European Rates Research J.P. Morgan Securities Ltd.

London, November 8, 2006

European Bond Futures Guide

European Rates: Derivatives Strategy
This note provides an introduction to the pricing and risks of European bond futures contracts, with some examples of trades and an explanation of JPMorgan futures analytics. Appendix shows the details of contract specifications for Eurex and Liffe bond futures contracts. Fabio BassiAC
(44-20) 7325-8615 fabio.bassi@jpmorgan.com

Gurpal Kalsi
(44-20) 7325-3691 gurpal.s.kalsi@jpmorgan.com

Philip Strother
(44-20) 7325-1545 philip.d.strother@jpmorgan.com

Introduction to European bond futures

This note provides an introduction to the dynamics of bond futures contracts with a focus on the European contracts. The note covers the main concepts of pricing and risk, and offers some examples of trades which can be implemented with these contracts. Additionally, it explains the JPMorgan risk measures and analytics. The contracts which we refer to in this piece are the Eurex traded futures, the Buxl, Bund, Bobl and Schatz, and the LIFFE traded Gilt futures. The daily volume in Eurex and Liffe bond futures has averaged, during 2006, about 250bn and 5.7bn respectively (from an average of 210bn and 3.5bn in 2005), and total amount of Eurex open interest position as of 1st November 2006 is about 380bn and 25bn (in Gilt). This compares with the size of German and Gilt cash government bond markets of 730bn and 320bn, respectively. A significant part of the success of these contracts relies on their liquidity. The users range from a wide spectrum of investors, such as real money accounts, pension funds, prop traders and hedge funds, who trade futures as hedging, relative value or speculative instruments.

delivery and pay the invoice price for the bond. At any time three of the quarterly delivery dates (March, June, September and December) are available. Liquidity tends to concentrate in the near dated (front) contract until before expiry, when an active market of the calendar spread gains liquidity. Hence, investors not wishing to take or make physical delivery, but still willing to keep the risk, take the opposite position in (close out) the contract and move their exposure to the next dated (back) contract.

Contract grade
Futures exchanges indicate the contract grade for each contract. This defines the basket of bonds which are eligible for delivery into each contract. Usually the specification for the bonds in the basket is related to the remaining maturity of the bonds on the delivery date (maturity window) and the notional issue size (above a minimum threshold). This is due to a need for liquidity in the bonds which are deliverable into a futures contract. For example, the DBR 6 Jun16 falls into the 8.5-10.5 years maturity window for the deliverabilty into the Dec06 Bund contract, however with an issue size below the 5bn Bund threshold (3.75bn) it is not eligible for delivery in the December basket (please see the appendix on page 9 for detailed contract specifications).

Standardisation, margining and delivery

A bond futures is a standardised forward contract for the sale or purchase of a fixed amount of par nominal bond that is deliverable into the contract. As with other futures contracts a position is initiated only with margin payments and gains and losses are settled on a daily basis, when the clearing house transfers money from the accounts of those with losses to the accounts of those with gains. The European contracts we analyse are for physical delivery. The shorts are required to make delivery (unless they close the position before expiry) and the longs are required to take

Conversion factor and invoice price

At expiry, the holder of a short position must deliver a certain amount of nominal to the long position. Interestingly, the choice of the optimal bond to deliver is in the hands of the short position. Hence, we can say that a long (short) position in a bond futures includes a short (long) position in the delivery option . The short can choose from any bond in www.morganmarkets.com

The certifying analyst is indicated by an AC. See last page for analyst certification and important legal and regulatory disclosures.

J.P. Morgan Securities Ltd. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545

fabio.bassi@jpmorgan.com gurpal.s.kalsi@jpmorgan.com philip.d.strother@jpmorgan.com

