Long-Term Capital Management (LTCM) implemented a convergence trading strategy involving corporate bonds and U.S. Treasuries. Expecting the spread between corporate bond yields and Treasury yields to narrow over time, LTCM took large leveraged positions, going long (buying) corporate bonds and short (selling) Treasuries. However, the 1998 Russian debt crisis triggered a flight to quality, causing corporate bond prices to fall and Treasury prices to rise, leading to a divergence of the spreads and massive losses for LTCM's trades. On July 1, 1998, LTCM initiated a convergence trade by going long $100 million notional of Baa-rated 10-year corporate bonds with a yield of 7.5% and coupon rate of 7%, and shorting $100 million notional of 10-year U.S. Treasury bonds with a yield of 5.5% and coupon rate of 5%. a. Explain LTCM's rationale for going long corporate bonds and short Treasuries in their convergence trade. What were the underlying assumptions behind this strategy? b. Calculate LTCM's expected profit from this convergence trade if yield spread goes to 100 basis points. c. However, in August 1998, the Russian debt crisis triggered a flight to quality. By September 1, 1998, the spread between Baa-rated corporate bonds and Treasuries had widened to 300 basis points (3%). Calculate LTCM's loss on this trade.
Long-Term Capital Management (LTCM) implemented a convergence trading strategy involving corporate bonds and U.S. Treasuries. Expecting the spread between corporate bond yields and Treasury yields to narrow over time, LTCM took large leveraged positions, going long (buying) corporate bonds and short (selling) Treasuries. However, the 1998 Russian debt crisis triggered a flight to quality, causing corporate bond prices to fall and Treasury prices to rise, leading to a divergence of the spreads and massive losses for LTCM's trades. On July 1, 1998, LTCM initiated a convergence trade by going long $100 million notional of Baa-rated 10-year corporate bonds with a yield of 7.5% and coupon rate of 7%, and shorting $100 million notional of 10-year U.S. Treasury bonds with a yield of 5.5% and coupon rate of 5%. a. Explain LTCM's rationale for going long corporate bonds and short Treasuries in their convergence trade. What were the underlying assumptions behind this strategy? b. Calculate LTCM's expected profit from this convergence trade if yield spread goes to 100 basis points. c. However, in August 1998, the Russian debt crisis triggered a flight to quality. By September 1, 1998, the spread between Baa-rated corporate bonds and Treasuries had widened to 300 basis points (3%). Calculate LTCM's loss on this trade.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
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Transcribed Image Text:Long-Term Capital Management (LTCM) implemented a convergence trading strategy
involving corporate bonds and U.S. Treasuries. Expecting the spread between corporate
bond yields and Treasury yields to narrow over time, LTCM took large leveraged positions,
going long (buying) corporate bonds and short (selling) Treasuries. However, the 1998
Russian debt crisis triggered a flight to quality, causing corporate bond prices to fall and
Treasury prices to rise, leading to a divergence of the spreads and massive losses for
LTCM's trades.
On July 1, 1998, LTCM initiated a convergence trade by going long $100 million notional of
Baa-rated 10-year corporate bonds with a yield of 7.5% and coupon rate of 7%, and
shorting $100 million notional of 10-year U.S. Treasury bonds with a yield of 5.5% and
coupon rate of 5%.
a. Explain LTCM's rationale for going long corporate bonds and short Treasuries in their
convergence trade. What were the underlying assumptions behind this strategy?
b. Calculate LTCM's expected profit from this convergence trade if yield spread goes to
100 basis points.
c. However, in August 1998, the Russian debt crisis triggered a flight to quality. By
September 1, 1998, the spread between Baa-rated corporate bonds and Treasuries
had widened to 300 basis points (3%). Calculate LTCM's loss on this trade.
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