FINM7405
Financial Risk Management
Lecture 7 Trading Game Quarter 1
Yield curve (June 2005)
 A flat yield curve, except for higher rates at the short end
 “The yield curve fell and flattened during the past three months. The
drivers of falling yields were falls in global (namely US) bond yields and
markets scaling back their expectations for rate rises by the Reserve Bank
of Australia. The March rate rise seemingly delivered a shock to the
economy that the RBA was not expecting. In particular, drops in consumer
and business confidence spooked the Bank about a follow-up rate rise.
With the dust having now settled with consumer and business confidence
partly restored, the RBA still holds a slight bias to raise interest rates
according to is most recent commentary.”
Trading Game – Prac Game Review
2
 Yield curve – short end
 The bulge in the yield curve at the short end suggests market
expectation of RBA increase in cash rate.
 RBA focuses on keeping inflation within its 2-3% target range,
and while inflation is currently well within that range, the June
outlook suggested several upward pressures on inflation (eg.
tight labour market, falling AUD forcing up import costs).
 Therefore, RBA may yet still raise the official cash rate.
Trading Game – Prac Game Review
3
 Yield curve – mid curve
 Economists sometimes suggest the middle of the curve is dependent upon the
GDP outlook, and GDP indicators include:
 Leading (eg. building approvals)
 Coincident (eg. retail turnover)
 Lagging (eg. employment)
 In June outlook, no information provided on building approvals, and retail
spending weak. So some evidence of weakening GDP and perhaps a fall in the
middle of the yield curve.
 Yield curve – long end
 Inflation is key driver here, but long-term economic growth outlook also important
 Inflation outlook is for pressure on the upside, because of a tight labour market
and weakening AUD
 Long-yields likely to lift if investors become concerned about inflation
Trading Game – Prac Game Review
4
Yield curve – Hint & what happened (Sept 2005)
 Hint: you were given the Domestic Interest Rate graph from the Sept economic
overview – which suggested Commercial Paper yield moved up a little as did ten
year bond yields.
 “The yield curve rose and steepened ever so slightly in the September quarter
with strength in domestic and global economic data a key driver. While the
Reserve Bank of Australia kept its official cash rate unchanged, many economists
re-instated their expectations for an official interest rate rise at some stage over
the coming 6-9 months. The improving domestic economic outlook is ensuring
an upward bias remains on economists’ inflation forecasts. And given the RBA’s
mandate is averaging inflation of 2-3%, the inflation outlook remains the key
factor to consider for determining the next RBA move on official rates.”
Trading Game – Prac Game Review
5
 Yield curve – what happened (Sept 2005)
 Short-term yields rose slightly as “economists re-instated their
expectations for an official interest rate rise at some stage over the
coming 6-9 months”
 Mid-term yields rose slightly following suggestions that GDP growth might
improve going forward, and “both dwelling and non-dwelling building
approvals showing strength in recent months” (contrary to our
expectations on slide 4)
 Long-term yields rose slightly in response to strengthening economic
outlook and inflation worries.
Trading Game – Prac Game Review
6
General strategy – Increase exposure to the middle and
long end of the curve
 Rising yields reduce the market value of issued liabilities – a good
outcome
 Raise $100M in bonds rather than commercial paper
 But, if possible we should to take into account the differing yield
moves and interest rate sensitivities on different points on the yield
curve (see next slide)
 Also, might be able to lower our cost of funds by:
 Paying fixed and receiving floating on swaps
 Selling futures
Trading Game – Prac Game Review
7
 Buy/Sell debt Versus Swaps Versus Futures
 Which one moves more?
June 05 Sept 05 Change
DB06 5.31% 5.40% 0.09%
DB08 5.32% 5.39% 0.07%
IRSDB08 5.52% 5.54% 0.02%
FUT3YR 5.06% 5.14% 0.08%
DB10 5.34% 5.42% 0.08%
IRSDB10 5.59% 5.62% 0.03%
DB15 5.36% 5.46% 0.10%
IRSDB15 5.61% 5.66% 0.05%
FUT10YR 5.10% 5.20% 0.10%
Trading Game – Prac Game Review
Preferred 3 year instrument
[Sell 3 year futures]
Preferred 5 year instrument
[Issue DB10]
Preferred 10 year instrument
[Issue DB15]
[Sell 10 year futures]
Overall preference:
increase exposure to 10-year yields 8
 Portfolio activity (June 2005)
 Raise $100m by issuing DB15
 Value of issued debt will fall when DB15 yields rise in July – Sept Qtr
 Sell ten year futures
 Profit will be earned on ten year futures as ten year yields rise
̶ Must raise $2,000 per futures contract in June as deposit margin. Will be paid back
in Sept with interest
̶ Must pay brokerage at $5 per contract in Sept (today)
̶ Will received profit in form of variation margin in Sept (today)
Trading Game – Prac Game Review
9
 Commodity/FX hedges
 Copper prices retreated as a result of easing in demand from Asia
 June 2005: don’t hedge QEPA March 2006 copper purchase
 AUD has risen against weakening USD but declined against an
improving Euro (and European economy)
 June 2005: don’t hedge QEPA March 2006 USD purchase
 June 2005: hedge APA Dec 2005 Euro purchase
̶ Buy forward Euros
Trading Game – Prac Game Review
10
 GOLD Team - Deal summary
 Sell ten year futures
 Issue required debt ($100m) – and raise deposit margin
- at DB15
 Buy $5m Euros forward
Trading Game – Prac Game Review
11
The yield curve returned to a ___________ during the past three months. No further moves on
the official cash rate and signs of slower domestic economic growth forced traders to re-assess
expectations of continued RBA tightening going forward, which ___________________. Despite
steady to falling domestic inflation, though, longer term yields _________ during the quarter
because of the influence of the international financial markets on our own. In particular, better US
economic data ______ bond yields, __________________________ due to lingering concerns
about the sustainability of the recovery that the data is indicating. Most traders are predicting that
a Federal election will be called in the next three months, but predictions about what this might do
to the yield curve are thin on the ground. What we know is that solid economic growth last year
has delivered a substantial budget surplus this year, and politicians on both sides have promised
income tax cuts should they get elected. Tax cuts at a time when the economy is already going
well are unambiguously negative for the bond market (ie. _______ rates), but if the economy is
truly slowing, then maybe tax cuts would be more appropriate.
Qtr 1 - Hint (commentary extract from June 2004)
12