Fixed Income - Arbitrage in a financial crisis - Swap Spread in 2008

1. Group 15
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Specialist Masters Programme
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1. Figueiredo, Joao
2. Xu, Mei
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GROUP NUMBER:
MSc in Finance
Module Code: SMM516
Module Title: Fixed Income
Lecturer: Alessandro Beber Submission Date: 31st March
2014
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2. Group 15
Fixed Income Arbitrage in a
Financial Crisis: TED Spread
and Swap Spread in
November 2008

3. Group 15
Part I
Context
Albert Mills is a former fixed-income strategist and trader at Morgan Stanley who has recently
joined one of his past colleague James Franey in the investment management company that
he founded - Kentish Town Capital (KTC). Mills’ knowledge about interest rate derivatives is the
main contribution to his new employer, and Mills has direct responsibility on $75 million (the
overall size of KTC is $300 million).
KTC’s strategy was to focus on fixed income relative value strategies, and had stayed away from
the mortgage market due to a lack of knowledge in this specific area of securities. As a result
the fund was clearly ahead of many competitors at the time of the case study (November
2008).
The economic environment at the time was the post Northern Rock’s and Lehman Brother’s
collapses and the subsequent turmoil in financial markets. Market volatility had increased
substantially across asset classes as Lehman’s counterparties had suddenly become exposed
to a great amount of market risk previously offset by their trades with Lehman and as a result
a flight to quality was taking place, with a very risk-averse sentiment ruling investors’ decisions.
Many investors had been closing positions and investing in Treasury bills alone, prime brokers
as KTC had increased collateral requirements to a point where it was almost impossible to hold
positions in anything but treasuries as well.
KTC’s profit had derived from selling short long-dated treasuries and going long in shorter-
dated treasuries, in duration-matched amounts (which is in some way a convergence trade).
As the fund betted on a steepening yield curve which had been triggered by the FED’s cut in
short-term rates, it had done well in spite of the crisis and Mills felt it was now time to exploit
opportunities in the market for U.S. dollar fixed-floating swaps.
At that precise date the thirty-year U.S. dollar fixed-floating spread had decreased from 30.25
to 6.25 basis points, having even been negative some days before this. The size of the swap
spread (6.25 basis points) was considerably low compared to the historical values that
averaged between 30 and 60 basis points, and Mills had never imagined that this value could
ever be negative. Given these values that he deemed “abnormally low” he felt that the current
low spreads presented a profitable trading opportunity.

4. Group 15
Part II
1. What is the swap trade that Mills is studying?
The swap trade that Mills is studying is a “bet” on swap spreads widening from their current
level (0.0625% or 6.25 basis points) back to average historical values (30 – 40 – 50 basis points).
The trade in practice
Mills is long the swap –he pays a fixed rate and receives a floating rate (i.e. Libor). Meanwhile
he buys the corresponding amount of 30-year treasury (May 2038) in order to be neutral in
terms of market interest rates (the DV01 values are matched), using repo financing (see Q2).
 Swap leg: Mills pays 2.128% every 6 months (4.2560% per annum), the fixed leg of the
swap, for the next 30 years. Mills receives the 3-month LIBOR rate (reset every 3
months), the floating leg, for the next 30 years.
 Treasury leg: Mills receives 2.0965% every 6 months (4.193% per annum), the yield of
the May 2038 treasury. He used a repurchase agreement (“repo”) to finance the
purchase and hence pays the repo rate (0.15% annually).
Matching the bonds duration to become neutral to interest rate fluctuations
Mills is long the swap and shorts the treasury. If interest rates go up/down, the value of his
swap increases/decreases (he pays a relatively lower/higher interest rate compared to the
market rate, which is valuable). In order to hedge this interest rate exposure, he buys a bond
with the same maturity (May 2038) in the right proportion to match the duration:
The swap with fixed leg has a DV01 of $1.7 million for $1 billion notional – The May treasury
2038 has a $1.746 million DV01 for the same notional. Mills buys $0.97 billion of the thirty
treasury (1.7/1.746 = 0.973). The “dirty” price of the treasury $0.97 billion is $1.04 billion,
including the accrued interest ($2.13 per 100 face value).

