Abstract
Today, butterfly trading is a very famous fixed-income trading strategy and is widely utilized by many traders and fund managers around the world. Most of the quantitative fixed-income research papers recommend the butterfly trade based on just the size of the butterfly spread itself. However, there is no information or analysis how to pick up the attractive butterfly trade systematically based on profitability. The attractiveness of the butterfly trade cannot be judged just by the size of the butterfly spread because it only takes care of the capital gain factor. Other than the capital gain factor, profitability depends on many factors such as carry, rate of mean reversion of the butterfly spread, size of necessary balance sheet, risk amount and so on. It is sometimes risky to rely just on the size of the spread. Especially, risk is not negligible when the magnitude of the capital gain factor in profitability is relatively small. We propose practical selection criteria of butterfly trades such as ROA and IR. We also illustrate the magnitude of the factors influencing the criteria adopting actual bond market data. With these criteria, managers in the fixed-income area can not only select attractive butterfly trades, but also judge whether or not they should allocate a firm's balance sheet to the butterfly trade.
