SYSTEMATICALLY TRADING GOVERNMENT BONDS USING SIGNALS FROM THE OVERNIGHT INDEXED SWAP MARKET

STATISTICALLY SIGNIFICANT AVERAGE PROFIT OF 1BP PER TRADE; BID-OFFER SPREADS COULD BE AN ISSUE*

A theoretical case is often made for the derivatives market responding faster than the cash segment to economic data and policy announcements. If this assertion is true, then signals from the synthetic space can be used to trade cash instruments.

In the Indian context, I tested this hypothesis using 5-year/10-year government security yields and the 5-year overnight indexed swap rates.

The results are encouraging. OIS rates lead the moves in the government securities market. There is evidence of a positive follow through (positive moves followed by positive, negative followed by negative). A simple trading rule designed to trade government securities generates statistically significant profits.

The back-testing exercise indicates average profits of about 1 basis point (t-statistic >5) per round trip. I have not accounted for bid-offer spreads. Yet, market makers can certainly exploit this empirical regularity (because they do not have to cross bid-offers).

Rule # 1: 5-year OIS and 5-year Gsec

Data: Daily closing yields from February 2, 2003 to April 29, 2009

Cross-Correlation Structure Suggests Positive Follow-through from Synthetic to Cash

Correlation (OIS (-1), Gsec (0)) = 0.22
Correlation (OIS (0), Gsec (0)) =0.50
Correlation (OIS (0), Gsec (-1)) = 0.01

Trading Rule

If Delta (5-year OIS Rate) > 0, then short 5-year government bonds
If Delta (5-year OIS Rate) <0,then buy 5-year government bonds
Delta: Daily close to close
Trade: Daily close to close

Performance Statistics*

Mean (bp): 1.1
Standard deviation (bp): 6.7
t-statistic: 6.6
No. of Positions: 1498
No. of loss-making positions: 624 (42%)
Maximum Gain (bp): 63.6
Maximum Loss (bp): 45.4

Rule # 2: 5-year OIS and 10-year Gsec

Data: Daily closing yields from July 23, 2001 to April 29, 2009

Cross-Correlation Structure Suggests Positive Follow-through from Synthetic to Cash

Correlation (OIS (-1), Gsec (0)) = 0.14
Correlation (OIS (0), Gsec (0)) =0.48
Correlation (OIS (0), Gsec (-1)) = 0.03

Trading Rule

If Delta (5-year OIS Rate) > 0, then short 10-year government bonds
If Delta (5-year OIS Rate) <0, then buy 10-year government bonds
Delta: Daily close to close
Trade: Daily close to close


Performance Statistics*

Mean (bp): 0.88
Standard deviation (bp): 6.9
t-statistic: 5.4
No. of Positions: 1801
No. of loss-making positions: 751 (42%)
Maximum Gain (bp): 76.5
Maximum Loss (bp): 79.9

* Performance statistics not adjusted for the duration of the security traded.
Source: Bloomberg; IMF Working Paper: Derivatives Effect on Monetary Policy Transmission