2 - Relative value trading using government bonds

Abstract

Relative value trades are used by portfolio managers when they believe that the yield curve will change shape, and flatten or widen between two selected points. Such trades involve simultaneous positions in bonds of different maturity. These trades are concerned with the change in yield spread between two or more bonds rather than a change in absolute interest rate level. The factor is that changes in spread are not conditional upon directional change in interest-rate levels; that is, yield spreads may narrow or widen whether interest rates themselves rise or fall. Typically, spread trades are constructed as a long position in one bond against a short position in another bond. If it set up correctly, the trade will incur a profit or loss only if there is a change in the shape of the yield curve. A relative value trade usually involves a long position set up against a short position in a bond of different maturity. The trade must be weighted so that the two positions are first-order neutral, which means the risk exposure of each position nets out when considered as a single trade, but only with respect to a general change in interest levels.