European Rates Research European Rates November 8, 2006

the basket in order to fulfill their obligation. Clearly, understanding the process of finding the optimal bond for the short to deliver is key in the valuation of a bond futures fair value, and in the assessment of the risk of a futures position. All the deliverable bonds differ in maturity and coupon, hence the exchange tries to place all the deliverable bonds onto an equal footing. In order to do so they compare the maturity and coupon structure of any bond with the maturity and coupon of a theoretical notional bond. For example, in the case of the Bund, it is a bond with 10y maturity from the delivery date and a 6% coupon. The resulting number is known as Conversion Factor (CF). A bonds CF is approximately the price of the bond at the delivery date (as settlement date) if it yielded the notional coupon, divided by 100. The CF is then rounded to six digits in Eurex and to seven digits for Gilts. The CF is lower than one if coupon is lower than notional coupon and vice versa. Example: The delivery date for the Dec06 Bund contract is 11th Dec 2006. The price of the DBR 3.25 Jul15 which gives a 6% yield on the 11th Dec06 is 81.97392. The conversion factor for this bond for the December delivery is then 0.819739.
Table 1 Conversion factors
Prices of bonds deliverable into the December 06 Bund contract such that they yield 6% on the 11th of December.

depends on the choice of bond that is delivered. The invoice price is not enough to assess the optimal bond to deliver, as it is only representing the revenue at delivery from the sale of futures and does not take into account the cost of bond purchase to make delivery. We need to look at this component to find out the most convenient bond to deliver.

Cheapest To Deliver & Implied Repo Rate

The holder of a short position can, at any point during the life of the contract, find out what is the optimal bond to deliver by analysing the return from the cash and carry transaction, where a bond in the basket is bought, futures are sold against it, and then, the held bonds are delivered into the contract. Clearly, as the short position has to buy the bonds, it will be optimal to buy cheaper bonds, this is why it is called the Cheapest To Deliver (CTD) bond. For any bond in the basket, the cost of buying can be expressed as: Purchase price = Pb + AI(s)i (2)

where Pb is the clean spot price of the bond and AI(s)i is the accrued interest to the settlement date. Hence, the choice of the CTD will be based on the comparison of (1) and (2), the revenue and the cost of the cash & carry transaction. The return from the cash and carry transaction, over a number d of days, can be calculated as implied repo rate (IRR): IRR = (Invoice price / Purchase Price -1) * 360/d = 360 (( Fd * CFi + AI(d)i ) / (Pb + AI(s)i) -1) / d (3) This is called the implied repo rate because it indicates the level at which the bond is implicitly financed during the cash and carry period. However, in order to buy the bond we need to consider also the cost of holding such a position, which is the financing, or repo, rate, R, of purchasing of the bond. (Pb + AI(s)i) * (1 + R x d / 360) = FwdPd+ AI(d)i (4) where FwdPd is the forward price of the bond at the delivery date. Putting it all together, we can then say that the CTD bond is the one which gives the best cash and carry return adjusted for the cost of building the postion, hence the one which maximizes (implied repo rate - actual repo rate). By combining (1) and (4) we can say that the implied repo

Bond DBR 3 1/4 Jul15 DBR 3 1/2 Jan16 DBR 4 Jul16

Price 81.97392 82.89368 85.71649

CF 0.819739 0.828937 0.857165

By definition, conversion factors are not dependent on market level, they are constant for a given bond and expiration month, as they express the difference of any specific bond coupon and maturity vs. the notional bond. The CF is fundamental in assessing the amount of money received by the short position going to delivery; that is known as the invoice price which is defined below for a generic bond i: Invoice pricei = ( Fd * CFi ) + AI(d)i (1)

where Fd is the futures settlement price, the CFi is the conversion factor of bond i and AI(d)i is the accrued interest for the bond i at the delivery date of the futures (consistent with the calculation of dirty bond price). The key point is that the amount of money received by the short position

J.P. Morgan Securities Ltd. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545

fabio.bassi@jpmorgan.com gurpal.s.kalsi@jpmorgan.com philip.d.strother@jpmorgan.com

European Rates Research European Rates November 8, 2006

rate will be equivalent to the actual repo rate if: ( Fd * CFi ) = FwdPd which is indicating that the fair futures price times the CF should be equal to the forward price of the CTD. This is true when there is no uncertainty on which bond is going to be delivered into the futures contract, and then the purchase of a bond at forward date is equivalent to a long position in the futures.

