Curve trades come in a couple versions, but both involve taking multiple positions to try to profit off of expected changes in the yield curve. The simpler version takes place in the bond market and is based on differences (and expected differences) in interests rates. The second, more complicated, version of the trade takes place in the credit derivatives market, and is a play on credit spreads.
Q. We’ve heard a lot about this in respect of the JPMorgan trading loss. What’s a curve trade?
A. There are two different versions. The common one is simply a way of playing expected changes in the yield curve. The more complicated one… and the one in the news a lot lately… is a credit derivatives play on bond spreads.
Q. Well, let’s go simple first. How does the common curve trade work?
A. Pretty simple: usually, of course, the yield curve is positive: you get paid a higher interest rate for making a long term loan than a shorter one. If you map out the interest rates for lengthening durations, it’ll draw an upward sloping curve. But you might expect that curve to change because, for example, you think long term rates will go up a lot more than short term rates: in that case, the yield will get steeper.
Q. And if you want to make that basic yield curve trade, what would you do?
A. You could short short term treasuries, and go long long term treasuries. Then you’ll make a profit (or lose!) based on changes in their relative yields. A curve trade.
Q. Alright, then, part two: how does the credit derivative version of a curve trade work?
A. Well, it’s the same kind of idea, but now we’re looking at credit spreads instead of bond yields. That is, how expensive a class of bonds, say high quality corporates, are compared to US Treasuries: that’s the spread. Because the longer you go out over time, the more risk there is, this spread curve also usually slopes up.
Q. But you can play expected changes in that curve, too, I guess.
A. Right, you can buy and sell various CDS indexes, for example, in the same way you’d play the straight yield curve changes. If you’re bearish on the world economy, you’d play the spreads to widen; if you’re bullish, you play them to narrow. And that’s the sort of trade the Whale was in that led to all the trouble.