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Transcript of Article:
Why did Franey do so well during the initial part of the crisis period?
He stayed away from mortage securities because of limited knowledge of this market.
Invested in traditional Fixed income and Treasury relative value trades
With the explosion of the financial crisis mortage-backed securities turned to be "toxic" and panic spreaded all over the market.
What is a steepening trade?
Q4. Give your views on the source of the
that exists and give n opinion whether Franey should try to exploit it.
Yield Spread =
the difference in yield between 2 bonds or between different segments of the bond market.
Franey should try to exploit this yield differential by holding:
- A long position
on the Treasury with the higher yield and
- A short position
on the Treasury with lower yield.
Q2. What is the potential trade that Franey is considering on Nov 4th, 2008?
Why did Franey do so well during the initial part of the crisis period? What is a steepening trade?
This strategy is exposed to several financing risks:
1) Widening spreads:
If the yield spread starts widening, Franey will receive a margin call from its broker.
Ryan Taliafero, Stephen Blyth
What is the potential that Franey is considering on Nov 4th, 2008?
How might the trade be financed? Give an explanation of the financing risks that exist.
Give your views on the source of the yield differential that exists and give n opinion whether Franey should try to exploit it.
Assess the trade. Would you recommend putting the trade on? How would you implement the trade?
Q3. How might the trade be financed? Give an explanation of the financing risks that exist.
This generated a "flight-to-quality" which led to an increase in the price of Treasuries Franey had precedently bought.
A strategy which investors can benefits from the change of the yield spread.
-This strategy can be effective when the long-term Treasury price will driven down as the decrease of the demand of long-term Treasury.
face amount of high yield bond :
Bond price: 141.8281/100*1000=
Accrual: 1000*10.625%* (82/365)=
Total price: 1418.282+ 23.68=
face amount of low yield bond:
(at short-term overnight rate): 1441.96-1267.60=
When yield spread ==> 0
PV of the portfolio(regardless of the interests):
No net investment from KTC’s capital
For the long position,
the broker lends only 98% of the amount purchased, at a 0.15% annual rate.
The residual 2% (the “haircut”) must come directly from KTC’s capital. In addition, the broker requires the purchased 10.625% bonds to be posted as collateral.
For the short position,
first KTC asks its broker to find another investor who is willing to lend KTC the 4.25% bond.
then KTC sells the borrowed bonds, and posts the cash received from the sale as collateral. In addition, it also has to post an additional 2% (again, the “haircut”) from its own capital. In this case, however, KTC receives a 0.10% interest on the additional cash posted.
2) Higher Haircuts.
If the prime broker decides that Franey’s credit merit has deteriorated or that the securities posted as collaterals have increased in riskiness, he could decide to increase the haircut.
3) Increasing rates:
If the economic conditions worsened, ST interest rates could increase, making more the roll-over strategy more expensive.
Reasons of yield spread existence:
Risk/rating of each security:
Riskier bonds offering higher yields
A bond with longer maturity offers a higher yield, when the yield curve is upward sloping
differences in yields between two government bonds when one of them had been sold recently (on-the-run), hence its is more liquid than the one which have been traded for many years (off-the-run)
During 2008, (liquidity crisis)
investors who used to keep off-the-run securities in their portfolios and experienced liquidity problems, start selling the illiquid bonds which led to lower bond prices and in turn to the widening of the yield spread.
Yield spreads are not fixed, they change all the time because bond yield are always in motion and certain circumstances lead to
When there is a yield spread caused by overreaction (arbitrage opportunity), an investor has to take advantage of it.
James Franey, an investment manager, studies two bond
The first one: a semi-annual coupon bond at 4.25% annual rate and mature in August 2015
The second one: a semi-annual coupon bond at 10.625% annual rate issued in 1985 and mature in August 2015
Fancey first became aware of the crisis in August 2007
Spread first appear at 2005 when the 4.25% bond was issued
In March 2008, the spread increased dramatically to 35 basis points and this is a very high level which could not be explained by liquidity
By 15 October, the spread reappear again, Fancey believe this is a chance for him to make an arbitrage profit by buying bond with higher yield and shorting bond with lower yield
He bet the spread would come back to zero
He then set up his strategy of financing the portfolio and also evaluate the financing risk he will be face
close the position!!