5. Group 15
Turning the trade into a profit
There is two ways the trade can be profitable:
Flows
 The floating leg, in most cases, will be profitable as the repurchase rate is a
collateralized borrowing rate and as a result it should always be lower than the LIBOR
rate (unsecured borrowing rate between financial institutions).
 On the fixed rate, Mills will pay the swap spread, currently 0.0625%; on aggregate the
flows will more or less cancel out as the negative payment of the fixed leg will be
matched by a positive payment on the floating rate. The effect on the value of the trade
should therefore be low.
Leg values
 The position will benefit when the spread widen: the treasury yield (4.193%) decreases
and/or the swap fixed rate (4.2560%) increases. If the yield goes down, the treasury
will sell at a premium. This works the same way on the swap fixed leg if the swap rate
increases. This part of the trade is the most important to monitor.
2. How could Mills finance the trade?
As mentioned in Q1, Mills will use a repurchase agreement to finance the purchase of the
treasury. He will pay the repo rate (0.15% annually) and will have a haircut of 2% (he will need
to post $21 million in capital to borrow the $1.04 billion needed to buy the bond).
3. What is the TED spread?
The TED spread or Treasury-Eurodollar spread is the difference between the 3-month futures
contract for U.S. Treasuries and the 3-month contracts for Eurodollars having identical
expiration month. The spread measures the credit risk of the borrowers associated with
Eurodollar futures as Treasury bills had always been assumed to be risk free.
When the TED spread increases, default risk should also be increasing, which will in turn lead
investors preference to safe investments. Inversely, default risk is considered to decrease when
the TED spread falls.
How would you compute it empirically?
The Three-month TED spread is calculated as the difference between the 3-month LIBOR rate
and the 3-month Treasury bill yield. The 3-month Treasury bills which are originally quoted at
discount rate are converted into bond equivalent yields.
In this sense, the spread measures banks credit worthiness, reflecting the difference in
borrowing rates for an uncollateralized loan by banks and a safe loan to U.S. government.
Therefore, TED spread is often used to track the difference between the LIBOR and the
appropriate repo rate, as these are no more than loans secured by government bonds.

6. Group 15
4. What are the risks in the trade that Mills is about to put on?
Risks can arise whether the swap spread narrows or widens as Mill anticipated.
[Narrowing spread] The yield on the 30-Year Treasury bond increases
An increase in yield on the 30-year Treasury bond has two implications. As the value of the
bonds decreases when the yield to mmaturity increases, the broker might require KTC to post
additional cash collateral to compensate for the negative price change or ask to sell some
Treasury bonds which will have as a direct effect to reduce leverage. The liquidity of the 30-
year Treasury bond will then affect KTC’s ability to sell the bond. Therefore, it is important for
KTC to have sufficient capital reserve to meet cash requirements. Secondly, in the renewed
repo transaction, the broker might increase the haircut to reflect the risk for a drop in value of
the collateral.
[Narrowing spread] 30-year swap rate decreases
If Mills has been required to post initial margin against the swap, additional cash collateral may
also be required if the swap rate declines. Again, this will require KTC to have some cash
reserve.
[Widening spread] 30-year swap rate increases and effect on counterparty risk
Inherent in any OTC contract, the counterparty might not be able to fulfill the promised
payments. Particularly, when the market rate increases, the counterparty risk will increase as
the floating leg could have received more in exchange for paying the same amount.
The success of Mill’s trade will also depend on his ability to renew repo agreements every 3
months for 30 years (or until the spread widens).
Why is the spread so low? Can the spread turn negative? Why?
Higher yield on long-term Treasury bond
In mid-October 2008, the US Treasury announced the purchase of preferred shares from nine
large financial institutions, which would mainly be financed by issuing long-term Treasury
bonds. The large increase in supply of Treasury bonds drove up their yield and hence imposed
a downside pressure on swap spreads.
The principal exchanged in a Treasury bond transaction is to be repaid at maturity (30 years
later in this case) whereas the principal is not exchanged in a swap transaction and the timely
payments are marked to market. In addition, the swap losses due to default of a counterparty
are only equal to the cost of replacing the position, when a default of a counterparty in bonds

7. Group 15
often means a loss of the principal. As such, the relatively riskier delivery method of Treasury
bond is reflected by a higher yield.
Lower 30-year swap rate
After Lehman’s bankruptcy, investors sought for replacing hedges as their swaps with Lehman
had become void, which was an enormous market force. Fixed rate bond issuers, who have
timely fixed obligations would benefit from a steepen yield curve to pay the floating. Secondly,
sovereign debt managers also tend to reduce the duration of their outstanding debt (both ask
to receive the fixed rate in a swap). Thirdly, institutional investors wish to benefit from the
carry gain by entering in swap. Finally, commercial banks are less inclined to hedge their short
term variable rate deposits. As a result, there would be relatively more floating than fixed-rate
payers in the interest rate swap market. The swap rate thus decreased to reflect the higher
demand for the floating position.
From the fixed-payers’ perspective of view, another reason that might contribute to a lower
swap rate is the lower hedging cost of floating swap dealers. In addition, capital requirements
and regulation may induce investors to use swap instead of bonds, reducing the yield of swaps
(risk-weighted asset regulation for instance). Another explanation is the view of the market
that governments like any entities can default which drove up government bond yields.