Treasury Futures Calendar Spreads with Tails

The difference in duration of the nearby and first deferred Treasury futures contract months typically creates “tails” to manage for each quarterly rollover. Rolling a given position at a fixed 1:1 ratio into the next month will not fully replicate the existing exposure, captured by differing DV01 values between contracts. Though the differences may not be large, neglecting to take them into account will change the duration of the portfolio being rolled.

In order to maintain the same dollar P&L sensitivity to changes in yield, a bespoke roll ratio that takes into account DV01s and conversion factors may be preferred. This required either an additional transaction to incrementally add the tail to one of the two legs, or a custom Globex strategy where the calendar spreads and tails are executed as one trade.

For a given front month position size (i.e. long 100), additional contracts are often added to the back month of the roll to preserve the same overall exposure (i.e. sell 100, buy 100+5). It is also possible to roll out of fewer front month contracts, to achieve a specific final position in the back month (i.e. sell 95, buy 95+5).

Users have shown a strong preference for customization and the ability to define their own ratios as needed. Different approaches to calculating risk exposure can produce significantly different tails to manage for the Treasury futures quarterly rollover.

The use of spot or forward dollar value of basis point changes (DV01s) of the cheapest-to-deliver (CTD) notes or bonds can result in large differences in tails. During our recent interval of very low short-term interest rates, it has been common for the front end of the curve, the 2-Year and 5-Year Treasury Notes futures, to exhibit more variation between the spot and forward calculations. The back end of the curve, Classic Bonds and Ultra Bonds, typically have less variation but can still show different values for spot and forward calculations.

CME Globex began offering User-Defined Spreads with Tails to provide a flexible solution and support the wide range of tails that may exist for a Treasury futures quarterly rollover. The UDS for Treasury Futures Calendar Spreads with Tails combine:

• Standard 1:1 Treasury Futures calendar spread pricing, and
• Existing functionality of the Covered UDS Trade Futures Allocation for the execution of Covered (Delta Neutral) options on CME Globex

Both the UDS for Treasury Spreads with Tails have been available since late 2015. Market participants are able to access the UDS for Treasury Spreads with Tails via CME Direct. Additionally, select ISVs support Treasury Spreads with Tails. Market participants should check with their ISVs to see if these strategies are supported.

Market participants seeking to roll positions with tails will likely need to buy or sell a certain percentage of one futures leg in order for them to maintain similar risk exposure in the deferred contract to their original positions in the nearby contract. For this purpose, in any given calendar spread transaction, UDS for Treasury Futures Calendar Spreads with Tails enables market participants to define the tail leg, the tail delta and its price per futures contract.

• The tail leg may be the front or first deferred month (that is, the expiring contract and the one following)
• The tail delta is specified as a percentage, expressed in decimal terms going out two places, of the number of 1:1 Treasury futures calendar spreads in the transaction
• The delta must match the direction of the chosen leg (that is, a calendar spread buyer may either buy more of the front leg or sell more of the deferred leg. A calendar spread seller may sell more of the front leg, or buy more of the back one.)
• The futures prices for the execution of the calendar spread can also be specified

Tail deltas may range from 0.01 to 0.99 (i.e., 1% to 99%), in minimum increments of 0.01 (i.e., 1%). Tail leg prices must be within the Price Reasonability Range as defined by the Global Command Center and must comply with the minimum price increment for outright transactions in the Treasury futures at hand. Good till Cancel (GTCs) and Good till Date (GTDs) order types are not available for executing UDS for Treasury Futures Calendar Spreads with Tails.

Assume that, using the values from the table below, the December 2018 and March 2019 2-Yr Treasury Note futures contract imply tail deltas of 12.6% with spot DV01s and 14.6% with forward DV01s. The positive tail shows that the March 2019 contract has the higher spot and forward DV01, meaning an increased sensitivity relative to the current position.