Chart 1 Futures price exhibits negative convexity

Yield movements make the bond futures tracking different bond in the basket Illustration only Price/factor 140

130 120 110 100 90 80 70

Source: JPMorgan

4.00% Jan 37

5.5% Jan 31 Futures price 4.122 4.265 4.75% Jul 34

BNOC: a measure to assess CTD status

The basis of a bond futures position is defined as the price of the bond in the cash market minus the futures settlement price: Basis = Spot price - futures price * conversion factor(CF)

Yield

Chart 2 Basis changes with yield curve movements

The basis of the lower duation Jan 31 is like a put option, widening in a sell-off

140

Price/factor

Illustration only

However, for comparison with the futures price, it is the forward price of the bond we need to consider. This we call the net basis: Net Basis = Fwd price - futures price * CF The difference between the spot price and the forward price is the cost of carry of the position, and for this reason the net basis is known as the basis net of carry, or BNOC. Intuitively, we may think that the bond which gives us the lowest BNOC would be the most advantageous to deliver the CTD bond. This is a valid approximation, which holds unless the price of the bonds in the basket are very dissimilar. To see why, we can go back to the return on the cash and carry short position; the difference between the implied repo rate and the market repo rate. Using the expressions for the repo and implied repo we had in the previous section, we find that this difference is given by R - IRR = (FwdPd - ( Fd * CFi )) / ( Pb + AI(s) ) which is proportional to the basis net of carry (BNOC) we have just introduced. In this way we see that the BNOC is a direct comparison of the rate the short is being charged to finance his position, the repo rate, with the rate of return he can expect from it, the implied repo rate. The only subtlety is that we must take into account the dirty price of the bond when comparing the net basis. The bond which minmises BNOC/dirty price will maximise

130 120 110 100 90 80 70

Source: JPMorgan

5.5% Jan 31 Futures price Yield

Chart 3 Option-like profiles of the basis

Basis profiles of the deliverable bonds in the Buxl basket. The lower duration Jan 31 show a put option profile, the medium duration Jul 34 a straddle profile and the higher duration Jan 37 a call option profile. Basis (cents) 350

300 250 200 150 100 50 0 -50 -60 -40 -20 0 20 40 60 80 100
Source: JPMorgan

4% Jan 37 5% Jan 31 4.75% Jul 34 Yield shift (bp)

the shorts rate of return when compared with his cost; this bond will be the cheapest to deliver. However, as market conditions can change the CTD status between the bonds in a futures basket, we need to analyse the impact of the risk of a switch in the futures price.

J.P. Morgan Securities Ltd. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545

fabio.bassi@jpmorgan.com gurpal.s.kalsi@jpmorgan.com philip.d.strother@jpmorgan.com

European Rates Research European Rates November 8, 2006

OABNOC: an acronym for relative value

An intuitive understanding of why a bond is CTD is useful and also provides an understanding of how and why the CTD can change overtime. The Buxl contract has been listed with a notional coupon of 4% and with yield levels close to the notional coupon it is more likely to see a change in the CTD. Chart 1 shows the price of the Dec06 Buxl contract (adjusted by the conversion factor) as a function of the 30 year benchmark yield. In a low yield environment (below 4.12%), the bond with lowest duration (Jan31) is the cheapest to deliver, since its low duration makes the bond cheaper than the others. As yields rise, the Jan31 is replaced by higher duration bonds, in turn the Jul34 and then the Jan37, in the case of a sell-off above 4.27%. The switch of CTD at different yields gives the long future position its negative convexity. The holder of a long position in the futures is always negatively impacted by a change in the CTD as the delivered bond is always the worst performing bond in the basket (the bond which rallies less or sells off more, intuitively). If this is the case, an investor would buy the futures only if the futures price reflects a fair compensation for the risk of receiving another bond at delivery (giving positive BNOC, and hence futures price* CF cheaper than the forward price of the CTD). The monetary value of the risk of getting a different CTD is defined as the delivery option and we can assess whether a future is fairly valued if the BNOC of the CTD is equal to the fair value of delivery option. We thus define the option-adjusted basis net of carry (OABNOC) as: OABNOC = BNOC fair value of the delivery option If the OABNOC is zero, then the BNOC contains the delivery option value and future is fairly priced. If this quantity is negative, then the delivery option is undervalued and the futures are rich. Conversely if the OABNOC is positive, the delivery option is overvalued and the futures are cheap with respect to fair value. The calculation of the value of the delivery option is a relatively computationally intensive process. We run a proprietary 2-factor model to determine the possible distribution of yield changes around the current values, and use this distribution to predict changes in the BNOC for all the deliverable bonds. The probability weighted level of the BNOC for the CTD under the various yield shift scenarios is our fair value of the delivery option. The yield shift distribution is built using the available implied vol information from the listed options on futures.

