Sunday, August 26, 2007


Butterfly - not this colorful one found in nature but is found around the world's financial markets! ... It is a fixed income (bonds / swaps) basket trading strategy to profit from anomalies of the interest rate term structure. The arbitrage is based on the principal of mean reversion where market expects the term structure's curvature to oscillate around its historical average position. Traders predict the shape of term structure and make a bet on it.

A Butterfly trading strategy is designed to profit from a relative mis-pricing of securities of different maturities while protecting against market and curvature risk. For instance if a trader maintains a view that a particular bond ,say a 4 yr zero, is priced higher relative to other bonds, he could short this bond in the hope that it would become cheaper in the near future. However such a strategy would involve too much market risk. If the interest rates fall then an outright short position in a 4yr bond would lose money anyway even if the trader had been right and the bond did become cheap relative to other bonds.

One way in which the trader could protect the short position is by buying a nearby issue, say a 2yr zero. In this case if the interest rates fall then the loss on the short position would be covered by the corresponding long position in the 2yr bond and vice versa. Thus if the relative mis-pricing were to correct the trader would make money regardless of the direction of the market movement. In other words such a strategy protects the trader against parallel shifts in the term-structure.

However one possible problem with such a strategy arises for non-parallel shifts in term structure. If the yield curve flattens, the yield on the 4yr bond might fall while the 2yr remains unchanged. Thus in this case the trader would lose money on the short position while the long would remain unchanged, thus even if the relative mis-pricing were to correct the trader would lose money. To cover the slope (change) risk the trader might take a long position in another bond with duration higher then 4 yrs, say a 6yr zero. With this strategy in place if the term structure flattens then the trader would lose money on the 4yr bond, gain on the 6yr bond while the position in the 2yr bond remains unchanged. If the term structure becomes steeper the opposite would hold true .Thus if the relative mis-pricing of the 4yr bond were to correct here the trader would register a net gain irrespective of any change in the term structure. In other words the strategy becomes direction neutral.

Such a strategy involving three securities of different maturities is called a butterfly trading strategy. The security in the middle of the maturity range, in this case the 4yr bond, is called the body, while the other two securities are called the wings. As described above such a strategy is designed to profit from relative mis-pricing while protecting against the interest rate level and slope risk.

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