The Treasury market is volatile during this financial crisis and it will remain so in the near future, given the uncertainty in inflation expectation and demand for the Treasury securities. Price volatility offers trading opportunities, but also risks, in both the cash and the futures markets.  Recent advances in financial technologies provide traders effective pricing and risk management tools to operate in this environment. This article describes one such tool:  Key Rate DV01.

Spread trading strategies such as the calendar spread and the basis trade between cash and futures are commonly used to trade on the price moves. But these strategies are blunt tools in controlling the yield curve risks. Futures contracts have embedded switch options and Treasury securities have varying coupon rates.  These and other characteristics may result in two seemingly similar securities or contracts differ in some significant ways with respect to their yield curve risk exposure.

A more precise measure of the yield curve risk of futures contracts and Treasury securities would enable a trader to use the risk capital efficiently as the risk exposure is more accurately measured. It would also allow the traders to capture small advantageous price movements because the arbitrage trades are more precise. In sum, a more accurate risk measure can lead to better trading and risk management, an important advantage in executing profitable trades.

Key Rate DV01 measures the price sensitivity of a futures contract or a cash bond to a one basis point change at the key rates along the Treasury spot curve. This measure is constructed based on two integral procedures: (1) determining the spot yield curve from the on-the-run Treasury securities; (2) simulating the price sensitivities of a futures contract or a cash security using a valuation model. We will discuss these two procedures below.

Yield Curve Historical Movements

The spot yield curve is the market valuation of a zero coupon bond at any time estimated from the on-the-run Treasury securities. This spot yield curve enables a trader to compare all Treasury related securities based on a standard present value measure.