The CBOT hopes to launch new yield curve spread contracts before the November elections. Traders can't wait.

By Margaret Elliott

Speculating on the shape of the yield curve is a bread-and-butter business for proprietary traders at the major derivatives dealers. But for almost everybody else it's a relatively complicated operation.

All that may change very soon. In October the CBOT is set to launch a long-planned and well-received pair of contracts on the yield curve spread. Options and futures will be available on the entire spectrum of active yield curve spreads on benchmark U.S. Treasury issues, from the 2-year/3-year spread to the 10-year/30-year spread. Quoted in eighths of a basis point, these contracts provide an easy way to speculate on changes in the shape of the yield curve or to neutralize a portfolio's exposure to these changes.

Although nobody expects yield curve spread options and futures to replace similar OTC products, the CBOT's new offerings stack up well against the competition. They are simpler than an OTC product: just one trade instead of a minimum of two, depending on the strategy pursued. Credit concerns are alleviated, because the Board of Trade Clearing Corp. guarantees the trade.

"It's a bit of novelty," says Eileen Klecka, senior product and marketing manager at the CBOT. "It is the first contract that is based on the spread between two Treasury instruments rather than a single underlying." This allows traders to isolate the yield curve slope with just one trade. By basing the options on a spread, the CBOT has eliminated the risks associated with legging into an exposure, which occurs when one side of an OTC trade is exercised, but not the other.

It also makes keeping track of a yield curve position much easier. In an OTC trade with two positions, traders have to perform ratio calculations on the sensitivity of each leg to interest rate changes and adjust the ratios (and sometimes tweak the positions) every time rates change. These calculations are cumbersome for all but the largest shops and can eat into a profit that is slim at the best of times.

The contracts are priced off the cash market, known as the on-the-run price, rather than the cheapest-to-deliver price. By mirroring the cash market and setting the options to expire with the futures, the CBOT bypasses delivery problems that might occur if these expirations were staggered. Duration too remains neutral through the life of the option. "The CBOT has made all the right choices," says Don Palazzollo, senior vice president and manager of the Americas division for Bank of America Futures in Chicago.

In a novel twist, and one the CBOT hopes will promote some arbitrage across the product, these contracts offer serial and quarterly expiration. In effect that means monthly expiration, allowing traders to pick up that month's most recently auctioned on-the-run Treasury securities. "It's neat," says Steve Pelletier at derivatives money manager Analytic·TSA, "because it is traded on the forward spread, but you know it will converge on the spot price regardless."

Delayed launch

Although the CBOT originally planned to launch the contract on September 21, it had to acknowledge in mid-August that not everyone associated with the project is on its marks-particularly the software vendors that provide the necessary analytic tools. To allow for an orderly and successful launch, the start date has been pushed back to October 18, according to the CBOT. "It's a real disappointment," says one trader.

Many market participants thought the launch was delayed because software vendors weren't equipped to quote prices for an inverted yield curve. CBOT's Klecka, however, says that particular glitch was solved in the spring. "Since most machines are not equipped to quote negative numbers, we added 100 to the quote. That means a normal yield curve spread might be quoted as 100.10000, where the spread is 10 basis points. If the spread inverts, then a spread of -10 basis points would be expressed 99.90000."

The CBOT hopes that the contracts will attract a broader range of participants into playing the yield curve. While this type of trade is easy for market-making banks and big proprietary traders, it is a tough one in the OTC market for smaller or foreign banks, corporates smaller than the Fortune 50 and many money managers. That's because a yield curve spread trade is necessarily complicated, involving myriad calculations and a lot of upkeep over the life of the trade. As an OTC trade, it falls on balance sheet and thus eats into credit lines. Since it is executed using cash products, either short or long, the OTC trade will require financing. All of these problems are solved by using the new CBOT products.

"We can't wait," says Analy-tic·TSA's Pelletier. "We have a yield curve product based on our economic data model that we are all geared up to trade." He suggests that for a money manager the contracts work very nicely as an overlay to a bond portfolio. If, for example, the yield curve flattens, he says, he could buy 30-years and sell 2-years in the cash market. Or he could simply overlay the yield curve futures contract, saving himself transaction costs and time.

Slow learners

The only real question is the same one that faces any new contract: will there be anyone to trade it? Because the CBOT could get no consensus on which of the benchmark points might trade more than any other, the exchange decided to launch all the points from day one. That could have the effect of leaving some spreads with no volume. No volume, no liquidity, no contract.

Most traders expect yield curve spread options and perhaps futures to start slowly. Even the CBOT admits that interest thus far has been concentrated in the options. John Hughes, senior vice president of OTC Trading at NationsBank in Chicago, says, "My personal opinion is the options may trade without the futures ever taking off." Several traders suggest that the market might develop like a quasi-OTC product, as a tight, lightly traded market that nevertheless has depth. But limited volume will not mean limited interest. "It will be more of a negotiated deal," says Hughes. "Think of it as an OTC option that the CBOT sponsors and clears."

Other observers warn that it will take time to get a new influx of players into these contracts. For instance, the CBOT wants to attract traders in the interest rate swap market that today use Eurodollar strips as part of the trade. "I don't see those people moving soon," says one OTC trader. "They have their programs set up and the Eurodollar strips serve them well." Another guesses that the contracts will attract what he calls "a whole new level of speculator-those who didn't have the wherewithal to get financing."

Traders point out that the introduction of these contracts is coming at a slow time in the market. "The yield curve is quite flat and the Federal Reserve Bank isn't very active," says one. With the biggest effects on yield curve spreads, at least in the short end, directly attributable to activities by the Fed, there won't be much volatility and thus little profit opportunity.

The power of electronic technology felt like historical destiny at exchanges last month, so many were the news events in which it played a key role.

At the American Stock Exchange all options specialists adopted an electronic book based on technology developed by Stockholm-based OM Systems International. The electronic book, which abolishes paper bookkeeping, files and stores all options orders, transactions and status information. It automates real-time positions, consolidates market data, compares trades. Previous customers for the well-regarded OM CLICK Exchange System are the CED Borsa and the Hong Kong Futures Exchange. The electronic book at the Amex , a modified CLICK, adapts screen trading for floor traders.

Electronic technology was also present at the mid-August breakup of the proposed alliance between France's Matif, the second-largest European derivatives exchange, and Germany's Deutsche Terminbörse. The coming of a unified European currency lent special urgency to some form of union between the two; so too did the need to counter London's dominance. The proposed marriage hit the rocks when the Germans demanded an all-electronic exchange and the French refused to abandon open outcry. "For the Germans it had to be electronic or nothing," said a Matif executive, adding they showed "real dogmatism." Matif is putting on a brave face despite this setback and a 24 percent decline in trading volume last year. Its head, Gerard Pfauwadel, told the press that his ongoing strategy will be to make Paris the central market for interest rate products in Euros.

Chicago was the other location for a technological milestone. The Chicago Mercantile Exchange unveiled the addition of seven cross-rate currency futures against the deutsche mark to the all-electronic GLOBEX-the first time ever it has offered an item on GLOBEX but not in the pits. Three of the seven (yen, Swiss franc and sterling) were tried but withdrawn from the floor. Clearly the hope is that they'll fly better on bits and bites.