If, for example, a market participant has a short position in December 2018 2-Yr T-Note futures and is seeking to roll into a short position of 100 March 2019 2-Yr T-Note futures, his spot tail delta would be 0.13. He can roll his position using the UDS for Treasury Spreads with Tails by creating a strategy with the following characteristics:

Buy 100 ZTZ8-ZTH9 Calendar Spreads. Buy 0.13 ZTZ8 at 105’080.

Again referencing the below table, in the case of the December 2018 and March 2019 US Classic T-Bond contract the spot and forward tail deltas are both -0.15%. Negative deltas indicate a higher front month DV01, meaning more contracts in the back month are needed (or fewer in the front month) to maintain the same exposure.

The -0.15% value is less than the minimum tail delta of 1% (0.01), however if the market participant wishes to round it up to the minimum he can roll his 100 short December 2018 US Classic T-Bonds by creating the following strategy:

Buy 100 ZBZ8-ZBH9 Calendar Spreads. Sell 0.01 ZBH9 at 137’05.

In addition to demonstrating positive and negative tail deltas, the above examples highlight that the incremental contracts can be used to hedge a specific number of front month contracts (by buying or selling additional lots in the back month), or to achieve a specific final position in the back month (by buying or selling additional lots in the front month).

However, it is worth reiterating that the incremental transaction must be in the same direction as that leg of the 1:1 calendar spread. Additionally, it is possible for the spot and forward tails to have a different sign (one positive, one negative), implying that market participants using different calculation methods would need tails on opposing sides.

Market participants planning to use UDS for Treasury Futures Calendar Spreads with Tails should be mindful of key differences between the trade allocation of these UDS and the standard Treasury calendar spreads. Experienced users of Covered UDS Trade Futures Allocation for the execution of Covered (Delta Neutral) options on CME Globex will be familiar with the trade matching algorithm First In First Out (FIFO) (Type F) and the rounding convention in the allocation of futures.

The spread and leg prices are calculated in accordance with the current CME Globex convention. The tail futures quantity is calculated by multiplying the tail delta by the number of executed Treasury calendar spreads. When the filled spread order would result in a fractional number of tails, a rounding algorithm is used. In general, normal rounding conventions apply but the algorithm also takes into consideration resting orders’ prior fills to determine whether there were “partial futures” that were not allocated in earlier match events.

For example, if two executions occur that would have each resulted in 4.3 tails, the first one is rounded down to 4 but the second is rounded up to 5, since the cumulative number of tails is 8.6 which is rounded to 9. If the next execution calls for 2.6 tails, the cumulative number of tails would be 11.2, thus it is rounded down and 2 tails are filled.

Similarly, this Exhibit demonstrates how a UDS Treasury Futures Calendar Spread with Tails would allocate futures tail amounts, assuming a trade quantity of 100 1:1 calendar spreads and a tail delta of 22% (0.22), where the 100 1:1 calendar spreads are executed in 10 separate transactions with spread quantity of 10.

UDS for Treasury Futures Calendar Spreads with Tails are similar to standard 1:1 calendar spreads in terms of spread pricing convention, minimum price increment (equal to ¼ of 1/32^nd of a price point per calendar spread, soon to be ⅛ of 1/32^nd for the 2-Year (ZT/TU with the upcoming January 2019 tick reduction), access, non-reviewable range, maximum order quantity, and ineligibility for block trades.

UDS for Treasury Futures Calendar Spreads with Tails differ from standard Treasury calendar spreads by trade matching algorithm First In First Out (FIFO) (Type F) and by assigning spread leg prices using only the standard pricing method. UDS for Treasury Futures Calendar Spreads with Tails are not eligible for the Single Line of Entry of Differential Spreads (SLEDS) pricing method, whereas standard 1:1 Treasury futures calendar spreads are available for both pricing methods, standard and SLEDS.

For more information, please contact:

Jonathan Kronstein
+1 312 930 3472
jonathan.kronstein@cmegroup.com

David Reif
+1 312 648 3839
david.reif@cmegroup.com