2. Read the following episode carefully. Italian Asset Swap Volumes Soar on Buyback Plans Volumes in the basis-swap spread market doubled last week as traders entered swaps in response to the Italian treasury’s announcement that it “does not rule out buybacks.” Traders said the increase in volume was exceptional given that so many investors are on holiday at this time of year. Traders and investors were entering trades designed to profit if the treasury initiates a buyback program and the bonds increase in value as they become scarcer and outperform the swaps curve. A trader said in a typical trade the investor owns the 30-year Italian government bond and enters a swap in which it pays the 6% coupon and receives 10.5 basis points over six-month Euribor. “Since traders started entering the position last Monday the spread has narrowed to 8 bps over Euribor,” he added. The trader thinks the spread could narrow to 6.5 bps over Euribor within the next month if conditions in the equity and emerging markets improve. A trader at a major European bank predicts this could go to Euribor flat over the next six months. The typical notional size of the trades is EUR50 million (USD43.65 million) and the maturity is 30 years. (IFR, Issue 1217)

(a) Suppose there is an Italian swap curve along with a yield curve obtained from Italian government bonds (sovereign curve). Suppose this latter is upward sloping. Discuss how the two curves might shift relative to each other if the Italian government buys back some bonds.

(b) Is it important which bonds are bought back? Discuss.

(c) Show the cash flows of a 5-year Italian government coupon bonds (paying 6%) and the cash flows of a fixed-payer interest-rate swap.

(d) What is the reason behind the existence of the 10.15 bp spread?

(e) What happens to this spread when government buys back bonds? Show your conclusions using cash flow diagrams.