Delivery option: non-linear payout of basis trades

A detailed analysis of the components of chart 1 reveals the profile of basis trades as level of interest rates. We show this explicitly in chart 2 and 3, were we have the basis as a function of yield for the different bonds in the Buxl basket, we see a graphical representation of the concept of delivery option. The difference between the futures adjusted price and the bond price represents the value of the basis (adjusted by the conversion factor). This basis, in the case of a low duration bond, tends to show a put-option-like profile, decreasing in the case of market rally (eventually it will go to zero and the current CTD will be delivered into the short futures position) and with upside in the case of market sell-off. Similarly, the chart shows that the high duration bond has a profile resembling that of a call-option. Thus we see the non-linear profile of basis trades and suggest an opportunity to create option like-profiles with combination of instrument with different convexity. The basis trades benefit from the relative behaviour between a specific bond and the futures contract. They are driven not only by level of yields (as shown in chart 3) but also by relative change in the slope of the curve, which could generate a change in the CTD, by funding rates or by futures relative mis-pricings (change in OABNOC).

Chart 4 CTD switching is taking place in European contracts

Maturity of the CTD of the Buxl contract in 2006. As yields moved higher in May-August, the CTD switched several times between the Jan37 and the Jul34, before reverting to the Jan31 when yields fell.

4.4 4.2 4.0 3.8 3.6 3.4 Dec-05

Source: JPMorgan

31 30y r Yields 30 29 28 CTD Yrs to Maturity 27 26 25 24 Mar-06 Jun-06 Sep-06

J.P. Morgan Securities Ltd. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545

fabio.bassi@jpmorgan.com gurpal.s.kalsi@jpmorgan.com philip.d.strother@jpmorgan.com

European Rates Research European Rates November 8, 2006

Hedging
On the pricing side we discussed the issue of change in CTD and its implications in terms of pricing and fair valuation of the contract. This component has to be considered also in the case of the risk profile of a bond futures contract. Since the future will track, to first order at least, the price changes of the cheapest to deliver bond, it is possible to construct a risk measure based on the present value of a basis point move in the underlying, or PVBP. From this, we can then provide a duration-like measure by normalising with respect to the price. However, any measure of risk which is based only on the current CTD does not properly capture the risk of a switch. Rule of thumb At delivery, when there is no carry left and there is no value in the delivery option, we can say that Futures price * Conv. factor = CTD Price A rule of thumb commonly, but incorrectly, used is to say that this is the case before delivery (the expiry assumption). Under this assumption, chg futures price = chg CTD Price / Factor Hence, if we take the change in respect to a change in the yield, we get: chg future / chg yield = PVBP future = PVBP ctd / factor

Chart 6 Deliverable bonds for the Buxl contract

The need for yield beta: the chart shows the spread between the DBR 4 Jan37 and the DBR 5.5 Jan 31 as a function of the yield of the DBR 4 Jan37. Jan 37 - Jan 31 Yield Spread (bp) 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 -3.5 -4.0 -4.5
3.5 3.6 3.7 3.8 3.9 4.0 4.1 4.2 4.3 4.4

Jan 37 Yield (%)

Source: JPMorgan

and hence a rule of thumb would suggest that the PVBP of the future is the PVBP of the CTD divided by its conversion factor. Unfortunately, there are three sources of error in the expiry assumption measure. Firstly, it explicitly ignores the fact that spot and forward prices do not necessarily move together. Secondly, it does not take into account the possibility of change in the CTD and its implications in the futures prices changes at different yield level. Finally, it is not necessarily true that all the bonds in the basket move in a parallel fashion and our riskmeasures should be adjusted to incorporate this. Option-adjusted risk measures In JPMorgans analytics, we correctly adjust for the optionality by re-evaluating the option at the yield shift points used to calculate the PVBP measure. This gives a significant advantage over its non-option adjusted measure in that it not only provides greater accuracy, but is also smooth near any CTD switch points. Intuitively, we can say that the risk of the bond futures is a weighted risk of all the deliverable bonds, using as weights the probability of a single bond to become CTD. Our option adjusted risk measures are defined as the change in the value of the futures price for 1bp change in the yield of the benchmark (and not the CTD). We assume no movement in the repo rates. Implicitly, in the parallel risk measure that we calculate, the implicit change in the benchmark and in the CTD are equivalent. Chart 4 shows the change in the maturity of the CTD which has occurred over the life of the Buxl contract and chart 5 shows the different risk measures, calculated according to the rule of thumb, described above, or according our calculation.

