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Opportunities in Canadian Fixed Income DerivativesCFA Ottawa – October 18th, 2012

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Table of Contents

Description of the Project Yield Curve

Types of strategies and participants active at the Montréal Exchange

Statistical overview of markets with peer benchmarking

Basis Trading

Collateralized Synthetics

Questions

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Building a Sovereign Futures Curve

OIS/ONX

Whi

tes

Reds

Gree

ns

BAX

CGF

CGB

LGB

CGZ

Fitch Moody`s S&P

AAA AAA AAA

1 of 15 1 of 16 1 of 14

Few remaining AAA ratingUS and Germany only two countries with full futures

curve.

Futures friendly regulatory reform (Basel

3, Dodd-Frank)Demand for transparency

in Canada

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Strategies & ParticipantsAsset Liability Management

Liability Driven Investing

Asset Allocation (GTAA)

Monetising

Manager Transitioning

Portfolio Manage

ment Techniqu

es

Rate Locking

Cash Flow Swapping

Hedging purchase/sale

Risk Manage

ment

Basis Trading (arbitrage)

Duration Management

Relative Value Trading

Volatility

Synthetics (collateralized)

Opportunistic

Strategies

InstitutionsDealers Treasuries Pension Funds Money Managers Insurance Companies

Central Banks Credit Unions Sovereign Wealth Funds Hedge Funds Mutual Funds

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Three-Month Canadian Bankers' Acceptance Futures (BAX)

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 YTD

(Sept)

-

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

100,000

-

100,000

200,000

300,000

400,000

500,000

600,000 BAX 3-Month STIR Futures (1998- 2012 )

Average Daily VolumeOpen Interest

Aver

age

Daily

Vol

ume

Ope

n In

tere

st (#

of c

ontr

acts

)

Source: MX

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Ten-Year Government of Canada Bond Futures (CGB)

CGB 10-year GoC Bond Futures

0

5 000

10 000

15 000

20 000

25 000

30 000

35 000

40 000

45 000

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 YTDSeptember

Aver

age

Daily

Vol

ume

-

50 000

100 000

150 000

200 000

250 000

300 000

350 000

400 000

Ope

n In

tere

st

Average Daily Volume

Open interest

Source: MX

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2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120%

20%

40%

60%

80%

100%

120%

140%

160%

54% 56%65%

88%

120%

146% 150%

120%

103%

120%

147%

Liquidity Ratio- Ratio of Futures Volume to Cash Market Volume

Ten-Year Government of Canada Bond Futures (CGB)

Source: Montreal Exchange, IIROC - computed with data as of H1 2012

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Source: Montreal Exchange, IIROC, CME, NY Federal Reserve, ASX, AFMA, UK Debt Management Office, NYSE Euronext LIFFEComputed with data as of H1 2012

Ten-Year Government of Canada Bond Futures (CGB)

0

1

2

3

4

5

6

7

1.47 1.69

3.5

5.26

6.51

10-year Government Bond Futures - Liquidity Ratio($value traded of futures divided by the $value traded of the cash market)

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Basis Trading

Definition: A bond`s basis is the difference between the price of a bond and the product of the bond`s conversion factor and the futures price.

Basis = Bond Price – (Futures Price x Conversion Factor)

Basis Trading:Basis trading is the simultaneous trading of cash bonds and bond futures to take advantage of expected changes in the relative prices of bonds and bond futures

Buying the Basis:To buy the basis, or go long the basis, is to buy the cash bonds and sell a number of futures equal to the bond`s conversion.

Selling the Basis:To sell the basis, or go short the basis, is to sell/short the cash bond and buy a number of futures equivalent to the bond`s conversion factor.

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Basis Trading

Sample Calculation:

Gross Basis = Bond Price – (Futures Price x Conversion Factor)

CarryOption

Value/Net Basis

Gross Basis

Carry:

Carry is the difference between coupon income earned on the bond and the cost of financing the

bond

Delivery Option Value:

The Delivery Option Value is the value associated with the short’s right to choose what bond to

deliver, and when to deliver it. The value of this option depends on the likelihood of shifts in the

cheapest to deliver, which in turns depends on the interest rate volatility.

