Hedging a Treasury Yield-Spread Swap with Cash Bonds or Futures
Summary
The document describes a proposed product paying a notional amount times the change in the spread between 30-year and 10-year Treasury yields. The response frames the hedge as exposure to two future yields, corresponding to the 10-year and 30-year points on the curve. It suggests offsetting the shorter-maturity sensitivity by shorting cash Treasuries with the relevant maturity, and hedging the longer point by buying long Treasuries, with periodic replacement by newly issued 30-year securities when needed. Exchange-listed futures are offered as an alternative to cash bonds.
The answer stresses that the hedge depends on the product’s actual terms. Caps, floors, other optionality, termination provisions, and whether the client can owe money when the curve inverts all affect the exposure. It notes that transaction costs are uncertain and should be covered by fees. The response gives a high-level hedge outline, not hedge ratios, a pricing model, or a treatment of basis, curve movements, collateral, or early termination risk.
Key ideas
- A yield-spread payment has sensitivity to both the future 10-year and 30-year Treasury yields.
- The response proposes shorting shorter-maturity cash Treasuries to offset the 10-year yield exposure.
- It proposes buying long Treasuries and periodically rolling into newly issued 30-year bonds for the longer-maturity exposure.
- Treasury futures may be used instead of cash bonds.
- Embedded options, inversion terms, early termination, and transaction costs can materially change the hedge.
Tags
Full text
# How do I hedge yield spread? # How do I hedge yield spread? We'd like to offer a product in which a notional amount $(N)$ is given, and the underlying is spread $(s)$ defined as, say, 30Y yield minus 10Y yield (both from treasury YTM yield curve). At the end of the trade, we give the client $N \cdot(s_t-s_0)$ in exchange for a transaction fee equal $N$ times some bps. How can I hedge my position? More detials: our product is likely to be casted into a total return swap (TRS) form. And we also offer early termination option but based on mutual negotiation and usually incur a punishiment fee for client if it happened(i.e., makewhole). Another termination condition is when the spread is moving in opposite direction, e,g, if the investor makes a bet the spread will widen, but it siginificantly narrows after entering the contract, then we will early terminate (or asking for more collateral, but I guess the design of such is again based on the hedging part). ## Answer by Dimitri Vulis (score 1) https://quant.stackexchange.com/a/63109 Is this all that there is to this product, no early termination, no embedded caps, floors, minimums, maxiumums, or any other optionality? If the curve inverts so much that 10Y>30Y at time t, will the client pay you instead? As currently described, the cash flow at t simply has sensitivities to two yields that no one knows now: 10Y+t and 30Y+t. To hedge the 10Y+t sensitivity, you can short some 10+t cash treasuries to exactly offset it. To hedge the 30Y+t sensitivity, you can buy now some 30Y cash treasuries (because this is the longest maturity available). If t is far enough in the future, you occasionally sell this and buy the on the run 30Y when they are issued. You could also use exchange-listed futures instead of cash treasuries. All these transactions have costs, not exactly predictable, that your fees should cover.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.