Chart 5 Option adjusted risk measures

The chart shows the PVBP for the Buxl contract calculated via the expiry assumption and via JP Morgans option adjusted measure. The option adjusted measure provides better accuracy and smoother behaviour accross CTD switches.

17.5 17.0 16.5 16.0 15.5 15.0 14.5 14.0 Dec-05

OA PVBP para

OA PVBP Beta

Rule of Thumb

Feb-06

Apr-06

Jun-06

Aug-06

Oct-06

Source: JPMorgan

J.P. Morgan Securities Ltd. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545

fabio.bassi@jpmorgan.com gurpal.s.kalsi@jpmorgan.com philip.d.strother@jpmorgan.com

European Rates Research European Rates November 8, 2006

Beta-adjusted and option-adjusted risk measures Additionally, we provide a further adjustment of risk measure across the curve. Curve movements are not, in general, completely described by parallel shifts and we tried to take that into account by providing risk measures not only option-adjusted, but also beta-adjusted. Chart 6 shows the change in the slope of the Buxl basket vs. the level of yields. Although the relation is not always very stable it is possible to see some directionality of the yield spread. The beta adjustment tries to improve the hedge ratio of bond and futures PVBP by incorporating the most recent directionality. The first step is to establish the relative movements of the bonds in the basket to the movements of the benchmark. We do this by regressing the weekly changes in yield for any particular bond against the changes in the benchmark over a period of 6 months. The regression coefficient, beta, tells us how much an issue will move for a given movement in the benchmark. We then recalculate the PVBP of the future using a 1bp movement in the benchmark yield, but with the yields of the other bonds in the basket moving in proportion to their yield betas. We refer to this as the beta adjusted PVBP. This PVBP measure may be thought of as being rebased to movements in the benchmark, so we will need to construct all quantities in our hedge ratio relative to the benchmark. To do this, we simply multiply the PVBP of the bond by the bond specific beta. Empirically, the betaadjustment is smaller than the option-adjustment when there is optionality, as is the case in the Buxl (see chart 5). Number of futures = PVBP of the bond * Yield Beta of the Bond / Option and beta adjusted PVBP of the future Example: Hedge for 100mm of DBR Jan37, PVBP = 17.85 (22Sep06) PVBP Buxl Rule of thumb: 14.71 1,213 contracts OA // PVBP: 15.33 1,164 contracts OA beta-adj PVBP: 15.40 1,159 contracts From PVBP to a duration measure
Table 2 Example bond portfolio
In the example in the text, the duration of this portfolio is extended by 0.75 years through the purchase of 768 Dec06 Bobl futures
Price DBR OBL DBR DBR DBR DBR 5.25% Jul 10 3.5% Apr 11 5% Jul 11 4.5% Jul 13 4.25% Jul 14 4% Jul 16 105.2 99.18 105.43 104.25 103.44 102.01

Once we have a correctly adjusted PVBP measure, we may construct a duration measure by normalising to the futures price. We may then use this measure to alter the duration of an existing portfolio of bonds by entering into the appropriate number of futures contracts. A duration measure represents the relative change in price for a given change in yield. Since the PVBP measure gives us an absolute change in price for a given (1bp) change in yield, we simply divide by the futures price (F) to arrive at the duration, DF: DF = PVBP / F If we buy N contracts to extend our portfolios duration, DP then the new duration of the portfolio, D, would be D = ( MV*DP + N*PVBP ) / MV where MV is the market value of our portfolio. A little algebra allows us to arrive at the following expression for the number of contracts we need to extend the duration of our portfolio by one year: N = MV/PVBP However, the unit of measure needs to be adjusted accordingly. The PVBP is expressed as cents per bp or in terms of per contract, hence we need to multiply the risk of a bp by ten thousand in the above formula. Example: We refer to the portfolio in table 2. Portfolio value: 474.3 mn Portfolio duration: 5.005 years Dec06 Bobl contract ( Oct 13th, 2006) PVBP (option, beta adjusted) 46.33 /bp N = 474.3 mn * 0.75/ (46.33 * 10,000) = 768 contracts (Target change in duration is 0.75 years)

