Bond Futures Research Articles

Forecasting Realized Volatility of Daily Returns

Despite the vast academic literature on modelling stochastic volatility, many finance practitioners still use the simple approach of J. P. Morgan (1997), based on the exponentially weighted moving average (EWMA) volatility combined with the $\sqrt{h}$-rule for scaling volatility with horizon. In this paper, we evaluate this approach using a universe of 47 liquid futures contracts, including equity index, currency, commodity, and bond futures. We find that the true slope (persistence) coefficients capturing the dependence between past and future realized volatility are {\it always strictly smaller than $\sqrt{h}$} for all 47 instruments, and experience large fluctuations over time; in particular, for almost all instruments in our sample slope coefficients spiked during the 2008 financial crisis. However, while for equity index futures slope coefficients returned to their pre-crisis level, this is not the case for all other four asset classes: after the crisis, slope coefficients stay well above their pre-crisis level. Exploiting predictability of these slope coefficients using rolling linear regressions significantly improves efficiency of realized volatility forecasting relative to the RiskMetrics benchmark. Our forecasting procedure is implementable in real time, and its performance is comparable (and sometimes even superior) to that of ARCH-type models over an interval of horizons, from 5 days to 2 months. As a practical application, we show that our volatility forecasts can be efficiently used for {\it managing risk of momentum strategies} and significantly reduce drawdowns.

Bond futures, inflation-indexed bonds, and inflation risk premium

We propose a new approach to measuring long-run inflation risk, the inflation risk premium, and inflation expectations for the UK over the period 1985–2012. By adding long-term bond futures to the information set of inflation-indexed and nominal bonds, inflation risk is measured as an incremental time-varying covariance obtained from a trivariate GARCH model with dynamic conditional correlations (DCC). The time-varying inflation risk premium and inflation expectations are extracted from the breakeven yield using the risk premium obtained from the previous step. We find that the risk premium has been decreasing over the sample period, with an average value of 87 basis points. The estimated long-run inflation expectations suggest that credibility has been improving over the period of inflation targeting policy, and are in line with the role of inflation targeting policy in anchoring expectations.

Forecasting the return distribution using high-frequency volatility measures

The aim of this paper is to forecast (out-of-sample) the distribution of financial returns based on realized volatility measures constructed from high-frequency returns. We adopt a semi-parametric model for the distribution by assuming that the return quantiles depend on the realized measures and evaluate the distribution, quantile and interval forecasts of the quantile model in comparison to a benchmark GARCH model. The results suggest that the model outperforms an asymmetric GARCH specification when applied to the S&P 500 futures returns, in particular on the right tail of the distribution. However, the model provides similar accuracy to a GARCH (1,1) model when the 30-year Treasury bond futures return is considered.

Forecasting the Return Distribution Using High-Frequency Volatility Measures

The aim of this paper is to forecast (out-of-sample) the distribution of financial returns based on realized volatility measures constructed from high-frequency returns. We adopt a semi-parametric model for the distribution by assuming that the return quantiles depend on the realized measures and evaluate the distribution, quantile and interval forecasts of the quantile model in comparison to a benchmark GARCH model. The results suggest that the model outperforms an asymmetric GARCH specification when applied to the S&P 500 futures returns at the 1 and 2 day, in particular on the right tail of the distribution. However, the model provides similar accuracy to a GARCH(1,1) model when the 30-year Treasury bond futures return is considered.

Bond futures and order imbalance: Examining international linkages

Order imbalance methodology is utilized to examine the link between trading activity and returns in the six most liquid international bond futures markets. Order imbalances are strongly related to contemporaneous returns, in the expected direction (i.e. excess buy (sell) orders push down (up) yields), even after controlling for aggregate market volume. There is evidence of contrarian investor behaviour following an increase in yields, but continuation of order imbalances when yields are falling (the prices of bond futures are rising). International bond futures markets are strongly intertwined with the US market having a strong influence on the returns and order-flow across all countries; this is likely an indication of the spill-over effect of US macroeconomic data.

