Based on FIXED INCOME ARBITRAGE IN A FINANCIAL CRISIS TED SPREAD AND SWAP SPREAD IN 2008 CASE C

Should Albert Mills do this trade? Back up your answer with the following analyses:

1. Write out the initial transaction and cash flows for the trade based on entering the swap, purchasing the Treasury bond, and borrowing using the repurchase agreement. Assume $1 billion notional principal for the swap and $0.97 billion face value for the Treasury bond. You may be very precise in your calculations or use the rounded numbers presented in the case. Assume that initial LIBOR is set at 2.51% and is fixed for three months (through February 2009), beginning the swap date (November 5, 2008). Be sure to take into account the 2% haircut on the repo.

Swap spread The swap spread that Mills was studying was the difference between two interest rates, the rate on the fixed leg of a fixed-floating swap and the yield on a Treasury bond of comparable maturity. The swap was a thirty-year swap, so the relevant Treasury bond was a 4.5% coupon bond due May 15, 2038. On November 4, this bond had a yield of 4.193%.3 On the same day, the fixed leg of a fixed- floating swap had a rate of 4.2560%,4 just 6.255 basis points more than the yield on the Treasury. It was this low 6.25 spread that had caught Mills' attention