What is a negative moth?
A negative butterfly is a non-parallel displacement of the yield curve where long-term and short-term yields fall more or rise less than intermediate rates.
A negative butterfly shift effectively increases the plot of the yield curve. The opposite of a negative butterfly, where the long and the short term given increase more or decrease less than the intermediate rates, is called a positive butterfly.
Key points to remember
- A negative butterfly is a non-parallel shift in the yield curve where long and short-term yields fall more or rise less than intermediate rates.
- A negative butterfly shift effectively inflates the yield curve – the center is called the “belly” and the ends are called the “wings”.
- Traders sell the belly (higher-yielding mid-term bonds) and buy the wings (lower-yielding short and long-term bonds) when faced with a negative butterfly.
Understanding a Negative Butterfly
Yield curves are graphical representations of the interest rates of bonds of similar quality relative to their maturity dates. Yield curves do not attempt to predict the future of bond rates, but the relative position of current rates can help investors decide which bonds are likely to perform best in the future. They are used to illustrate investors’ feelings about the value of various bond maturities.
The most common yield curve plots the yields of US Treasuries (short, medium and long-term bonds). Usually, the Treasury yield curve arcs upward from left to right, with short-term bonds on the left yielding less than medium-term bonds in the center and long-term bonds on the right. This is because investors generally expect a higher return because they lend their money for longer periods.
The reasons for shifts in the yield curve are complex and depend on investor sentiment, economic news and Federal Reserve politics, among other factors. However, bond yields do not always follow the standard rules. For example, short-term and long-term rates could fall by 75 basis points (0.75), while intermediate rates only decrease by 50 basis points, (0.50). The resulting bump in the center of the graph is a negative butterfly shift. The reverse is a positive butterfly (where the graph looks like a U-shape).
From a bond trading perspective, why this is happening is less important than what to do about it. More importantly, butterfly shifts provide traders with arbitrage opportunities, as spreads can be traded to maximize short-term profits. A common refrain in bond trading when the yield curve becomes a negative butterfly is to sell the belly and buy the wings, which means selling the higher-rate intermediate bonds – or butterfly belly – and acquiring short-term and long-term bonds. links (which are the lower outer wings of the butterfly in the graphic model). In this way, traders try to equalize their exposure to non-parallel moving bond maturities. In reality, bond traders will consider many variables when strategy buying and selling, including average due date of bonds in their portfolio, although the shape of the yield curve is an important indicator.
Butterfly Negative vs Butterfly Positive
A negative butterfly occurs when short-term interest rates and long-term interest rates decline more than medium-term interest rateaccentuating the bump in the curve.
In contrast, a positive butterfly occurs when both short-term interest rates and long-term interest rates rise at a faster rate than medium-term rates. This creates a non-parallel offset in the curve, making the curve less bumpy (or less curved).
For example, suppose that the 1-year returns goods of treasure and 30 years treasury bonds increase by 50 basis points (0.50%). Further, assume that the 10-year rate cash notes remains the same; the convexity of the yield curve would increase, creating a positive butterfly.
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