Risk vs Trend Driven Global Tactical Asset Allocation

The 2008 financial crisis has severely challenged passive forms of investment. In this paper, we compare two systematic investment processes that a global asset allocator may employ to preserve its capital in the face of a turbulent financial environment. The allocation, derived from the popular approach, has garnered a strong interest from both scholars and practitioners in the recent years. It aims at enforcing a constant risk target and maintaining a balanced risk profile over time. This paper introduces a novel approach, which enhances the risk-driven strategy by cutting the exposure to downward drifting assets. We then compare the risk-adjusted performances of risk and trend driven approaches on different investment universes (composed of equity, commodity, currency and bond futures contracts) over the 1993-2012 period. We find that a trend-driven approach yields increased Sharpe ratios and lower drawdowns in average relative to a risk-driven strategy. However, the outperformance of the trend-driven process is not stable over time: periods with exploitable trends alternate with long-lasting trendless periods. Overall, the key advantage of the trending strategy over the risk-driven one is its higher smoothness. This is due to a better resilience to 2008-like financial meltdowns, which are well-predicted by trending signals and undermine the diversification objective pursued by the risk-parity approach. These results demonstrate the value of coupling risk and trajectorial signals in tactical asset allocation.

Non-fully invested derivative-free bond index replication

The problem we address here is the replication of a bond benchmark when only a fraction of the portfolio is invested for the replication. Our methodology is based on a minimization of the tracking error subject to a set of constraints, namely (1) the fraction invested for the replication, (2) a no-short-selling constraint, and (3) a null-active-duration constraint, the last of which may be relaxed. The constraints can also be adapted to accommodate the use of interest rate and bond futures. Our main contribution, however, is our derivative-free approach to replication, which should prove very useful for managing assets when the use of derivatives is prohibited, for instance, by certain investors. We can, thus, still benefit from replicating a traditional investment in a bond index with a fraction of the portfolio according to our risk appetite. The rest of the portfolio can be invested in alpha-portable strategies. An analysis without the use of derivatives over the period from January 1, 2008 to October 3, 2011 shows that with 70–90 % invested for the replication, the annualized ex-ante tracking error can range from 0.41 to 0.07 %. We use principal component analysis to extract the main drivers of the size of the tracking error, namely, the volatility of and the differential between the yields in the objective function’s covariance matrix of spot rates. These results highlight our contribution of a generic and intuitive yet robust approach to bond index replication.

Greenspan Shrugs: Central Bank Communication, Formal Pronouncements and Bond Market Volatility

This paper presents empirical evidence on one aspect of central bank communication policy – formal pronouncements by central bankers – to better understand whether this channel matters and, if so, the nature of the information being transmitted. We examine the relationship between three types of pronouncements from Chairman Alan Greenspan -- speeches, testimonies, and FOMC meetings (STF’s) -- and volatility in the 30-year U.S. Treasury bond futures market. Using high-frequency, intraday data proves important in uncovering the impacts of pronouncements on the bond market. Three questions relevant to central bank communication policy are addressed (see Figure 1 for a summary). We find that STF’s matter for bond market volatility, that this impact depends on the transmission of information (rather than just noise), and that this information reflects both substantive content and a coordinating signal. We further find that speeches only deliver content, that testimonies are largely a coordinating device, and that FOMC meetings play both roles. These findings of an important coordination channel document the relevance of the “global games” model of Morris and Shin and the “herding” model of Banerjee and the associated policy implication that pronouncements by the central bank may reduce welfare by overwhelming important private information.

Equity Risk as a Determinant of Future Term-Structure Volatility

We show that equity volatility serves as a determinant of future Treasury term-structure volatility over the recent October 1997 to June 2013 period. We find that equity volatility contains incrementally reliable information for the subsequent volatility of: (1) 10-year and 30-year bond futures returns, (2) the term-structure's level, and (3) the term-structure's slope. We present additional evidence that suggests a flight-to-quality/flight-from-quality pricing avenue is a likely contributor to the volatility linkages, where time-varying economic uncertainty can generate both a large positive serial correlation in stock volatility and a time-variation in the precautionary savings motive and diversification benefits of holding bonds.

