Overview of Trading Strategies
Introduction to common JGB trading strategies and their applications
Overview of Trading Strategies
The Japanese Government Bond (JGB) market is one of the world’s largest and most sophisticated fixed income markets, with outstanding issuance exceeding ¥1,000 trillion. Within this deep and liquid market, institutional investors and dealers employ a range of trading strategies to generate returns, manage risk, and express views on interest rate movements.
This chapter introduces the primary trading strategies used in JGB markets. Unlike simple directional bets (buying if you think rates will fall, selling if you think they’ll rise), these strategies are more nuanced—they exploit specific features of the yield curve, capture predictable return components, or take advantage of temporary mispricings between related instruments.
Why Study JGB Trading Strategies?
Understanding these strategies is essential for several reasons:
- Portfolio Management: Institutional investors like banks, insurance companies, and pension funds use these strategies to enhance returns while managing duration and convexity exposure
- Risk Management: Many strategies are designed to isolate specific risks (curve steepness, convexity, basis) while hedging out unwanted exposures
- Market Understanding: Trading activity drives JGB price dynamics, so understanding strategies helps explain why yields move the way they do
- Practical Application: These aren’t theoretical constructs—they represent actual positions taken daily in ¥ trillions by market participants
The Foundation: Risk Metrics from Chapter 5
All JGB trading strategies build upon the risk metrics we covered in Chapter 5 - Risk Management:
- Duration (5.1, 5.2): Measures sensitivity to parallel yield curve shifts
- DV01 (5.3): The yen change in bond value for a 1bp yield change
- Convexity (5.4): Measures how duration itself changes as yields move
These metrics allow traders to construct positions that are duration-neutral (no exposure to parallel shifts), cash-neutral (no net capital deployed), or optimized for specific yield curve scenarios. We’ll see these concepts applied throughout this chapter.
Categories of JGB Trading Strategies
The strategies covered in this chapter fall into several broad categories:
1. Carry and Roll-Down Strategies (Section 7.2)
These strategies seek to capture the predictable components of bond returns:
- Carry: The yield income earned minus financing costs
- Roll-down: Capital gains from bonds “rolling down” an upward-sloping yield curve as time passes
Risk-Return Profile: Low to moderate risk, steady returns in stable rate environments. Vulnerable to sharp rate increases.
Typical Users: Banks, life insurance companies, yield-seeking investors
2. Curve Trades (Section 7.3)
Curve trades involve taking simultaneous long and short positions at different maturity points to profit from changes in the shape of the yield curve:
- Steepeners: Profit when the curve steepens (long-short spread widens)
- Flatteners: Profit when the curve flattens (long-short spread narrows)
These are constructed to be duration-neutral, so they don’t profit from parallel shifts—only from curve shape changes.
Risk-Return Profile: Moderate risk, directional view on curve shape required. Protected against parallel shifts but exposed to curve movements.
Typical Users: Hedge funds, proprietary trading desks, macro funds
3. Butterfly Trades (Section 7.4)
Butterfly trades are three-legged positions (typically sell the middle maturity, buy the wings) designed to profit from changes in curvature at specific points on the yield curve. They’re constructed to be both duration-neutral and cash-neutral.
Risk-Return Profile: Low to moderate risk, exploits mean-reversion in curve curvature. Requires precision in execution.
Typical Users: Relative value traders, quantitative funds, dealer desks
4. Basis Trades (Section 7.5)
Basis trades exploit the relationship between cash JGBs and JGB futures contracts. The “basis” is the difference between the cash bond price and the futures-implied price. These trades often involve:
- Buying the cheapest-to-deliver (CTD) bond
- Selling JGB futures
- Holding to delivery or unwinding when basis converges
Risk-Return Profile: Low risk when held to delivery, carry-like returns. Exposed to CTD switches and repo rate changes.
Typical Users: Dealers, arbitrage funds, cash-futures market makers
5. Arbitrage Strategies (Section 7.6)
True arbitrage opportunities in JGB markets are rare due to high market efficiency, but relative value opportunities exist:
- On-the-run vs. off-the-run: Trading liquidity premiums
- Cross-market arbitrage: JGBs vs. swaps, JGBs vs. other sovereigns
- Repo arbitrage: Exploiting financing rate differentials
Risk-Return Profile: Very low risk (true arbitrage) to low-moderate risk (relative value). Returns are typically small but stable.
