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Demand for Options to Hedge Against Treasury-Yield Drop Surges

Demand for options that profit if Treasury yields fall this week has surged as traders speculate that the outcome of the Presidential and Congressional elections will give U.S. government bonds a boost.

Open interest in calls, which gain in value if the 10-year Treasury futures’ price rises, that expire on Nov. 9 increased by about four times as much as that for puts, on Nov. 2, CME Group Inc. data shows. Puts appreciate if bond prices fall, which occurs when yields rise. Open interest in the calls rose by almost 30,000 contracts while puts rose about 8,000. Total volume on all weekly options that day for the CME Group’s Treasury futures reached a record high since the contracts begin in 2011 for this period before expiration.

Treasury 10-year notes were little changed as Americans head to the polls to decide whether President Barack Obama or challenger Mitt Romney will guide the world’s biggest economy. With national and state-level data showing Obama with a slim edge over Romney, investors are buying options to hedge short-term swings in rates.

“People are hedging not just the election but also with the risk that we may not know the results by tonight or even tomorrow morning,” said John Brady, managing director of global futures and options at futures broker R.J. O’Brien & Associates in Chicago, in an interview. “This thing could drag on. If that is the case, people expect the equity market to not like it and a risk-off environment, which would benefit Treasuries.”

Open Interest

Puts grant the right to sell the underlying futures, and calls grant the right to buy. Open interest is the total number of contracts that have not been closed, liquidated or delivered.

Open interest in the November so-called week-2 options, which expire on Nov. 9, had record open interest seven days prior to expiration for any week 2 series contracts, of 58,816, CME Group data showed on Nov. 2. While total open interest in all November weekly options, at 77,500, was a also record high for this time prior to expiration. Trading volume in the weekly options on Nov. 2 was the third highest ever at 85,258 contracts, with 45,000 in the Nov. 9 expiring contracts, CME data show.

The CME Group, the world’s largest futures market, began trading the weekly options last year to provide traders and investors a tool to hedge and speculate on short-term swings in 2-, 5-, 10- and 30-year, as well as so-called ultra Treasury-bond futures. The CME’s ultra-bond contract designates Treasuries with maturities of 25 years or more for delivery, while the exchange’s 30-year bond future allows delivery of government bonds that mature in 15 years or more.

‘Election Fever’

“There is a lot of betting going on with these options on the impact of the election on the bond market,” said Sean Tully, managing director in New York of interest rate products at CME Group, in an interview. “Most of the demand is driven by global macro hedge funds. These funds could have large outstanding positions and want to hedge them through the election in case there is an unexpected outcome or could be taking advantage of the volatility they expect in the marketplace because of the election.”

The U.S. 10-year yield dropped less than two basis points, or 0.02 percentage point, to 1.71 percent this week, from 1.72 percent on Nov. 2.

Futures contracts are agreements to buy or sell a specific amount of a commodity or security at a specific price and time. Unless the contract is offset before the settlement date, participants in the contract must buy or sell the underlying asset.

“Demand for the options has surged due to election fever,” said Jim Lee, head of U.S. derivative strategy at Royal Bank of Scotland Group Plc’s RBS Securities unit in Stamford, Connecticut.

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