Extreme Correlation of Stock and Bond Futures Markets: International Evidence

AbstractThis study explores time‐varying extreme correlation of stock–bond futures markets in three major developed countries. In the United States and the United Kingdom, there is evidence of positive extreme stock–bond correlation when both futures markets are extremely bullish or bearish. In Germany, stock–bond futures extreme correlation is negative, suggesting the most diversification potentials of bond futures when German stock index futures market plunges. Macroeconomic news, the business cycle, and the stock market uncertainty all significantly affect the median stock–bond futures correlation. However, only the stock market uncertainty still significantly affects the extreme stock–bond futures correlation when the stock market is extremely bearish.

RBA monetary policy communication: The response of Australian interest rate futures to changes in RBA monetary policy

This paper examines the Australian interest rate futures market reaction to changes in Reserve Bank of Australia (RBA) monetary policy. Having determined market expectations from 30-day Interbank futures, the study finds evidence that interest rate futures react strongly to target rate announcements across the maturity spectrum, with a stronger reaction evident in short maturity futures. Further, there is evidence of an asymmetric news effect whereby volatility reacts more strongly to bad news. Disaggregation of the market reaction into target- and path-surprise factors demonstrates that the change in market expectations of future target rates plays a significant role in explaining changes in yield, particularly for bond futures. There is strong evidence that monetary policy statements drive the path-factor, while the December 2007 modification in policy communication has improved the ability of the RBA to influence market expectations.

Realized Covariance Tick-by-Tick in Presence of Rounded Time Stamps and General Microstructure Effects

This paper presents two classes of tick-by-tick covariance estimators adapted to the case of rounding in the price time stamps to a frequency lower than the typical arrival rate of tick prices. Through Monte Carlo simulations, we investigate the behavior of such estimators under realistic market microstructure conditions analogous to those of the financial data examined in this paper's empirical section, that is, nonsynchronous trading, general ARMA structure for microstructure noise, and true lead–lag cross-covariance. Simulation results show the robustness of the proposed tick-by-tick covariance estimators to time stamp rounding, and their overall performance is superior to competing covariance estimators under empirically realistic microstructure conditions. These results are confirmed in the empirical application where the economic benefits of the proposed estimators are evaluated with volatility timing strategies applied to a bivariate portfolio of S&P 500 futures and 30-year U.S. treasury bond futures.

Derivative-Free Replication of a Bond Benchmark with a Fraction of the Portfolio

The problem we address here is the replication of a bond benchmark when only a fraction of the portfolio is invested for the replication. Our methodology is based on a minimization of the tracking error subject to a set of constraints, namely (1) the fraction invested for the replication, (2) a no short selling constraint, and (3) a null active duration constraint, where the last one can be relaxed. Our main contribution lies in the derivative-free approach to replication. The constraints can, however, be adapted to accommodate the use of interest rate and bond futures. The methodology proposed here responds to the particular needs of the asset management industry where clients unwilling to invest in derivatives can still benefit from replicating a traditional investment in a bond index with a fraction of the portfolio according to their risk appetite. The rest of the portfolio can be invested in alpha-portable strategies. An analysis without the use of derivatives over a period spanning from 1st January, 2008 to 3rd October, 2011 shows that for 70% to 90% invested for the replication the annualized ex-ante tracking error can range from 0.41% to 0.07%. These results highlight our contribution of a generic and intuitive yet robust approach that is still not employed as the industry standard.

