Fixed Income in a Financial Crisis (A): US Treasuries in November 2008

Academic Year 2013/2014

Executive Summary

In the first part of our report, we investigate if a 35 basis points yield spread represents mispricing of two bonds, both with the same maturity but one with a coupon rate of 10.625% and the other 4.25%. Our investigation also determines if the yield spread represents an arbitrage opportunity. In our investigation, we calculate the theoretical yield spread between the two bonds and compare the figure with the observed yield spread. It is cited in the case that the observed yield spread could be due to different liquidity premium for each bond or simply due to different durations. Through our calculations, we discover …show more content…

Therefore, as price distortions stemming from liquidity premiums subside, we expect the yield spread to tend towards the theoretical -26 basis points. In the unlikely event that the effects of liquidity premium persist for a long time, the yield spread should still converge to zero near to or at maturity of both bonds. As such, we conclude that the 10.625% coupon bond is underpriced relative to the 4.25% coupon bond and the 4.25% coupon bond overpriced relative to the 10.625% coupon bond. Hence, we believe that an arbitrage opportunity exists and Franey’s strategy of long 10.625% coupon bond and short 4.25% coupon bond will work.
Duration
We find that duration is unable to explain the apparent mispricing. Our calculated theoretical yields for both bonds indicate that the bond with higher duration has a higher yield than the bond with lower duration. This is in line with the slope of the interpolated yield curve, which is upward sloping. When the yield curve is upward sloping, the bond with higher duration should command higher yield since a greater proportion of its present value will be reduced by higher future interest rates, as compared to the bond with lower duration.
Conceptually, the scenario observed in the case study where the bond with higher duration has a lower yield than the bond with lower duration should exist only when the yield curve