Fixed Income Arbitrage in a Financial Crisis (A) Case Solution And Analysis, HBR Case Study Solution & Analysis of Harvard Case Studies

Fixed Income Arbitrage in a Financial Crisis (A) Case Solution

Assume aS5M capital investment in the T 10.625s and the corresponding capital amount required for the short position. Discuss the choices KTC would have to make were the yield-to-maturity on the T 4.25s of August 2015 to decline by 5 basis points and the yield on the T 10.625s of August 2015 remained unchanged (i.e. a widening of the spread to 40bps).

With the long position investment in bond; the investors buy a security and owns it &expecting that the price of the bond would going to increase in the near future; whereas the short position refers to the sale of security with the believe that the price of bond would reduce in value, in the near future(MILTON, 2020).

In addition to this, by assuming 5 million dollar capital investment in the long position of 10.625% bond and short position of 4.25 percent bond each, and decline in the yield-to-maturity on the T 4.25s of August 2015 by 5 basis points of 0.50% and the yield on the T 10.625s of August 2015 remain unchanged (i.e. a widening of the spread to 40bps); the value of the 5 million dollar position in the 4.25 percent bond would reduce by $146000.

Furthermore, with the short position investment in bond; KTC would need to sell the security now by expecting that there wouldn’t beany increase in the bond’s price in the future, and the significant reduction in the yield to maturity on 4.25% bond is reduced by 5 basis point or 0.50 percent.The investor with short position investment would sell the stock with the believe that the price of bond would be reduced and by assuming that yield to maturity on 4.25% bond is reduced by 5 basis point, which would gain benefits by buying the stock at the lower price and make profit return on the bond.

Moreover, the yield spread between the two bonds of 10.625% and 4.25% indicates the stable economic conditions in future. The wide yield spread indicates towards higher risk, which is backed by the deteriorating conditions in the credit markets as well as the nervousness and hesitation of the investors-regarding the overall business environment(Oppenheimer, 2013). For the investors, KTC could exploit the yield spread of 40 basis point of 0.40 percent, in order to earn a profit for the investors. Thus, the trade should be taken by KTC due to the wide yield spread as it allows the investors to demand high risk premium. Additionally, Franey would be benefited by making arbitrage through buying bond, which would be traded at higher yield, and short bond which would be traded at the lower yield.

Given the information provided and your answers to questions 1-2, would you recommend KTC undertake the proposed transaction? Explain why.

Taking under consideration the opportunities of demanding the risk premium, gaining benefits from wide yield spread, fast and easy exploitation of the price differences and risk-free profit;Franey is recommended to undertake the proposed transaction.

The arbitrage profit would be earned by Franey through simultaneous-purchase and sell of the security, due to the difference in the price. The possibility of earning arbitrage profit is also elevated when the bond is bought at higher yield and short bond is traded at lower yield. Also, Franey would be benefited from the wide yield spread, resulted from the price difference between the two bonds. Additionally,during the global financial crises of 2008; the investors were confirmed of the liquidity concerns & the securities became illiquid as no one was ready to purchase them. Franey is advised to exploit the arbitrage opportunity by using the long position on treasury with high yield as well as a short position on the treasury with lower yield. The arbitrage opportunity would provide mechanism to make sure that the prices of the bond would not deviate substantially from fair for longtime period. Additionally, exploiting the arbitrage opportunity would allow Franey to earn profit, as arbitrage opportunity guarantees a constant profit and it normally does not have any exposure. Furthermore, the weakening economic conditions would push the investors to demand a wider yield spread and greater risk premium. Hence, Franey should develop the trade and exploit the arbitrage opportunity.................

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