Handling Futures Roll Distortions in Market-Based Yield Curves

Summary

The document discusses whether futures rolls can distort short-end yield curves built from nearby interest rate futures. A roll may create short-lived imbalances that affect observed futures prices and, in turn, the rates inferred from them. The answer recommends retaining those observations in a market-based curve rather than smoothing away possible irregularities, since visible curve features may reflect real market conditions.

As an alternative analytical view, a trader can construct a separate fair-value curve using personal assumptions about where rates should trade. Comparing that curve with the market-based curve can help identify relative-value opportunities. The response argues that a yield curve need not be perfectly smooth and gives T-bill maturity humps related to debt-ceiling concerns as an example of a market feature with an underlying explanation. It offers a judgment about curve-building philosophy, not a quantitative method for measuring roll effects or a rule that every distortion should be ignored.

Key ideas

• Futures rolls can cause temporary pricing imbalances that affect rates inferred from futures.
• A market-based curve can retain observed irregularities rather than smoothing them away.
• A separate fair-value curve can represent a trader's assumptions about appropriate pricing.
• Comparing market and fair-value curves can reveal relative-value opportunities.
• Curve humps or jumps may reflect market concerns, though the answer gives no quantitative test for roll-related distortions.

Tags

# Libor futures rolling adjustment & curve building


# Libor futures rolling adjustment & curve building












Can futures rolling affect curve constructing? Let's say that i'm using future 1 and 2 to construct the short end of my curve. As i understand it, rolling will create volatility (as volumes spike), which can affect the futures prices and thus the rates deduced from those futures. So is there a risk that the part of the curve implied from these futures presents some kind of jumps in this rolling period? Thank in advance.

## Answer by Helin (score 1, accepted)

https://quant.stackexchange.com/a/35684

Futures roll can potentially create some short-term imbalances that distort market pricing. Whether or not that should be accounted for in curve construction is philosophical. In my mind, there's no reason to – you're building a market-based curve, and you shouldn't override the market. You can, however, build a separate "fair value" curve which incorporates some of your personal views on where things should be trading at. Comparing this fair value curve with the market-based curve is how you discover relative value trading opportunities.

Also, I wouldn't worry about "jumps" in the curve in general. There's no reason why the yield curve has to be perfectly smooth. You may have read about the humps in the T-bill curve around October maturity. The hump simply reflects market concerns about whether or not the debt ceiling will be lifted in time. There are always reasons for why these abnormalities exist; it's best to show them so as to reveal potential trading opportunities, rather than smoothing them out just to make the curve look nicer...

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.