Assignment # 1 Case Name(s): Fixed Income Arbitrage in a Financial Crisis (A)

Section : 2 Professor : Evan Dudley, Ph.D

Date : October 2nd, 2020

MFIN 829 – Fixed Income Instruments and Markets

Course

Team 2A Member Names Student Number

1 Amit Tayal 20250940

2 Bilash Das 20246183
3 Cleo Li 05873433
4 Cece Chindah 20246243
5 Dong Feng 20229304
6 Solomon Sserwanga 20246940
7 Zack Chetrat 20217033
Executive Summary

After the fall of Lehman Brother and Norther Rock, the market was in turmoil at the end of 2008,
starting from 2007. There was an extreme lack of liquidity, dramatic widening of spreads across
all assets classes during this credit crunch. Volatility had spiked up drastically, and all participants
of the markets became risk averse. As a result, there was a dramatic uptick in the LIBOR rate,
which further dried up all liquidity in the global markets.

The fund Kentish Town Capital (KTC) was established by the former Morgan Stanley star trader
James Franey. James was an expert in relative value trades, and his strategies had performed well
so far compared to his competitors. Originally a curve steepener believer, James Franey, like many
other funds, quickly closed these positions and was only allowed to trade treasuries, which were
the only collaterals acceptable in this storm. Nearly two months after the fall of Lehman, on
November 4th, 2008, James was speculating on the convergence of the spread of two treasuries,
and it seemed at the point of time the worst chapter of the spread widening had already gone. After
observing the spread of these two off-the-run treasuries, the fund manager James Franey was
considering to enter a pair trade to bet on the mean reversion of the spread of these two treasuries.
If James were able to establish the L/S positions and to exit for profit taking quickly at the right
time, he was right to spot an arbitrage opportunity of narrowing of the spread from 35bps to zero
or below zero of these two Treasury bonds – long of 10.625% and short of 4.25%. With all else
being the same, the 10.625% bond to long was currently priced by the market with a higher yield
than the bond to short of 4.25%. The higher coupon bond was relatively cheaper in the current
market condition than the lower coupon bond in the market turmoil. James was expecting the
market to correct the situation to its normality, where higher coupon bond should worth more with
a lower yield than the lower coupon bond with a high yield. This mean reversion would result in a
risk less profit at the time of expiration of these two treasuries.

Given the analysis and in this paper, our team came up with the recommendation to proceed with
the trade with a list of assumptions and scenario. With the existence of this arbitrage opportunity,
James Franey should proceed with the 5 million investment, which would allow him to long 250
million of the 10.625% bond after leverage and to short 219.77 million of the 4.25% after duration
matching.
Part I: Question 1

The core of this arbitrage strategy is to bet on the spread convergence of two treasuries – 10.625%
and 4.25%, from 35bps to zero or below. The widened spread was driven by the subprime credit
crisis from 2007 – 2008. The mean reversion of such spread could happen any time, and it would
be normal for divergence to happen during panic time. Such volatility was the theme of across all
asset classes at the point of time when James Franey, the fund manager, was trying to decide if he
should open the arbitrage trades. All market participants, including all broker dealers and hedge
funds, are able to observe such divergence, the spread can converge can happen fairly quickly.
Therefore, it would heavily depend on the liquidity of these two off-the-run bonds. Regardless of
the fact that there would be no issuer credit concerns, the market conditions would dictate the
haircuts and collaterals of these trades with the prime brokers.

The existence of arbitrage opportunities was blatantly shown in its historical spread graph, as
demonstrated in Exhibit 3. The spread was mostly below 10bps in mid-2000s. As the market
conditions exacerbated, the spread widened and converged a couple of times. As mentioned in the
case, James Franey observed a widening of the spread to 35bps recently, and the convergence
quickly evaporated and spiked up to its currently level of 35bps again in a couple of days of time.
Such wild-west volatility was very rare and dramatic. It would be a 100% riskless profit at the
point of expiration; however, the fund manager would have to decide if the fund can survive any
further margin calls, if the spread were to further widen again.

