Holder of T-bills Expects Rising Short-term Rates, Falling Long-term RatesStrategy - Sell T-bills, buy TNX puts to profit from interest rate expectations.
Forecast: Investor owns Treasury bills and expects short-term rates will rise, long-term rates will decline.
Objective: To profit from a reshaping of the yield curve.
Strategy: Sell Treasury bills. Deposit cash in Money Market and purchase puts on the l0-year Treasury yield (TNX).
Having analyzed the latest market developments and the U.S. government's package of proposed fiscal and monetary measures, an investor has come to a conclusion that short-term rates may rise from 3% to 4% and intermediate-term rates will decline from 6.25% to 5.75%. Currently, the investor has $20,000 in U.S. Treasury bills and if his projection is correct his Treasury bills will go down in value.
An investor has $20,000 in U.S. Treasury bills and is concerned that short-term rates will rise therefore causing a decline in the value of his bills. This investor anticipates a drop in intermediate-term rates and would like to profit from his projection for the move in interest rates. The investor will sell his T-bills and will deposit $18,000 in a money market account and $2,000 will be used to buy puts. Suppose that a three-month, at-the-money TNX put cost 1 point or $100 (1 x $100 multiplier x 1 put). The investor would buy 20 puts at 1 costing $2,000. The breakeven level for the put position is 61.50 (62.50 strike price - 1 cost of put).
TNX Settlement Value Below Breakeven (61.50):
If the investor is right and 10-year Treasury yields do decline to 5.75%, a settlement value for TNX at 57.50 , the TNX 62.50 put option would be exercised. The holder of the puts would receive the amount by which the closing yield has declined below the strike price. The investor would also be earning interest on his $18,000 in his money market.
If short-term interest rates did rise as anticipated, then he would be better off having sold the T-bills and having deposited the money in a money market. If short-term rates declined, the T-bills that were sold would have risen in value and the investor would be earning less interest on his money market. In this case he would have been better off having held onto the T-bills.
- Strike Price: 62.50
- Less Settlement Value:-57.50
- Profit: 5
- Amount Paid to Holder(5x$100x 20 puts): $10,000
- Less Cost of Puts:-2,000
- Profit: $8,000
If by expiration the TNX decreases slightly to 62 or a yield of 6.2%, the holder would exercise his puts. He would receive the amount by which the settlement value is below the strike price. The amount received would be less than what was originally paid, but it would offset some of the cost. The investor would also be earning interest on his $18,000 in his money market.
- Strike Price: 62.50
- Less Settlement Value:-62
- Cost of Puts: $2,000
- Less Amount Paid to Holder (.50 x $100 x 20 contracts):-1,000
- Loss: $1,000
Settlement Value At or Below Short Call Strike (40):
If the settlement value is at or above 62.5, the yield on the 30-year Treasury at or above 6.25%, the holder would have lost the total premium of $2,000, in this example. However, no matter how high interest rates climb the most that can be lost is the premium paid. The investor still has $18,000 in a money market earning interest.