Fixed Income Arbitrage in a Financial Crisis Case Study Solution
Background
In September 2008, Lehman brothers became bankrupt which drastically affected the money market,and impacted on fix swap rate.
Due to this incident,the fix floating swap spread decline from 30.25 basis points to 6.25 basis points. Furthermore, with the passage of time, this 6.25 basis point further reduced to negative values which further affected the market conditions.After this incident, the market analyst assumed that the money market would stabilize and the swap rate will again increase to either 30, 40 or 50 like the position in the past.
Mr. Miller the personal from Kentish Town Capital (KTC) thought that the current low level of swap spread presented a profitable trading opportunity to the company. He supports this idea with the fact that due to the bankruptcy of Lehman brothers collateral lending became much more difficult and the demand for treasury bonds increased in the money market. Therefore, Miller wants to grasp this opportunity and want to earn higher profits from the situation.
To grasp this opportunity Miller identified two options, first option is that he will enter into a contract which has no cost. In this option,Miller will enter into a 30-year swap through buying US Treasury Bond, Miller intends to finance it through the overnight repo. In this option, Miller will pay a fixed rate which will be lower than the Treasury bond rate in oppose to receiving floating rate from the other party he assumes that it will be greater than paying back the repo.
The other option which is under consideration by Miller is that he will buy a swap spread at the basis points of 6.25. In this option, he assumed that market will soon reach at its previous state of 33 basis points. And in the result,Miller will generate the profit of up to 30 times more than dollar sensitivity with an increase in basis point. However, if spread rate reduces to zero then the net loss will be restricted to 6.25 swap spread.
Fixed Income Arbitrage in a Financial Crisis Harvard Case Solution & Analysis
Analysis
By taking the notional amount of $1 billion and six-month swap rate of 2.50% the swap represents the inflows of approximately 1.075.Furthermore, the Treasury purchase price of the swap is calculated as $1.041 billion, we calculated this value by adding accruals and face value of treasury bonds and then multiplied this amount by the starting purchase price of the Treasury bond which is 0.97. Moreover, to calculate the outflows of the swap we subtract 2%the repo haircut from the calculated treasury purchase price of 1.041 hence the resulting outflows are $1.062 billion. After that to calculate the net cash flow of the swap we subtracted total inflows from the total outflows hence the resulting net cash flows are $0.013 billion...................
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