After examining details of these 2 bonds, the bond to long @ 10.625% had a higher yield of 3.61%
than that of 4.25% with yield of 3.26%. Due to the coupon effect of the bond, the 10.625% should
have a lower YTM than the lower coupon bond 3.26%, with all else being the same. The higher
coupon bond, with the same tenor as the lower coupon bond, should be more expensive than the
lower coupon bond. This coupon effect, however, was not showing in the current pricing of these
two bonds. This further proved that the current market spread was upside down and unnatural. By
looking at the current yield curve, it could be easily identified that these bonds were mispriced by
using the 7-year spot rate of 3.21%. Since the expiration date of these two bonds were roughly
6.78 years, using the 7-year rate would simply the calculation without any interpolation.
• The 7 yr spot rate was 3.21%, which was lower than that of what Franey was looking to
long by 40 bps and to short by only 5bps. This indicated that there was a mispricing in
these bonds relative to the yield curve that could be exploited.
• The yield curve itself doesn’t justify the spread between these two bonds. The 10.625%
was underpriced, which was perfect to set up as the long position; the 4.25% was also
underpriced by only 5bps, which was significantly lower than the difference of 40 bps for
the 10.625% bond to long.
• Price differences would create a significantly P&L after leverage of 50x.
• The 10.625% bond’s modified duration was 5.1368, which was lower than the duration of
the 4.25% bond of 5.8408.

Q1 @ 7 Yr 3.21 current
Long yield
COUPON 10.625%
YTM 3.61% 3.21%
MATURITY(YEARS) 6.7781
PAR 100
t 82
T 184
Bond Basis 1
Begin of Coupon period 8/15/2008
Next Coupon date 2/15/2009
Settlement date 11/5/2008
Maturity date 8/15/2015
Price(flat) 141.8288 144.8306
Accrued Interest(AI) 2.3675 2.3675
Price(full) 144.1963 147.1981
Duration 5.1368 5.1651
Macaulay 5.2296 5.2480
DV01 0.0741 0.0760

PV+ (Full) 144.1222 144.1222

PV- (Full) 144.2704 144.2704
Convexity 33.4500
 Q1 @ 7 Yr 3.21 current
Short yield
COUPON 4.250%
YTM 3.26% 3.21%
MATURITY(YEARS) 6.7781
PAR 100
t 82
T 184
Bond Basis 1
Begin of Coupon period 8/15/2008
Next Coupon date 2/15/2009
Settlement date 11/5/2008
Maturity date 8/15/2015
Price(flat) 105.9723 106.2851
Accrued Interest(AI) 0.9470 0.9470
Price(full) 106.9193 107.2321
Duration 5.8408 5.8437
Macaulay 5.9360 5.9375
DV01 0.0624 0.0627

PV+ (Full) 106.8569 106.8569

PV- (Full) 106.9818 106.9818
Convexity 40.0329

The two bonds with the same tenor possess different characteristics that influenced its yield. The
liquidity premium was something constantly changing and unpredictable. It plays critical role in
bond pricing. As the 30-year Treasury has a significantly less amount of bonds in circulation than
the 10-year Treasury, it makes the 10-year Treasury a more attractive security. However, this
premium would be priced into the bond, making it too rich. Also the dollar yield on the short bond
was lower making it a more attractive security for selling to finance the long position. The yield
spread on the two bonds cannot be justified by the yield curve, as other factors like duration of the
bond, coupon rate and liquidity can influence pricing and yield.
KTC Capital Long/Short Trade Setup

KTC Capital [the hedge fund as the prime brokerage client]

Long 10.625% bond Short Seller of 4.25% bond
Daily Repo Transaction [for funding] Daily Reverse Repo Transaction [to borrow]

Through the daily reverse repo

Through the repo transaction, transaction, the fund receives the
the fund receives the ST bond of 4.25%
funding for the long position
As part of the reverse repo, the
The fund lends out the fund deposits the proceeds from the
10.625% bond short-sell to the prime broker.

