Bond Market Pricing and Trading Strategies
Formulate a trading strategy in the global interest rate markets appropriate to some aspect of the current economic situation. The strategy may involve money market instruments, government bonds, corporate bonds or emerging market debt.
You might elaborate on some aspect of the lecture material, you could draw upon the seminar discussion topics, you could use material from the financial media, or you might develop a strongly held view of your own.
The work should be a maximum of 3000 words in length
These notes are for guidance purposes only. You need not follow the exact outline or structure set out below but marks will be awarded according to whether the requirements of these sections have been met or not. The notes are intended to provide a guide to the type of content that is required.
The coursework should demonstrate the ability to:
1. Infer the outlook for interest rates based on economic theory
Describe and analyse the current economic situation in an economy (or economies) of your choice. Discuss the outlook for short-term interest rates and/or bond yields. Do not make this section a general review of global economic developments. The analysis should support your chosen trading strategy. Address some of the following questions:
• Is economic activity picking up or slowing down?
• What is the current trend of borrowing activity in the household and corporate sectors and is it sustainable?
• What is likely to be the impact of any changes in government policy?
• What is happening to economic activity and policy in the major trading partners?
• Is there any evidence of unsustainable imbalances building in the economy?
• How much available slack is there in the economy?
• Is there any evidence of inflationary pressures increasing?
• Is the central bank likely to be raising or lowering interest rates over coming months?
You may include tables and charts to support your argument. This section is likely form up to about 1000 words or about one third of the project. 30% of the marks available will be rewarded for this material.
2. Evaluate what is currently discounted in the market
Examine what is currently discounted in the interest rate markets and assess whether there is a trading opportunity based on your evaluation of the economic outlook. You should address some of the following points, where appropriate to your choice of particular strategy:
• What is priced into futures contracts concerning central bank policy?
• What are the forwards discounting for the path of bond yields?
• How is the shape of the yield curve priced to evolve?
• What are the forwards discounting for short rate or bond yield spreads relative to elsewhere?
• What allowance for risk premiums should be made in inferring what is priced in to the forwards?
• How are risk premiums likely to behave in the circumstances of your outlook for the economy?
• What are the risks or possible scenarios relative to your central case view?
• How are the risks skewed, in your opinion, relative to the forwards?
You may include tables and charts to support your argument. This section is likely to form up to about 1000 words or about one third of the project. 30% of the marks available will be rewarded for this material.
Taken together, these first two sections should form the core of the project. Anybody can state a trading view (“buy bonds”), but these two sections will demonstrate your ability to analyse the current economic situation, consider the outlook for interest rates, assess the risks, and examine carefully what is discounted in the markets.
3. Identify a trading strategy
Formulate a trading strategy based on your analysis of the economic outlook and what is currently discounted in the markets. Your strategy might include one of the following, for example:
• Outright long or short at the front-end of the yield curve.
• Calendar spread trade using futures contracts.
• Short rate spread between two countries.
• Outright long or short at the long-end of the curve.
• Trades to anticipate a change in shape of the yield curve.
• Bond yield differential trade between two countries.
• Box trade of one yield curve against another.
• Long or short CDS index trades.
• Long or short emerging market credit.
You should be careful to state the anticipated investment horizon for the trade and the choice of instrument (cash, futures, forwards, options, swaps). This section should contain detailed calculations – e.g. funding costs, anticipated horizon returns – in support of the trading strategy.
Any trading recommendation based on the outlook for corporate credit spreads should be expressed as a generic view in terms of a traded index rather than a “single name credit” (the purpose of the module is to identify macro trading strategies, not to assess credit risk per se).
This section is likely to form about 500 words of the project. 30% of the marks available will be rewarded for this material.
4. Monitor the performance of the strategy
Finally, having formulated the trading strategy, state how the performance of the trade will be monitored. Traders are constantly reassessing their strategy in the light of new information and market price action. Some of the issues to be addressed include the following:
• What is the initial target for the trade?
• Will you have a rigid stop-loss for the trade?
• What will be the most important pieces of economic information to monitor?
• What sort of news would cause you to reassess the trade more positively?
• Would you increase the size of the trade under certain conditions?
• What sort of news would cause you to reassess the trade more negatively?
• Would you take the trade off under certain conditions?
This section is likely to form a maximum of about 500 words of the project. 10% of the marks will be awarded for this brief concluding section.
1.Choudry, Moorad: An Introduction to Bond Markets,(Fourth
Edition), John Wiley & Sons Ltd, UK (2010)
2. Martellini, L., Priaulet, P., Priaulet, S. (2003): Fixed Income
Securities Publisher: Wiley Finance, UK (2003)
3. Sundaresan, Suresh: Fixed Income Markets and Their
Derivatives, Elsevier (2009)
4. Tuckman, Bruce and Serrat, Angel: Fixed Income Securities,
(Third Edition), Wiley Finance, New Jersey (2011)
5. Cecchetti, S.G., (2006): ‘Money, Banking and
Financial Markets’, McGraw-Hill International
6. Mishkin, F.S., and Eakins, S.G. (2006): ‘Financial
Markets and Institutions’, Addison-Wesley
7. Hull, J.C. (2008): Options, Futures and Other
Derivatives, Pearson Prentice-Hall (Seventh
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