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Coupon Income = (3/2) x (112/183) = 91.8 cents Financing Cost = 107.143 x .01422 x (112/365) = 46.8 cents

Coupon Income

Financing Cost Carry

91.8 46.8 45.05

Basis Trading - Carry

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CarryOption

Value/Net Basis

Gross Basis

45.05 19.25 64.3

Basis Trading – Option Value/Net Basis

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Basis - Optionality

Switch Options

• Parallel curve movements

• Yield spread changes• New Issues

Timing Options

• Carry (positive/negative)

• Wild card• End-of-month

Rule of Thumbs for Cheapest-to-Deliver Bonds:•when yields are low, the lowest duration bond is the CTD•when yields are high, the highest duration bond is the CTD

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Basis Trading - recap

Bond Price

Forward Price

Futures Price Bond Price x Conversion

Factor

GrossBasis

Carry

Net Basis/Option

Value

Source: Bloomberg LP

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Reverse Cash and carry trade (basis trade)

SITUATION

A bond trader notes that the price relationship between the cheapest-to-deliver 3% December

2015 Government of Canada (GoC) bond and the 5-year GoC bond (CGF) futures contract is out-of-

line. The trader’s observation is supported by the following information:

CGF futures contract details: Cheapest-to-deliver bond details:CGF futures expiry June 2015 Coupon 3%Last delivery day 29-Jun-2015 Maturity 01-Dec-2015CGF futures price 116,55 Bond price 106.296CGF futures implied repo rate 0.834% Conversion factor 0,9065Net Basis 0.193 Actual repo rate 1,422%

The trader realizes that the current pricing offers an arbitrage opportunity. The implied repo rate

from the futures is less than the actual repo rate, which suggests that the CGF contract is cheap.

Consequently, he initiates a reverse cash-and-carry trade, consisting of selling of the cheapest-to-

deliver bond in the cash market and buying the CGF futures, to lock-in a profit.

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STRATEGYThe trader initiates a reverse cash-and-carry trade that involves the following steps:1. Short the cheapest-to-deliver bond. Receive the bond price + accrued interest.2. Buy the futures contract.3. Lend the proceeds received at the current short-term financing rate.4. Pay any intervening coupon during the life of the futures contract.5. Pay the futures invoice price + accrued interest to the seller.6. Cover the short sell with the bond received from the futures seller.7. Calculate arbitrage profit.

Initial dataPrice of the cheapest-to-deliver bond 106,296Accrued interest(99 days = December 1 to March 9 settlement date)

814

Financing rate (actual repo rate) 1,422%Conversion factor 0,9065Price of the CGF futures 116,55Days from settlement to futures delivery (March 9 to June 29) 112Days from next coupon to futures delivery (June 1 to June 29) 28

Reverse Cash and carry trade (basis trade)

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Reverse Cash-sand-Carry Transaction Amount (per $100,000 notional amount) RemarksShort the CTD bond $106,296 + $814 = $107,110 Price of bond + Accrued interest

Lend the proceeds until CGF futures delivery

$107,110 x 0.01422 x 112/365 = $467 Amount received from selling the bond x Short-term financing rate x Number of days/365

Income to pay during the life of the CGF futures (coupon for June 1 to June 30)

$1,500 Coupon income

Total income of the bond position $107,110 + $467 - $1,500 = $106,075 Proceeds + Lending - Income to pay

Delivery price of the deliverable bond at CGF futures delivery

($116,55 x 0.9065) + $230* = $105,883

* $100,000 x 3% coupon x 28/365

Futures invoice price x Conversion factor + Accrued interest received by the seller from the bond buyer

Arbitrage profit (per CGF futures) $106,076 – $105,883 = $193 Total income from the bond position - Delivery price of the deliverable bond

Reverse Cash and carry trade (basis trade)

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Hedging Tool

Objective: To hedge 11 mm Canadian 10-year bondsSolution: Short 84 CGB`s (Bloomberg PDH1)

Source: Bloomberg LP

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Hedging Tool

Source: Bloomberg LP

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Collateralized Synthetics

SITUATION

An investor would like to construct a synthetic bond portfolio to take advantage of a yield enhancing

opportunity. In addition to seeking this opportunity, the investor would also like to improve the

liquidity of her portfolio, and make it more operationally efficient by reducing the number of bonds

held in it.