Source: JPMorgan

Yield Mod. Dur. Notional (mm) Market value (mm) Mod. Dur 3.693 3.246 95 99.940 3.701 3.929 90 89.262 3.702 4.057 50 52.715 3.712 5.140 75 78.188 3.722 6.378 80 82.752 3.744 7.774 70 71.407 Portfolio 474.264

324.41 350.71 213.86 401.88 527.79 555.12 5.005 Years

J.P. Morgan Securities Ltd. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545

fabio.bassi@jpmorgan.com gurpal.s.kalsi@jpmorgan.com philip.d.strother@jpmorgan.com

European Rates Research European Rates November 8, 2006

When-issued
As new bonds are issued during the life of a bond futures contract, they can become deliverable in a specific basket, if they satisfy the criteria for deliverability. This is often the case in the Schatz contract, where the yet-to-be-issued 2year benchmark becomes CTD of the back month Schatz contract. Clearly, for pricing, valuation and risk consideration the yet-to-be-issued bond has to be included in the futures projection, especially when there is chance for that bond to become the CTD of the contract. The flaw of not using the when-issued information can be quite significant as pricing and risk would be based on an incorrect CTD. In JPMorgan analytics, we forecast the issue dates and maturities based on debt issuing patterns; these bond specifications are updated as the bond-issuing authority announces the details of the auction schedule. In order to find out what is the expected coupon, we make the assumption that the bond is issued at or below par, hence we get a coupon from the current benchmark yield rounded to the nearest quarter point. Once we have all the details in terms of dates and coupon (assumption) we can then proceed in two directions to assess relative value of the futures. We may either assume that the future is fairly valued with respect to the (when issued) CTD, and imply from this an asset swap spread (coming from the invoice price), or we may assume the level of the asset swap spread for the when-issued bond relative to an existing one, and then back out the fair value of the future when the when-issued bond is taken into account. Table 3 shows the basis analysis where the when-issued Dec08 will be the CTD for the March contract. The current coupon assumption is from current yield level. The different approaches of our assumption can be seen in the table showing the true-asset-swap calculation.
Table 3 When-issued true-asset-swap analysis
Asset swap calculation based on swap spread assumption and invoice asset swap spread levels. The assumption is that the when issued bond will be 4bp narrower than the OBL-148

Delivery windows In Europe The Gilt futures (on UK government bonds) contract provide a delivery window in which the short can pick up not only the best bond to deliver but also the optimal time for delivery. This gives the short an extra timing option. Broadly speaking, if there is positive carry on the CTD, the short should deliver at the end of the window, whereas in a negative carry scenario, every day is costing the short carry so the preference is to deliver as early as possible in the window. However, the option available to the short will, like any option, decrease in value over the life of the contract (theta or time decay). Hence if the carry is positive but small compared to the time decay, it is still possible that the optimal delivery time may be somewhere prior to the end of the contract. This scenario will only occur when the optionality of the contract is significant and the time decay is then comparable to carry measures. In the Eurex contracts (Buxl, Bund, Bobl and Schatz) there is no delivery window so the optionality is restricted only to which bond is delivered.

Basis trade: option-like profile

We have seen that the futures option adjusted basis net of carry (OABNC) gives us an indication as to whether the futures is rich or cheap with respect to fair value. Alternatively, we can read the information about the futures richness or cheapness, as an indication of the market valuation of the delivery option. Going back to our definition for the option-adjusted-basisnet-of-carry (OABNOC) we see that it shows the mispricing of the net basis (BNOC) vs. our fair value of the delivery option. In general, we would like basis trades where we can
Chart 7 Delivery option not necessarily fairly priced by BNOC
Net basis vs. fair value of delivery option at different 30-year bmk yield level

40 35 30 25 20 15 10 5 0 -5 Mar 10
Source: JPMorgan

Benchmark yield Buxl estimated option value Buxl BNOC

Schatz Mar06 Futures Price = 103.83 => invoice AS = -21.4

Bond WI-BKO 3 Dec08 DBR 3 Apr 09 OBL-148 3 Apr09 Asset Swap Spread BNOC -21.8 1 -29.1 26 -25.8 81

