Duration-Neutral vs Cash-Neutral Curve Trades

A trader who thinks the curve will steepen buys a short-maturity bond and sells a long-maturity bond, or is it the other way around? Before that question even matters, a bigger one does: how much of each? Buy $100 million of both legs and you have a cash-neutral trade that is still secretly a large bet on the overall level of rates, because a 10-year bond moves far more per basis point than a 2-year bond. Size the legs so their basis-point sensitivities offset and you have a duration-neutral trade, isolating the curve shape and nothing else.

Why DV01, not notional, is the right ruler

A bond's DV01 is the dollar change in its price for a one-basis-point move in yield. A 2-year note has a small DV01 because there is little time for a rate change to compound into price; a 10-year note has a DV01 several times larger for the same face amount, because more distant, larger cash flows are more sensitive to the discount rate. Weighting a curve trade by notional treats a dollar of 2-year risk as equivalent to a dollar of 10-year risk, which it is not, weighting by DV01 makes a basis point of one leg's move worth the same as a basis point of the other's, which is the only sense in which the trade is "neutral" to a parallel shift.

Worked example: sizing a 2s10s steepener

Say the 2-year note has a DV01 of $1,900 per $100 million face, and the 10-year note has a DV01 of $8,700 per $100 million face. A trader wants to put on a duration-neutral steepener: long $100 million of the 2-year, short enough 10-year to offset it.

so the short leg is about $21.8 million face of the 10-year. Check: the 2-year leg's DV01 is $1,900 (on $100m face); the 10-year leg's DV01 on $21.8m face is $8{,}700 \times (21.8/100) = 1{,}897$, i.e. about $1,897, matching the 2-year leg to within rounding. A 10-basis-point parallel rise in both yields moves the long 2-year leg by about $19,000 of loss and the short 10-year leg by about $18,970 of gain, they roughly cancel. If instead the 2-year yield rises 5 basis points while the 10-year falls 5 basis points (the curve steepens), the position gains on both legs, because that is precisely the shape it was built to capture.

Worked example: what cash-neutral actually is

Now size the same idea cash-neutral instead: $100 million long 2-year, $100 million short 10-year. The 10-year leg's DV01 is $8,700 versus the 2-year leg's $1,900, a net short DV01 of $6,800. A parallel 10-basis-point rally (yields fall across the board) would lose roughly $6{,}800 \times 10 = 68{,}000$, i.e. about $68,000, on the net short-duration position, regardless of whether the curve steepens or flattens at all. The "curve trade" is actually a large, disguised bet that rates rise, dwarfing whatever the curve-shape view was worth.

Beyond parallel: curve trades still carry curve risk

Duration-neutral only cancels a parallel shift, it does nothing to protect against the curve twisting in some other shape, which is exactly the risk the trade is designed to express. It also does not cancel convexity: a 10-year note's price is more convex than a 2-year note's, so a very large parallel move (not just a small one) leaves a residual gain or loss even on a DV01-matched book, because DV01 itself changes as yields move. Desks running curve books track this second-order effect and periodically rebalance the notional ratio, not just at inception but as the trade ages and yields drift.

Where it shows up

Curve steepeners and flatteners, 2s10s, 5s30s and similar, are the standard macro rates expression of a view on the shape of the curve (recession fears flattening it, growth and inflation re-steepening it), and they are essentially always run duration-neutral for exactly the reason above: a directional rates view belongs in an outright long or short bond position, not smuggled into a curve trade by accident.

Key terms

• DV01 (dollar value of a basis point), dollar price change of a position for a one-basis-point yield move.
• Cash-neutral, equal dollar notional on both legs of a trade.
• Duration-neutral, equal DV01 on both legs; isolates exposure to curve shape from the level of rates.
• Steepener / flattener, a trade that profits if the spread between two maturities widens (steepener) or narrows (flattener).