Typical Users: High-frequency traders, market makers, arbitrage funds
Role in Institutional Portfolios
Different types of institutions employ these strategies for different purposes:
Banks
- Focus on carry trades and basis trades to generate net interest margin
- Use curve trades to manage asset-liability duration mismatches
- Regulatory capital requirements (IRRBB - see Chapter 5.6 when available) influence strategy selection
Life Insurance Companies
- Long-duration liabilities drive preference for carry trades with long-dated JGBs
- Use curve steepeners when expecting Bank of Japan policy normalization
- Focus on stable, predictable returns to match policyholder obligations
Pension Funds
- Employ liability-driven investment (LDI) approaches using long JGBs
- Curve trades to adjust duration without changing overall exposure
- Limited use of leveraged strategies due to regulatory constraints
Hedge Funds & Proprietary Trading Desks
- Active in all strategy types, especially butterflies and relative value arbitrage
- Use leverage to amplify returns from small mispricings
- Contribute significantly to market liquidity and price efficiency
Risk-Return Spectrum
The following table summarizes the approximate risk-return characteristics of each strategy type:
| Strategy Type | Typical Volatility | Return Target (Annual) | Primary Risk | Leverage Used |
|---|---|---|---|---|
| Carry Trades | Low | 0.5% - 2.0% | Parallel rate rises | Moderate (2-3x) |
| Curve Trades | Moderate | 1.0% - 3.0% | Wrong curve direction | Moderate (2-4x) |
| Butterfly Trades | Low-Moderate | 0.3% - 1.5% | Curve convexity shifts | High (5-10x) |
| Basis Trades | Very Low | 0.2% - 0.8% | CTD switches, repo | Low (1-2x) |
| Arbitrage | Very Low | 0.1% - 0.5% | Execution, model risk | Very High (10x+) |
Note: Return targets assume normal market conditions and exclude extreme scenarios like the 2016 move to negative rates or the 2024 YCC exit.
Market Environment and Strategy Selection
The attractiveness of different strategies varies with market conditions:
Steep Yield Curve + Stable Rates
- Carry trades work best: Large roll-down gains available
- Steepener trades less attractive (curve already steep)
Flat Yield Curve + Rate Uncertainty
- Butterfly trades become more attractive (exploiting local curve anomalies)
- Carry trades less attractive (minimal roll-down)
High Volatility Periods
- Arbitrage opportunities increase (temporary mispricings)
- Directional carry trades become riskier
BOJ Policy Transition Periods
- Curve trades critical (2024 YCC exit created massive curve volatility)
- Basis trades profitable (futures-cash relationships disrupted)
Connection to Theoretical Models
While these are practical trading strategies, they’re grounded in financial theory:
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Carry trades relate to the expectations hypothesis (yield curve reflects expected future rates) and term premium theory (compensation for duration risk)
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Curve trades exploit violations of the local expectations hypothesis and term structure models
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Butterfly trades are linked to principal component analysis of yield curve movements (level, slope, curvature)
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Basis trades exploit deviations from cost-of-carry relationships and derivatives pricing theory
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Arbitrage trades test the law of one price in practice
Practical Considerations
Before implementing any JGB trading strategy, consider:
- Transaction Costs: Bid-offer spreads, especially in off-the-run issues
- Financing: Repo market access and GC vs. SC rates (Chapter 2.9)
- Liquidity: Ability to enter/exit positions at desired sizes
- Regulatory Constraints: Capital requirements, position limits
- Operational Complexity: Systems needed for mark-to-market, risk reporting
- Market Impact: Large positions can move prices, especially in less liquid maturities
What’s Ahead in This Chapter
The following sections provide detailed coverage of each strategy type:
- Section 7.2: Deep dive into carry trades and the roll-down effect
- Section 7.3: Curve trades (steepeners/flatteners) with duration-neutral construction
- Section 7.4: Butterfly trades and curve convexity exploitation
- Section 7.5: Basis trades between cash JGBs and futures
- Section 7.6: Arbitrage and relative value opportunities
Each section includes:
- ✓ Conceptual explanation of the strategy
- ✓ Mathematical formulation and position construction
- ✓ Worked examples with realistic ¥ amounts
- ✓ Risk analysis and when the strategy works/fails
- ✓ Practical implementation considerations
By the end of this chapter, you’ll understand not just what these strategies are, but when to use them, how to construct them, and what risks they entail—knowledge essential for anyone working with JGBs professionally.