Mar 14

Mar 18

Mar 22

Mar 26

Mar 30

4 3.98 3.96 3.94 3.92 3.9 3.88 3.86 3.84 3.82 3.8

J.P. Morgan Securities Ltd. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545

fabio.bassi@jpmorgan.com gurpal.s.kalsi@jpmorgan.com philip.d.strother@jpmorgan.com

European Rates Research European Rates November 8, 2006

buy the delivery option (long basis: long bond & short futures) at a cheaper level compared to our fair value. For example, chart 7 shows an opportunity when the fair value of the delivery option exceeded the level of the net basis at trade inception, with the net basis was trading at about 10 cents. The suggested long basis trade could benefit from either a convergence of the delivery option market value (BNOC) to its fair value; or clearly, resembling the profile of a put option from a market sell-off. In the following period, the mispricing between delivery option and BNOC actually narrowed, with net-basis moving closer to the fair value of delivery option, with long yields rates moving higher. JPMorgan analytics provide daily information on relative value between futures and cash and offer useful information on relative value opportunities in the basis space

the same CTD, and there is low risk of a CTD switch, the main driver of the calendar spread is the forward financing rate of the bond between the front and the back month delivery. The long calendar position is equivalent to receiving the bond at expiry of the front contract and delivering it at expiry of the back. The breakeven repo rate for holding the bond between expiries can be compared to the 3-month forward funding rate. The difference between 3month Libor rate and the forward financing rate is called the implied repo rate specialness. The relative value of this specialness and its dynamic going into delivery is often used to make a call on dynamic of the calendar spread. If the specialness is historically low (high), which would be equivalent to a forward financing rate high (low), the calendar may be considered cheap (rich). Where the optionality in the contract is significant (i.e. where the probability of a switch in the CTD is higher), we need to consider relative value components, such as the option-adjusted basis net of carry of the two contracts or the relative level of swap spread for the different CTD bonds. An increase in funding rates generally causes futures prices to rise relative to cash prices, since it decreases the carry. Thus the calendar spread reflects changes in the shape of the short end of the yield curve: for example, if four-month funding rates rise while one-month rates remain the same, the calendar spread would be expected to fall. Changes in funding rates affect back month futures more than front month futures, since the back month contract has three months more of carry in its basis. If the CTD of the front and back contracts are different the change in the level of yield has an impact on the calendar spread, as the two contracts have different duration. Additionally, any change in the slope of the yield curve, driven by macro movement or by idiosyncratic bond effects, has an effect on spreads. The JPMorgan Rollover Outlook provides hedge ratios for rolling futures positions and analysis of the dynamics of duration neutral calendar spreads. Lastly spreads may become richer or cheaper depending on the balance of long and short hedgers and investors who are rolling positions.

The calendar spread

When managing futures position, the dynamic of calendar spread is extremely critical and can be a source of further alpha in portfolio management. In the bond futures world, a calendar spread is defined as: Spread = Front Future - Back Future During the life of the front contract, and especially in the 4 to 6 weeks before delivery an active and liquid market of the calendar spread is available. The calendar spread can be traded on its own, for speculative purposes, or to aid rolling contracts. For example an investor with a long position in the front contract needs to sell the spread (sell the front contract and buying the back contract) to keep the exposure in the back contract, without going to delivery. Our views on the rolls can be found in the quarterly European Bond futures rollover outlook. There are different drivers of the calendar spread, such as level of rates, yield curve, relative value, change in funding rates and supply and demand dynamics. The task of the analyst is not only in finding the different drivers of the spread, but also in pointing out in a specific case which ones are likely to be the dominant factors. This is dependent on relative value and macroeconomic considerations. In the simple case where the front and back contracts have
8

Term 4.5 - 5.5 6 100,000 EUR 5 Bln EUR 5 Bln EUR 10 Bln EUR 1.5 Bln GBP 500 Mil CHF 100,000 EUR 100,000 EUR 100,000 GBP 100,000 CHF 6 4 6 6 8.5 - 10.5 24 - 35 8.75 - 13 8 - 13

Schatz

Bobl

Bund

Buxl

Gilt

Conf

Appendix

Basket Range (yrs)

1.75 - 2.25

Coupon

J.P. Morgan Securities Ltd. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545

Contract Value

100,000 EUR

Min Issue

5 Bln EUR

fabio.bassi@jpmorgan.com gurpal.s.kalsi@jpmorgan.com philip.d.strother@jpmorgan.com

Specifications of European Bond Futures for Eurex and Liffe.