In order to construct the synthetic bond portfolio, the investor would need to sell the bonds in his

portfolio, and replace them with a long futures position paired with a short-term money-market

instrument. The goal would be to construct a portfolio that reacts in the same way to the difference

market conditions, and interest rate fluctuations as one consisting of cash bonds only. In order to the

achieve this, the investor would use the same technique to determine a hedge ratio, but in this case

would create a position that replicates the price changes, as opposed to one that offsets them.

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DATAInitial data as of October 15th, 2012.

Total capital to invest: $10,000,000Targeted modified duration of portfolio 2.00 Conversion factor of the OTR .9413Average yield: 1.25% Modified duration of the CGZ contract: 1.75Average coupon: 1.00% Value of a basis point: 0.019Value of a basis point: 0.02 Repo rate: 1.20%Current On-the-run 2-year: CAN 1% Nov 1, 2012 December CGZ contract price: 108.05

Collateralized Synthetics

In this example we will demonstrate this strategy using the CGZ (Two-Year Government of Canada Bond Futures) contract with a portfolio value of $10,000,000.

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Computing the hedge ratio: HR = BPVPortfolio Conversion factorOTR

BPVFutures

HR = 0.020 .9413 0.019 HR = 0.9908 Number of contracts needed: 10,000,000 0.9908 = 49.54 or 50 contracts 200,000 The strategy consists of buying 50 CGZ contracts and invested the surplus (after initial margin deposited at the CDCC) in a general collateral repo transaction.

Collateralized Synthetics

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RESULTS

We assume that on December 18th 2012 the yield curve experienced a parallel shift of + 25bps. We can forecast the following P&L for each scenario (synthetic and bond portfolio) using the duration DV01 figures.

Collateralized Synthetics

Synthetic PortfolioGain/Loss on futures position (0.019 x -25 x 2,000 contract multiplier x 50) -$47,500Interest on repo transaction (0.012 x 64/365 x $10,000,000) $21,041

Total - -$26,459

Bond PortfolioGain/Loss on bond portfolio (2 x -0.0025 x $10,000,000) -$50,000Accrued interest (1% x 64/365 x $10,000,000) $17,534

Total - -$32,465

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Conclusion

By substituting some bonds for futures and money market instruments, an investor is able to take

advantage of a yield enhancing opportunities while maintaining the characteristics of his portfolio.

In order to demonstrate this example, many variables were simplified. For example, the

performance of the synthetic is dependent of the cheapness of the futures contract acquired. Due

to varying market conditions, the relative cheapness of the futures contract can vary. In addition,

although we demonstrated the strategy utilizing risk free collateralization, it isn`t uncommon for

institutions to substitute T-bills and repo transactions for better yielding AAA asset-back securities.

Coupling these two effects can significantly influence the outcome of the strategy.

Collateralized Synthetics

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The information presented is for educational purposes only and is not intended for trading purposes and shall not be interpreted in any jurisdiction as constituting a recommendation, advice, opinion or endorsement concerning the purchase or sale of derivative instruments, underlying securities or any other financial instrument or as constituting legal, accounting, tax, financial, investment or other advice. Past performance is not necessarily indicative of future performance. Therefore, the Bourse recommends that you consult your own advisors in accordance with your needs.

Jason TaylorSenior Manager, Fixed Income Derivatives(514) 871-3519jtaylor@m-x.ca