Rates · R8 · 9 min
Curve trades, carry and roll-down
Set up a trade on the gap between short and long yields, size it so only the gap matters, and work out what a bond earns while you wait.
In the news: “2s10s steepened 8bp after the Bank of England meeting”: the trade that profits from that move, and how a desk sizes it.
The essentials
- Curve trade
- A bet on the gap between two , such as 2s10s, rather than their level. A buys the shorter bond and sells the longer one, gaining as the gap widens; a does the reverse.
- Central-bank views
- Two-year yields follow expected most closely. Expecting faster cuts than the market has priced suits a steepener; expecting more hikes than priced suits a flattener.
- DV01 weighting
- Size the legs to move the same per . £1m of 10-year moves about £820 per bp and £1m of 2-years about £190, so £50m of 2-years pairs with about £11.6m of 10-years.
- Carry
- What a bond position earns if nothing moves: its yield minus the rate that finances it. A bond yielding 4.5% financed at 4.0% 0.5% a year; financing above the yield is negative carry.
- Roll-down
- On an upward-sloping curve, a bond’s yield falls as it ages into a shorter maturity. A 5-year at 4.20% that becomes a 4-year at 4.05% gains about 0.15 × its , in per cent.
Sizing a curve trade
N_B = N_A × DV01_A ÷ DV01_B
- N_A, N_B
- notionals of the two legs
- DV01_A, _B
- DV01 of each bond per £1m of notional
How it works
1. Betting on the gap
The 2-year gilt yields 4.0% and the 10-year 4.6%: a 2s10s gap of 60bp. You can bet on that gap widening or narrowing without betting on whether yields overall go up or down. That is a curve trade.
2. Steepeners and flatteners
To bet on the gap widening, buy the 2-year and sell the 10-year: a . To bet on it narrowing, do the opposite: a . In swaps, receiving fixed acts like owning a bond, so a steepener receives fixed for 2 years and pays fixed for 10.
3. Linking it to the central bank
Two-year yields follow expected most closely. If you think the Bank will cut sooner than markets expect, 2-year yields should fall most and the gap widen: a steepener. If you expect more hikes than priced, 2-year yields should rise most and the gap narrow: a flattener.
4. Equal amounts aren’t equal risk
£1m of 10-year gilts moves about £820 for each basis point, but £1m of 2-year gilts only about £190: that is their . Buy £10m of one and sell £10m of the other and you are mostly betting on 10-year yields, not on the gap.
5. Size the legs by DV01
Make both legs move the same per basis point: notional B = notional A × DV01 of A ÷ DV01 of B. Against £50m of 2-years, sell £50m × 190 ÷ 820 = £11.6m of 10-years. Now if all yields move together, the two legs cancel.
6. Profit is DV01 times the change in the gap
With matched DV01s, only the gap matters. A steepener with £9,500 per bp on each leg makes £9,500 for every basis point 2s10s widens: 8bp wider is +£76,000, whether yields rose or fell. If the gap narrows instead, it loses the same way.
7. Carry: earning while you wait
If nothing moves, a bond position still earns or costs money. A bond yielding 4.5% that you fund by borrowing in at 4.0% earns 0.5% a year just for being held: its . If repo costs more than the bond yields, carry is negative and holding the bond costs you every day.
8. Roll-down: ageing along the curve
A 5-year gilt yields 4.20% and the 4-year 4.05%. Hold the 5-year for a year and it becomes a 4-year bond; if the curve hasn’t moved, it now yields 4.05%. Its yield fell 15bp, so its price rose by about 0.15 × its duration, in %. That gain is .
Try it
Move the 2-year and 10-year yields. A steepener makes money when 2s10s widens, whichever way yields go overall. The curve is made up for illustration.
Bull steepener2s10s +65bp (from 40bp)
Worked example
You expect the Bank of England to cut faster than priced. You buy £50m of 2-year gilts (DV01 £190 per £1m) and sell 10-year gilts (DV01 £820 per £1m) against them. Then 2-year yields fall 12bp and 10-year yields fall 4bp.
- DV01 of the 2-year leg: 50 × £190 = £9,500 per bp.
- 10-year notional: £50m × 190 ÷ 820 = £11.59m, also £9,500 per bp.
- 2-year leg: yields fell 12bp, so +£9,500 × 12 = +£114,000.
- 10-year leg: you are short and yields fell 4bp, so −£9,500 × 4 = −£38,000.
- Net: +£114,000 − £38,000 = +£76,000, which is £9,500 × 8bp of steepening.
+£76,000: 2s10s steepened 8bp on £9,500 of DV01 per leg.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
Pitch me a curve trade based on what central banks are expected to do.
Why weight a curve trade by DV01 rather than notional?
What are carry and roll-down, and why do they matter in a quiet market?
Remember
Leg B = leg A × DV01 of A ÷ DV01 of B
Size curve trades by DV01 so you bet on the gap, and check carry and roll-down to see whether you are paid to wait.