Min Price Change % Value 1point 0.1 10 EUR 0.1 10 EUR 0.2 20 EUR 0.01 10 GBP

0.005 5 EUR

0.01 10 CHF

The tenth calendar day of the The tenth calendar day of the The tenth calendar day of the The tenth calendar day of the respective quarterly month, if respective quarterly month, if respective quarterly month, if respective quarterly month, if this day is an exchange this day is an exchange this day is an exchange this day is an exchange trading day; otherwise, the trading day; otherwise, the trading day; otherwise, the trading day; otherwise, the exchange trading day exchange trading day exchange trading day exchange trading day immediately succeeding that immediately succeeding that immediately succeeding that immediately succeeding that day. day. day. day.

Any business day in the delivery month ( at seller's choice )

The tenth calendar day of the respective quarterly month, if this day is an exchange trading day; otherwise, the exchange trading day immediately succeeding that day.

European Rates Research European Rates November 8, 2006

Delivery

Two exchange trading days Two exchange trading days Two exchange trading days Two exchange trading days Two business days prior to the Two exchange trading days prior to the Delivery Day of the prior to the Delivery Day of the prior to the Delivery Day of the prior to the Delivery Day of the last business day in the prior to the Delivery Day of the relevant maturity month. relevant maturity month. relevant maturity month. relevant maturity month. delivery month relevant maturity month.

LTD 08:00 - 22:00 08:00 - 22:00 08:00 - 22:00 March June Sep and Dec with nearest three tradable 08:00 - 18:00 08:00 - 22:00

Trading hours

08:00 - 22:00

Source: JP Morgan, Eurex, Euronext.Liffe

Delivery Month

J.P. Morgan Securities Ltd. Fabio BassiAC (44-20) 7325-8615 Gurpal Kalsi (44-20) 7325-3691 Philip Strother (44-20) 7325-1545

fabio.bassi@jpmorgan.com gurpal.s.kalsi@jpmorgan.com philip.d.strother@jpmorgan.com

European Rates Research European Rates November 8, 2006

Analyst certification: The research analyst(s) denoted by an AC on the cover of this report (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analysts compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report. Risks to Strategies: Put or Payer Sale. Investors who sell put or payer options are exposed to the level of the underlying falling below the strike of the option. Therefore, at maturity of the option, if the level of the underlying is below the strike, an investor will have to purchase the underlying position from the buyer of the option in return for the strike of the option, or provide equivalent financial compensation if it is a cash settled option. Call or Receiver Sale. Investors who sell call or receiver options are exposed to level of the underlying rising above the strike of the option. Therefore, at maturity of the option, if the spread on the underlying is above the strike, an investor will have to source a long position which he/she must hand over to the buyer of the option in return for the strike of the option, or provide equivalent financial compensation if it is a cash settled option. Call Overwrite. Investors who sell call options against a long position in the underlying give up any appreciation in the level of the underlying above the strike price of the call option. Additionally, they remain exposed to a decline in the underlying in return for the receipt of the option premium. Put Overwrite. Investors who sell put options against a short position in the underlying give up any decline in the level of the underlying below the strike price of the call option. Additionally, they remain exposed to a rise in the underlying in return for the receipt of the option premium. Call Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the underlying level is below the strike of the call option at maturity. Put Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the underlying level is above the strike of the put option at maturity. Straddle or Strangle. The seller of a straddle or strangle is exposed to underlying level ending up above the call strike or below the put strike at maturity of the option. If an investor has a short in the underlying and overlays this with selling a straddle or strangle, they will define their lower exit point where underlying falls below the put strike. Additionally, they will lose twice as much as an outright short risk position if the underlying is above the call strike. Conversely if an investor is long the underlying and overlays this with selling a strangle, they will define their higher exit point by the call strike and lose twice as much below the put strike. Risks to strategies: Not all option strategies are suitable for investors; certain strategies may expose investors to significant potential losses. We have summarized the risks of selected derivative strategies. We advise investors to consult their tax advisors and legal counsel about the tax implications of these strategies. Pricing Is Illustrative Only: Prices quoted in the above trade ideas are our estimate of current market levels, and are not indicative trading levels. 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