Fixed Income Arbitrage In Financial Crisis Harvard Case Solution & Analysis

Introduction

After acquiring 13 years of fixed income trading experience at Morgan Stanley, Franey has started his own investment management firm. Franey was able to raise $300 million for hisnew hedge fund KTC. In 2008,there was global economic crisis and there was also an opportunity to earn potential profits from this economic crisis.

Hedge funds are alternative investments using pooled funds, which Franey haspooled up to $300 Million that may be used in different bond trading strategies to earn active return. Hedge funds are aggressively managed and there is significant use of leverage or margin. Hedge funds manager often charges annual fund management feed based on NAV and a profit share as well.

KTC has performed well in the initial crisis period because Franey was not involved in mortgage securities because he did not have enough knowledge of his type of market. He continued to invest in traditional fixed income and treasury related trades which was major reason that KTC performance was good as compare to other hedge fund managers. Franey was smart enough to avoid investment in mortgage related securities because those assets proved to be toxic asset in 2008

Analysis

Franey is a fixed income trader who is studying two bonds. The first one is semi-annual coupon bound which yields coupon rate of 4.25% and will mature in August 2015, while the second bond is also as emiannual coupon bond which yields 10.625% annual rate issued in year 1985 and will mature in August 2015.As Franey was aware of financial crisis in August 2007.

When the first bond was issued at 4.25%, spreads appeared in 2005.In 2008, when there was financial crisis, investors required return of return and the bond value was declining. There was also an increase in the spreads. Spreads increased up to 35 basis points. Spread of 35 basis points was so high that it was unable to be explained.

In October 15, spreads were again shown in the market,however, Franey he was able to make arbitrage profits. Arbitrage profits can be earned by simultaneous purchases and sale of asset due to pricing difference. There is possibility of arbitrage profit when there is pricing difference of similar asset in different markets due to supply and demand reasons.

Franey wished to make arbitrage profit by buying bond which is traded at higher yield and short bond which is traded at lower yield. Franey is of view that in some point in time spread will become zero, thus a risk free profit can be earned from this potential strategy.

Franey isactually betting on spreads of the two bonds and try to earn profits. Another strategy that Franey wasusing was steepening trading,in which he will reap benefits when there will be change in spreads.Franey will yield good profits from long term yield when treasury prices will fall down due to the decrease in demand of long term treasury.

There are many reasons for decrease in long term yield such as investors wish to earn held return from short term treasuries which fluctuates more. If long term treasuries are hold when investors have confidence in the economy and if no one wishes to hold,then prices will fall and yields will increase.

Fixed Income Arbitrage In Financial Crisis Case Solution

With better position in high yield, the bond buying of bond with expectation that the bond value will goup, and short position in the sale of bond which will not be owned by the investor rather it will be borrowed from the broker. Short sale is initiated when it is expected that the value of bond will decline.

The potential profit and loss for Franey areas follows;

Buy

Sell

Face Value

100

Face Value

100

Yield

3.61%

Yield

3.26%

Coupon Rate

10.63%

Coupon Rate

4.25%

Price

141.8281

Price

105.9688

Value 01

0.0741

Value 01

0.0625

Modified Duration

5.14

Modified Duration

5.84

Maturity

Aug-15

Maturity

Aug-15

The face value of the bond is $100 which is high while its market value is $141.828.The market value is higher because the coupon rate is higher than current prevailing interest rate in the market.

On the other hand,low yield face value is also $100 and it yields 3.2% as compared to coupon rate of 4.25%. This bond which is sold or short is of low yield as compared to the bond which is long..........................

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