RBA Monetary Policy Communication: The Response of Australian Interest Rate Futures to Changes in RBA Monetary Policy

This paper examines the Australian interest rate futures market reaction to changes in RBA monetary policy. Having determined market expectations from 30-day Interbank futures, the study finds evidence that interest rate futures react strongly to target rate announcements across the maturity spectrum, with a stronger reaction evident in short maturity futures. Further, there is evidence of an asymmetric news effect whereby volatility reacts more strongly to bad news. Disaggregation of the market reaction into target- and path-surprise actors demonstrates that the change in market expectations of future target rates plays a significant role in explaining changes in yield, particularly for bond futures. There is strong evidence that monetary policy statements drive the path-factor, while the December 2007 modification in policy communication has improved the ability of the RBA to influence market expectations.

On the Effects of Private Information on Volatility

We study the relationship between order flow and volatility. To this end we develop a comprehensive framework that simultaneously controls for the effects of macro announcements and order flow on prices and the effect of macro announcements on volatility. Using high-frequency 30-year U.S. Treasury bond futures data, we find a statistically and economically significant relationship between the absolute value of order flow and volatility. Moreover, this relationship is robust, inter alia, to a number of factors including the introduction of liquidity effects, use of data measured over a different frequency, and market conditions.

Time series momentum

We document significant “time series momentum” in equity index, currency, commodity, and bond futures for each of the 58 liquid instruments we consider. We find persistence in returns for one to 12 months that partially reverses over longer horizons, consistent with sentiment theories of initial under-reaction and delayed over-reaction. A diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors and performs best during extreme markets. Examining the trading activities of speculators and hedgers, we find that speculators profit from time series momentum at the expense of hedgers.

Price adjustment to news with uncertain precision

We analyze how markets adjust to new information when the reliability of news is uncertain and has to be estimated itself. We propose a Bayesian learning model where market participants receive fundamental information along with noisy estimates of news’ precision. It is shown that the efficiency of a precision estimate drives the slope and the shape of price response functions to news. Increasing estimation errors induce stronger nonlinearities in price responses. Analyzing high-frequency reactions of Treasury bond futures prices to employment releases, we find strong empirical support for the model’s predictions and show that the consideration of precision uncertainty is statistically and economically important.

Bond Futures and Order Imbalance: An International Comparison

Order imbalance methodology is utilized to examine the link between trading activity and returns in the six most liquid international bond futures markets. Order imbalances are strongly related to contemporaneous returns, in the expected direction (i.e. excess buy (sell) orders push down (up) yields, even after controlling for aggregate market volume. There is evidence of contrarian investor behaviour following an increase in yields, but continuation of order imbalances when yields are falling (the prices of bond futures are rising). International bond futures markets are strongly intertwined with the US market having a strong influence on the returns and order-flow across all countries; this is likely an indication of the spill-over effect of US macroeconomic data.

Analytical bounds for Treasury bond futures prices

The pricing of delivery options, particularly timing options, in Treasury bond futures is prohibitively expensive. Recursive use of the lattice model is unavoidable for valuing such options, as Boyle in J Finance 14(1):101–113, (1989) demonstrates. As a result, the main purpose of this study is to derive upper bounds and lower bounds for Treasury bond futures prices. This study first shows that the popular preference-free, closed form cost of carry model is an upper bound for the Treasury bond futures price. Then, the next step is to derive analytical lower bounds for the futures price under one and two-factor Cox-Ingersoll-Ross models of the term structure. The bound under the two-factor Cox-Ingersoll-Ross model is then tested empirically using weekly futures prices from January 1987 to December 2000.

Extreme Correlation of Stock and Bond Futures Markets: International Evidence

Using daily stock and bond futures data of three developed markets (the U.S., the UK and Germany), this study explores time-varying extreme correlation of stock-bond futures markets. There is evidence of positive extreme correlation between stock and bond futures markets in the U.S. and the UK when both markets are extremely bullish or bearish. By contrast, German stock-bond futures extreme correlation is negative, which suggests most diversification potentials of German bond futures market when German stock index futures market plunges. Macroeconomic news, the business cycle and the stock market uncertainty all significantly affect the median stock-bond futures correlation. By contrast, only the stock market uncertainty (perhaps as a measure of investor sentiment) still significantly affects the extreme stock-bond futures correlation, when the stock market is extremely bearish.