The municipal‐treasury futures spread

Abstract

ith the debut of the municipal bond index futures contract in June of 1985, W market participants began keeping a watchful eye on the municipal-Treasury futures spread. This spread has varied widely, ranging from a low of negative eight points up to a high of plus 10% points. This has led market participants to question whether or not muni futures are being priced appropriately relative to Treasury futures.If, in fact, one market is mispriced relative to another, one can often profit from the situation by purchasing the underpriced security and shorting the other. It is particularly easy to utilize such opportunities in the futures markets. Transactions costs for futures trades are very low-ranging from $12 to $25 per contract. By contrast, arbitrage that involves the use of the cash market can be expensive for nondealers, particularly if it involves shorting a security; it is difficult to short municipal bonds, even for dealer firms. Thus the municipal-Treasury futures spread can help keep municipal futures closer to their theoretical level.In this article, after presenting a brief overview of the municipal futures contract, we develop a model of the theoretical range for the muni futures-Treasury futures spread (the MOB). Comparing actual spreads with our theoretical model, we show that in its early months the municipal futures contract was mispriced, and this was reflected in the MOB spread. More recently, however, the MOB has usually traded *The authors would like to thank John M. Cheney, and two anonymous referees for their helpful comments.

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“…For this and other reasons,a number of researchers have conducted empirical studies to determine if there are profitable trading opportunities in intercommodity spread trading. Some of these studies included: treasury bills and treasury bonds (Jones, 1981;Easterwood and Senchack, 1986), gold (Rolfo, 1981), gold and Eurodollar turtles (Poitras, 1987), gold and T-bill spreads (Monroe & Cohn, 1986), municipal bond and treasury bond (Arak, Fischer, Goodman, & Daryanani, 1987), index futures (Billingsley & Chance, 1988), soybean complex spread (Johnson, Zulauf, Irwin, & Gerlow, 1991), gold-silver spread (Wahab, Cohn, & Lashgari, 1994), spreads in agricultural futures (Barrett & Kolb, 1995) and treasury futures spreads (Park & Switzer, 1996). Monroe and Cohn (1986), for example, investigated the relative efficiency of gold futures to T-bill futures.…”

An analysis of the failed municipal bond and note futures contracts

“…Arak, Fischer, Goodman, and Daryanani (1987) found that using the MOB spread was an attractive trading strategy that could be made more profitable by identifying trading bounds. They identified trading bounds and the economic factors that affected the levels of the bounds.…”

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“…Arak, Fischer, Goodman, and Daryanani (1987) developed a model of the theoretical range for the MOB spread. They found that compared with the theoretical arbitrage bounds, the original municipal futures contract was mispriced in its early months, but traded within the arbitrage bounds thereafter.…”