Chapters.November.2006.

fm Page 30 Wednesday, October 4, 2006 3:10 PM

30 • CFA Digest • November 2006

Profiting from Mean-Reverting Yield Curve

Trading Strategies

Choong Tze Chua, Winston T.H. Koh, and Krishna Ramaswamy

Journal of Fixed Income
vol. 15, no. 4 (March 2006):20–33
The authors investigate the returns generated by strategies that
aim to profit from mean reversion in the level, slope, and
curvature of the yield curve. They find that a subset of strategies
offers risk-adjusted returns that are superior to, and uncorrelated
with, the returns of select fixed-income and equity benchmarks.

The authors analyze the profitability of a number of yield-curve

strategies that are based on the premise that the yield curve displays
mean-reverting behavior. The aim is to determine whether it is possible
to consistently earn risk-adjusted returns after transaction costs that
are comparable or superior to those of two benchmarks—the Lehman
Brothers U.S. Government Intermediate Bond Index and the S&P
500 Index. The strategies analyzed seek to profit from mean reversion
in three aspects of the yield curve—rate level, slope, and curvature.
For each of these three aspects of the yield curve, two separate
strategies are examined: one that trades in expectation of mean
reversion across the yield curve and one that trades for mean reversion
at individual or adjoining portions of the yield curve.
The sample used consists of monthly data on zero-coupon U.S.
Treasuries from a yield curve of bills and bonds (with maturities out
to five years). The authors recognize and (when appropriate) adjust
for the systematic biases that may occur in their dataset—in particu-
lar, the use of zero-coupon Treasuries. The time period of the dataset
is June 1964 to December 2004, and returns are calculated for a one-
month holding period. The unconditional yield curve to which mean
reversion is expected is—for any given maturity on any given date—
the simple average of all yields observed for that maturity from 1964
until the month preceding that date. A 102-month training period

Choong Tze Chua and Winston T.H. Koh are at Singapore Management Univer-
sity. Krishna Ramaswamy is at the University of Pennsylvania. The summary was
prepared by Gerard Breen, CFA, Wellington Management Company, LLC.

”2006, CFA Institute

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Debt Investments • 31

for construction of the unconditional yield curve is allowed for, so

trading for the strategies begins in January 1973. Finally, the returns
of the various strategies are adjusted for risk (using the standard
deviation of the payoff) so that they are more directly comparable to
the risk-adjusted returns of the two reference benchmarks.
The results suggest that for strategies pursuing mean reversion in the
absolute level of yields, neither the strategy based on mean reversion
of average yield levels across the curve nor that based on yield levels
at individual maturity points can offer consistently superior returns.
For strategies pursuing mean reversion in the slope of the yield curve,
the authors find that trades involving mean reversion across the yield
curve cannot offer consistently superior returns, although, conversely,
those involving mean reversion between just two adjacent points on
the yield curve can. For strategies pursuing mean reversion in the
curvature of the yield curve, both trades involving curvature across
the curve and those involving the curvature of just three adjoining
points on the curve are found to offer consistently superior returns.
Finally, the authors find that the most consistently profitable and
statistically robust of all the strategies is that which pursues mean
reversion of the slope between two adjacent points of the yield curve.
The strategies that are found to be profitable have returns comparable
to or better than the two reference benchmarks on a risk-adjusted
basis. Indeed, some strategies have the ability to outperform reference
benchmarks by a factor of almost 6 when risk-adjusted payoffs before
transaction costs are compared. Furthermore, the authors find that
the returns on these yield-curve strategies have a low correlation with
the returns on the reference benchmarks, thus providing diversifica-
tion benefits. However, transaction costs are found to diminish the
relative and/or absolute profitability of these yield-curve strategies,
although the best performing strategy (mean reversion of the slope
between two adjacent points of the yield curve) is resiliently profitable
in spite of the impact of trading costs. In order to mitigate this impact,
the authors argue that trading frequency could be reduced, the
threshold signal to enter a trade could be raised, or the use of
structured derivatives could replace that of cash instruments.
Keywords: Debt Investments: term-structure analysis; Portfolio Management: debt
strategies

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