from STRIPS-Implied-Value (ALL coupon STRIP portfolio) No. of UniqueNo. of Obs.Mean Notes Panel A: All Notes ,44124 Pre-Jan. 1, ,33920 Post-Jan. 1, ,10228 [21.99]*** Panel B: On-the-Run Notes , Pre-Jan. 1, , Post-Jan. 1, , [30.41]*** Panel C: 1st-Off-the-Run Notes , Pre-Jan. 1, , Post-Jan. 1, ,42398 [10.75]*** Panel D: 2nd-Off-the-Run Notes ,82090 Pre-Jan. 1, ,38991 Post-Jan. 1, ,43188 [1.60]

18 Table 2…Contd. No. of UniqueNo. of Obs.Mean Notes Panel E: 3rd-Off-the-Run Notes ,68472 Pre-Jan. 1, ,26167 Post-Jan. 1, ,42377 [6.43]*** Panel G: All Deliverables, excluding On-the-Run, 1st, 2nd, and 3rd Off-the-Run Notes ,84944 Pre-Jan. 1, ,95836 Post-Jan. 1, ,89149 [23.83]*** Panel I: All Non-Deliverables ,8032 Pre-Jan. 1, ,0450 Post-Jan. 1, ,7584 [19.67]***

19 Table 2…Contd. Panel J: Pricing Deviation from SIV (coupon/principal STRIP portfolio) No. of Obs.Mean All Notes ,1013 Pre-Jan. 1, ,3472 Post-Jan. 1, ,7544 [7.68]*** On-the-Run Notes Pre-Jan. 1, Post-Jan. 1, [0.77] 1st-Off-the-Run Notes Pre-Jan. 1, Post-Jan. 1, [1.27]

20 Table 3 Lending Rates No. of Obs. No. of Unique Mean with SpecialnessNotesNotes with Specialness(incl. zeros) Panel A: All Notes ,0234, Pre-Jan. 1, ,8571, Post-Jan. 1, ,1663, [6.69]*** Panel B: On-the-Run Notes ,3901, Pre-Jan. 1, Post-Jan. 1, , [5.00]*** Panel C: 1st-Off-the-Run Notes , Pre-Jan. 1, Post-Jan. 1, , [2.52]*** Panel D: 2nd-Off-the-Run Notes , Pre-Jan. 1, Post-Jan. 1, , [3.48]***

21 Table 3…Contd. No. of Obs. No. of Unique Mean with SpecialnessNotesNotes with Specialness(incl. zeros) Panel E: 3rd-Off-the-Run Notes , Pre-Jan. 1, Post-Jan. 1, , [4.19]*** Panel G: All Deliverables, excluding On-the-Run, 1st, 2nd, and 3rd Off-the-Run Notes , Pre-Jan. 1, , Post-Jan. 1, , [13.08]*** Panel I: All Non-Deliverables ,9331, Pre-Jan. 1, , Post-Jan. 1, ,7761, [11.43]***

22 Table 4 Determinants of Deviations from SIV GMM Regressions with Newey-West (1987) standard errors with 30 lags

23 Auction Cycle

24 Table 5 Determinants of Pricing Deviations & Specialness for the OTR Note VariablesOTR Notes Av. Prc. Dev. Av. Spc. Intercept (3.24)***(3.51)***(3.92)***(3.69)***(3.33)***(3.32)***(3.48)***(3.80)*** Auction Size (offered to public) (2.90)***(3.18)***(2.17)**(4.07)***(4.05)*** Auction Size (total) (5.04)***(4.99)***(4.62)*** Post-2003 Dummy (6.72)***(6.66)***(6.23)***(6.45)***(2.32)**(2.35)**(3.60)***(3.89)*** Bid-to-Cover Ratio (6.30)***(6.49)***(6.93)***(6.35)***(1.15)(1.13)(0.13)(0.06) % of Issuance Awarded to Dealers/Brokers (1.49)(1.37) % of Issuance Awarded to Foreigners (1.32)(0.85) Average % of Issuance Awarded to Dealers/Brokers (per note)(0.71)(0.94)(1.19)(0.04) (0.98) Average % of Issuance Awarded to Foreigners (per note)(3.33)***(1.71)*(1.93)*(0.29)(0.22)(0.17) Yield Difference (2.03)**(3.39)***(3.56)***(2.41)**(2.11)**(0.68)(0.73)(2.93)*** Average % of Issuance Awarded to Foreigners x Yield Difference(2.97)***(3.15)***(0.01)(0.03) % of Issuance Awarded to Foreigners x Yield Difference(1.47)(2.26)** Periods (2-weeks) until Off-the-Run (3.80)***(3.70)***(4.59)***(4.37)***(5.20)***(5.19)***(5.87)***(6.26)*** Reopened Issue Dummy (2.03)**(2.52)***(3.32)***(2.49)***(3.40)***(3.42)***(4.11)***(4.00)*** Future Reopening Issue Dummy (0.05)(0.54)(0.19)(0.49)(1.23)(1.22)(2.62)***(3.62)*** Adj. R

25 Table 6 PCA Panel A: PCA (May December 2002), (1,466 obs., 31 Notes) PCMeanStd. Dev %1.00% %0.76% %0.64% %0.52% %0.43% %0.35% Panel C: PCA (January June 2008), (910 obs., 31 Notes) PCMeanStd. Dev %0.86% %0.58% %0.46% %0.38% %0.32% %0.27%

26 Eigenvector for the 1 st Factor

27

28

29 Conclusions Market is becoming less segmented in recent years. The on-the-run premium is not an idiosyncratic feature of the most recently auctioned note. Despite the fact that the introduction of electronic trading should have resulted in a greater distinction in liquidity between the on-the-run note and older notes, their relative pricing deviations has shrunk. We show that the pricing deviations we document may not imply that an arbitrage opportunity exists. Price premia, repo specialness, and liquidity are at least partially distinct phenomena. We show that being deliverable against the 10-year note futures contract is valuable.

30 Thank You!


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