Trading Bond Volatility

Terry Flanagan

The market for interest-rate derivatives, by far the largest asset class in the over-the-counter market, is estimated to be 40 times the size of the equity market in terms of notional value outstanding, yet until recently it’s lacked a consistent benchmark for calculating and trading volatility.

That’s changed since the launch by CBOE Futures Exchange of its CBOE/CBOT 10-year U.S. Treasury Note Volatility Index (VXTYN Index), trading of which began one month ago. The VXTYN Index, on which futures on VXTYN are based, is calculated by applying the CBOE Volatility Index (VIX) methodology to futures options data from CME Group’s 10-year U.S. Treasury note contract — one of CME Group’s most actively traded interest rate options products. CBOE has been disseminating daily values for the VXTYN Index since last year.

“We partnered with CME on this index. We are extracting their Treasury note options prices based on their ten year note futures contract, taking those data points and putting them into our propriety VIX methodology to create an interest rate VIX, which is the VXTYN Index,” John Angelos, director, institutional marketing, U.S., and head of Asia Pacific at CBOE, told Markets Media. “As we did with VIX for the equity derivatives space, we’re doing with VXTYN for the interest rate space. We’ve created a pure and simple way to trade implied vol on the Treasury note futures contract.”

Potential users of VXTYN futures could include mortgage-backed securities investors and other large credit managers seeking to hedge against adverse interest rate movements; large bond funds that are naturally long interest rate volatility and are seeking a yield-enhancing mechanism; and hedge funds, volatility arbitrage firms and global macro participants.

“We envision our users to be anybody that has a linear exposure to interest rate volatility,” said Angelos. “It could be a real money asset manager, like the State Streets of the world, or a bond manager like the Pimcos and Blackrocks, where they have an embedded interest rate vol in their portfolios. This would act as a so-called tail risk hedge. Particularly when interest rates go up in a dramatic fashion, their portfolios can be adversely affected by that rate move. VXTYN futures will help mitigate those types of moves in rates.”

Prior to the launch of VXTYN futures, in order to trade interest rate volatility on a listed marketplace, users had to do it synthetically with straddles and strangles, which they would have to continuously delta-hedge in order to isolate expected volatility, a tedious and time consuming process.

“What we’ve done is take that concept and streamlined it through our VIX methodology to create a so called one-stop shopping, where you can trade interest rate volatility with one VXTYN futures contract, versus multi-dimensional legs to synthetically get exposure to the same thing,” said Angelos.

The Merrill Option Volatility Expectations Index (MOVE) index, a yield curve weighted index of the normalized implied volatility on 1-month Treasury options, does reflect market estimate of future Treasury bond yield volatility, but it isn’t tradable.

Three Lead Market Makers (LMMs) have been appointed to make markets in VXTYN futures.

“Everybody knows VIX is a fear gauge of equities,” said Angelos. “The VXTYN Index is a fear gauge of interest rates, a barometer of volatility in the ten year sector. We’ve created both an index to track that vol and a futures contract to trade it.”

Featured image via iStock

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