Dealer
Prime Brokerage LOB/ Securities
Lending Desk, in conjunction with
the Repo Funding Desk, Swap Desk

Lends out the cash to Dealer lends cash $

provide funding
The prime clients lends the
securities to the dealer [and the
Receives 10.625% bond
dealer will distributes the
securities to other borrowers]

Other Prime Client or Market Participants

Other Prime Clients or Dealers Other Prime Clients or Dealers

* who are short of the 10.625% of the bond and * who carry the long position in 4.25% bond that
have excess cash to lend KTC needs to borrow and need ST funding
Part 2: Question 2

➢ As information depicted in the case, KTC’s 10.625% coupon bond full price is 144.1962808
(per 100 face value bond) @ 3.26% yield-to-maturity and 4.25% coupon bond full price is
$106.919284 (per 100 face value bond) @ 3.26% yield-to-maturity.

➢ If yield-to-maturity declines by 5 basis points, i.e., @ 3.21% yield-to-maturity in 4.25%

coupon bond, full price stands at $107.2320655 with 0.2925% increase in bond price.
However, 10.625% coupon bond’s price shall remain same as there is no change in yield-to
maturity.

➢ For better estimation in bond price % change, it is logically supported to show duration impact
and convexity impact for every basis point change in yield-to-maturity. Considering modified
duration 5.84 for 4.25% bond and convexity 40.03290483, estimated % change in bond price
will be equal 0.2925%. As such, it is demonstrated that actual % change in bond price perfectly
matches with estimated % change in this case.

Position Impact (With Hedging Ratio) for 5 basis drop in YTM:

Taking into consideration of hedging ratio in long and short position (hedging ratio:
$1,441.96/$1267.60 =1.137551; the inverse is 0.879), KTC’s assumed short position will be equal
to 219,770,312.63 ($250,000,000.00/1.137551) with long position $250,000,000.00 for capital
investment of $5,000,000, after the duration matching.

Choice – 1

KTC would have make choices how to adjust his position in the arbitrage trade for loss in value
due to a drop of 5 basis points in yield to maturity. The estimated loss is $642,914.28 which KTC
would be required to replace from cash its cash resources this loss in the value of prime broker’s
collateral which will increase assumed capital investment.
Choice – 2
If KTC could not provide this additional cash collateral, then it would be required to reduce total
position by selling the long position and buying back of short position for $32,145,713.79, which
is approximately 14.627% of short position at this new higher price. To maintain the trade balance
(haircut 2% and loan to collateral 98%), KTC would likely close similar fraction of long position
in 10.625% bond.

%Change Invested Loss in the Cap

Capital Short Total Loan-collateral Remaining Total Buy Back short
in Bond Capital in value of Maintaining -
Investment Position ratio - 98% Short Position position
Price short position investment 2% haircut

0.2925% 4,395,406.25 642,914.28

5,000,000.00 219,770,312.63 3,752,491.98 183,872,106.87 187,624,598.84 32,145,713.79

Position Adjustment when Haircut increased to 3%:

➢ However, due to financial crisis, bond market situation, liquidity in the market, credit quality,
increase riskiness of government bonds and other unforeseen circumstances, prime broker may
change haircut as 3% and loan to collateral ratio 97%.

Invested
%Change Loss in the Cap
Capital Capital in Short Total Loan-collateral
in Bond value of Maintaining - Total Position Buy Back short position
Investment short Position ratio - 97%
Price investment 3% haircut
position

0.2925% 4,395,406.25 642,914.28 94,687,246.73

5,000,000.00 219,770,312.63 3,752,491.98 121,330,573.92 125,083,065.90

➢ Under the changing circumstance of haircut 3% and loan-collateral 97%, KTC requires cash
contribution from its resources. Alternatively, KTC would have to close appropriate fraction
of its position (almost 43% position) to bring the loan to collateral ratio 97%.

Part 3: Question 3

We recommend the fund manager James Franey to take the trade and maintain these positions for
half a year.

Key Assumption
Volatility
On November 4th, 2008, the credit market was near the very late stage of its credit cycle. Markets
across the globe were heightened by the theme of dried-up liquidity, subprime bubble burst, and
widening spread across all asset classes. We assume that the volatility has reached its peak at the
point of time. There would not be a further spike of volatility, but the liquidity would dry up. The
market is going to stay volatile for the next half a year at its currently level.

