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

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

Introduction

James Franey – the investment manager confronted an apparent arbitrage opportunity during the global financial crises of 2008, when he witnessed the wide yield spread between two U.S. Treasury bonds, with similar maturity. One is the semiannual coupon bond at 4.25% and matures at the same date on August 2015, and another is semiannual coupon bond at 10.625% and matures at same date on August 2015. He had first become aware of the financial global crises in August 2007, in 2005 the spread was first appeared when the bond 4.25% was issued. In March 2008, the base point of the bond had dramatically accelerated to 35 points.It was the higher level which could not have been even explained by the liquidity,due to which Franey thought to exploit the yield spread in order to earn a return for his investors.

In addition to this, by 15th October, Franey contemplated to make an arbitrage profit through purchasing bonds at higher yields and shorting the bonds with lower yields. He had to decide that if there was an opportunity; how much of the capital fund would be used to allocate and how he would he structure a trade, in order to exploit the arbitrage opportunity.

Determine whether the observed yield spread can be justified by the yield curve provided in Exhibit 3 of the case study.

The higher coupon bond was priced to yield 3.61 percent, while the lower coupon bond was priced to yield 3.26 percent. The slope of the annual yields on the bond is upward, which indicates that the financial market tends to expect higher future interest rates. The rising interests rates of bond tend to cause decrease in the bonds’ prices and causing the bonds’ yield to rise. In addition to this, the yield spread could be justified by the yield curve provided in the Exhibit 3 of the case, on account of the fact that the slope of the yield curve is upward, showing that the investors could be benefited from the high-yield corporate bonds and the yield spread between two bonds is growing in 2008 with 35 basis point of 30 percent. Almost coincident with the Lehman bankruptcy; the widening of the yield spread had begun to accelerate as well as reach to a peak of the 35 basis point, hence the wider spread between two bonds with similar maturity means higher yields following lower prices of bonds.

Moreover, the widening of spread between the two bonds is also backed by the fact that the less liquid and older 10.625 percent bond had earned a modest yield premium of 3 to 5 basis points; whereas, the 4.25 percent bond was on the run. With the passage of time, the yield spread movements is witnessed and ultimately the spread had grown back to its prior peak of 35 basis points. Following the widened yield spread between the US treasury bonds with similar maturity; the US dollar yield curve on November 3rd, 2018 shows an increasing slope of the annual yields, hence representing the investors’ expectations for the healthy economic growth. The shorter term interest rates are significantly lower as compared to the long term interest rates, hence yield curve begun to increase………………..

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