UT (Tax & Chancery) UT-2022-000134 UT-2022-000135 UT-2022-000137 - [2025] UKUT 00214 (TCC)

Changes in market interest rates typically affect the price of the bond. In essence, when the market interest rate rises, the price of a bond falls and when the market interest rate falls, the price of a bond increases. This is the “directional risk” of a bond which represents the sensitivity of the price (and therefore the yield) of a bond to changes in the interest rate. It is also referred to as the “delta risk” or “PV01 risk” (Footnote: ¹).

A bond trader is exposed to the PV01 risk in relation to any bonds held. The only way for a bond trader to eliminate that risk entirely is to execute a perfectly offsetting position – ie if one has bought €5m of 30-year BTP cash bonds, then to sell €5m of identical 30-year BTP cash bonds. However, the cash market is less liquid and balance sheet intensive. Traders will commonly seek, therefore, to hedge their risk with BTP futures.

A BTP future is a contract by which the parties agree to, respectively, buy and sell cash BTP bonds (falling within certain qualifying criteria) at a future date at a fixed price. Holding a futures position can offer protection against directional risk.

Cash bonds, because of the underlying capital sum involved, are balance sheet and capital intensive for banks. Futures, however, require limited capital until the futures contract expires and the cash bond(s) are delivered. Prior to delivery, banks post an initial margin, which is typically a fraction of the value of the underlying bond(s) (around 3%), on their balance sheet.