Question
Background: In the lecture notes we consider yield spread convergence of the 29 year bond with the 30 year bond. The idea is that one
Background: In the lecture notes we consider yield spread convergence of the 29 year bond with the 30 year bond. The idea is that one can take a position in both bonds that will benefit if spreads converge. Of course, one could also make a bet that spreads will diverge.
Problem: Assume that you wish to take a bet on the yield spread between two bonds: a 10-year corporate bond rated BB and a 10-year Treasury bond.
Information about both bonds follows:
10 year Treasury bond | 10 year BB corporate bond | |
Maturity | 10 years | 10 years |
Coupon rate | 5% | 7% |
YTM | 5.5% | 7.5% |
Current price | $96.193 | $96.526 |
DV01 | $0.0744 | $0.0680 |
Assume that you believe the economy is going to get much worse in the future, and you wish to make your bet based on this premise. Also assume that you will buy 1000 units of the bond that you are going to hold "long." Finally, ignore margin requirements, interest on cash proceeds, and any intervening coupon payments of the long and short bonds.
State your initial balance sheet assuming you implement the trade. Assume that you come up with the cash to fund the long position out of your pocket. Be sure to clearly label each column and describe each entry. Also be sure to include the totals.
Assume that in 1 month, the following is the information about the two bonds
10 year Treasury bond | 10 year BB corporate bond | |
Maturity | 10 years | 10 years |
Coupon rate | 5% | 7% |
YTM | 6% | 7% |
Current price | $92.561 | $100 |
(1) Restate your balance sheet using the above information. Be sure to clearly label each column and describe each entry. Also be sure to include the totals.
(2) What is your gain or loss on equity in dollars? What is your percentage gain or loss on equity as a holding period return?
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