Liquidity
Liquidity is one of the most important factors that would contribute to the success of execution of
James’ strategy. It is a key assumption that the market conditions would remain at its current level
or better. On November 4th, 2008, we assumed that the fund manager James Franey would expect
the market to be at its worst condition. This meant that the liquidity would not further dry up. This
means that James Franey can successfully establish his both long and short positions; in case of
partial liquidation of any positions, KTC would not face any liquidity squeeze. Therefore, there
wouldn’t be any significant discount to the long position or higher premium on the short position
during unwinding.

Yield Curve Shape

At the point of time, the yield curve was still upward sloping as indicated by Exhibit 3. A steeping
curve would benefit the Relative Value trade. However, there is a risk that the curve would invert
during adverse market conditions. In order to execute James’ expertise in Relative Value strategy,
it is imperative to assume that the yield curve would stay at its current shape or further steepens,
leading to a narrowing of the spread. Since it is not on the table right now, it makes the treasury
arbitrage opportunities more attractive.

Timing
Timing is critical to take profit for arbitrage opportunities. Impaired by the liquidity of the bond
markets, James Franey would need to time the unwinding trades properly to avoid liquidity
squeeze. This would require skills and experiences.

Haircut and Financing Rate

The fund is charged by a haircut of 2% on both long and short, and the financing rates are currently
0.15% and 0.10% annualized. The key assumption is that the haircut is going to be relatively stable
and only going to moderately increase when the market condition further exacerbates. A double-
digit haircut is not considered possible in this case under my assumption. Haircut and financing
rates are highly impacted by LIBOR, which is dictated by the market sentiments overnight. The
fund will be vulnerable when the OIS spikes up further.

4 C’s of KTC & Suitability

Capacity
Kentish Town Capital (KTC) is a small hedge fund, having only 5 million committed capitals.
This indicates that it is a relatively small client of any bank’s prime brokerage desk. This means if
there are any major credit events, there would be significantly higher requirements of collaterals,
haircuts or borrowing rate. Because all trades are renewed on a daily basis, the margin
requirements would vary on a daily basis, based on the market condition overnight. This means
that the fund would be easily subject to any liquidity events. For any small prime accounts, the
bank would likely to require credit enhancements. In case of credit events, in additional to post
additional collaterals, the bank would require KTC to present enhancements like Letter of Credits
or post excess spreads.

When there is a liquidity event, there is very likely to have a tightening of capital available for
arbitrate from both other investors and other banks. This is the kind of risk KTC has to take on in
order to execute the Relative Value trade. KTC has a low to moderate risk tolerance but has a high-
risk appetite for a 50x leverage.

Collateral
The collateral for this trade is the long position in the higher coupon rate treasury. There is no
credit quality issue of the issuer; however, the long is used as the collateral to pledge a very high
leverage. Under normal market conditions, on-the-runs and off-the-runs are mostly liquid;
however during extreme liquidity event, it would not be possible to post additional collateral. As
mentioned in the case, the fund simply would not be able to use anything other than treasury as its
collaterals. In the recession period, the loan-to-collateral ratio will go down. However, for the
purpose of this case, the assumption is made that ratio of 98% would remain the same.

Covenants
This would the arrangement between KTC and its prime brokers. The case did not disclose any
further account restrictions.

Character
Based on information in the case, the fund manager James Franey was a star fixed income trader
with Morgan Stanley for 13 years. He wouldn’t leave Morgan Stanley to found his own fund if he
weren’t successful and feeling ready to commit his own capital of 5 million dollars. He was that
veteran and shiny star on the trading desk. We can deduct that he was very experienced, confident
and competent. The fund was relatively young, founded only in 2006 with only 2 years of track
record.

Because the fund is pledged by James’ personal capital, it is critical that the James is able to keep
up with any maintenance margin as high as the 6 million. Due to the aggressive leverage ratio, any
partial liquidation would likely to generate a huge loss. Combining the key assumptions and the
KTC’s 4Cs, this trade is suitable for KTC. James Franey should go ahead with the execution and
hold the positions for half a year. We recommend the fund to set up a stop loss for a further
widening of 50bps of this trade, depending on the other positions held by the fund and their
correlations.