For the sake of simplicity, taxes, commissions and other trading costs have
been omitted from the discussions and strategies in this discussion; these
should be taken into account when making your investment decisions. The
strategies are based on hypothetical situations and should only be considered as
examples of potential trading approaches.
Holder of T-bills Expects Rising Short-term Rates, Falling Long-term Rates
Strategy - Sell T-bills, buy TNX puts to profit from interest rate expectations.
Investor owns Treasury bills and expects short-term rates will rise,
long-term rates will decline.
Objective: To profit from
a reshaping of the yield curve.
Strategy: Sell Treasury
bills. Deposit cash in Money Market and purchase puts on the l0-year
Treasury yield (TNX).
Having analyzed the latest market
developments and the U.S. government's package of proposed fiscal and
monetary measures, an investor has come to a conclusion that short-term
rates may rise from 3% to 4% and intermediate-term rates will decline
from 6.25% to 5.75%. Currently, the investor has $20,000 in U.S.
Treasury bills and if his projection is correct his Treasury bills will
go down in value.
An investor has $20,000 in
U.S. Treasury bills and is concerned that short-term rates will rise
therefore causing a decline in the value of his bills. This investor
anticipates a drop in intermediate-term rates and would like to profit
from his projection for the move in interest rates. The investor will
sell his T-bills and will deposit $18,000 in a money market account and
$2,000 will be used to buy puts. Suppose that a three-month,
at-the-money TNX put cost 1 point or $100 (1 x $100 multiplier x 1 put).
The investor would buy 20 puts at 1 costing $2,000. The breakeven level
for the put position is 61.50 (62.50 strike price - 1 cost of put).
Settlement Value Below Breakeven (61.50):
If the investor is
right and 10-year Treasury yields do decline to 5.75%, a settlement
value for TNX at 57.50 , the TNX 62.50 put option would be exercised.
The holder of the puts would receive the amount by which the closing
yield has declined below the strike price. The investor would also be
earning interest on his $18,000 in his money market.
short-term interest rates did rise as anticipated, then he would be
better off having sold the T-bills and having deposited the money in a
money market. If short-term rates declined, the T-bills that were sold
would have risen in value and the investor would be earning less
interest on his money market. In this case he would have been better off
having held onto the T-bills.
- Strike Price: 62.50
- Less Settlement Value:-57.50
- Profit: 5
- Amount Paid to Holder(5x$100x 20 puts): $10,000
- Less Cost of Puts:-2,000
- Profit: $8,000
Settlement Value Between Breakeven Level (61.50)
and Put Strike Price (62.50):
If by expiration the TNX
decreases slightly to 62 or a yield of 6.2%, the holder would exercise
his puts. He would receive the amount by which the settlement value is
below the strike price. The amount received would be less than what was
originally paid, but it would offset some of the cost. The investor
would also be earning interest on his $18,000 in his money market.
- Strike Price: 62.50
- Less Settlement Value:-62
- Cost of Puts: $2,000
- Less Amount Paid to Holder (.50 x $100 x 20
- Loss: $1,000
Settlement Value At or Above Put Strike Price
Settlement Value At or Below Short Call Strike (40):
the settlement value is at or above 62.5, the yield on the 30-year
Treasury at or above 6.25%, the holder would have lost the total premium
of $2,000, in this example. However, no matter how high interest rates
climb the most that can be lost is the premium paid. The investor still
has $18,000 in a money market earning interest.