April 2011
Beginner
368 pages
11h 20m
English
Chapter 12
Conditional Trades
In previous chapters we went through the thought process for taking views on the curve as well as swap spreads. For all these quantities, numerous factors drive them and at different times, the magnitudes of the factors vary, adding to the difficulty in trading. One factor common in both the curve and spreads is the level of interest rates, with both being directional to interest rates at times. This link to the level of rates can be in either direction depending on the environment; at times, for example, the curve may flatten as interest rates rise, but other times the curve may steepen with similar yield moves. Swap spreads can display similar directionality with regard to interest rates, especially during mortgage duration extension episodes. This chapter considers a common class of trades in the fixed income markets known as conditional trades, which combine concepts from the underlying rates and options market to express views on the directionality of either spreads or curves with rates.
As we mentioned earlier, one of the keys to trading rates is to structure trades that take as specific a view as possible and hedge out remaining, unwanted risks. Doing this reduces the possibility of unforeseen effects influencing profit and loss (P/L); given the multitude of factors that drive interest rates, an unexpected factor is never far away. Conditional trades use options to take views on the curve or swap spreads only in certain interest rate scenarios ...
