Question
Your fixed income arbitrage hedge fund has $100 in capital. Assume that you observe the following two U.S. Treasury bonds today (both bonds just paid
Your fixed income arbitrage hedge fund has $100 in capital. Assume that you observe the following two U.S. Treasury bonds today (both bonds just paid their last coupon payment yesterday):
Bond | Issue Date | Maturity Date | Coupon Rate | Price (Dirty) | Yield-to-Maturity | Modified Duration |
1 | 6/15/10 | 6/15/30 | 3.50% | 800 | 6.00% | 7.5 |
2 | 6/15/00 | 6/15/30 | 6.50% | 1,000 | 6.50% | 8.5 |
A] Briefly explain how you could take advantage of an existing arbitrage opportunity by buying 1 of the bonds and short selling 1 of the other bonds. (You will buy or sell exactly 1 of each bond.)
B] If your broker charged you a 3% haircut on a repurchase agreement for your long position and required 2% margin on your short position, how much cash would you have to invest to execute both trades?
C] If the yield on the 6.5% coupon bond decreased to the 6% yield on the 3.5% coupon bond, it would be worth $1,050; If the yield on the 6.5% coupon bond increased to 7%, it would be worth $950. Assume that the yield on the 3.5% coupon bond does not change.
What would your profit and rate of return be if the yield on the 6.5% coupon bond rose to 7%? How much more cash would you have to provide to the broker?
D] Is this trade eventually guaranteed to be profitable? What are the risks for your $100 fund?
E] If the yields shifted lower, but the spread remained the same, would you expect to make a profit or a loss, or would you make $0 in net profit? Briefly explain. (No calculations required to answer this part)
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