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

Abstract

Investment manager James Franey confronts an apparent arbitrage opportunity during the global financial crisis of 2008 when he notices a wide yield spread between two U.S. Treasury bonds that mature on the same date. Franey must decide if there is an opportunity, how to structure a trade to exploit it, and how much of his fund's capital to allocate. Case exposition includes considerable detail on financing arrangements, particularly short-selling, margin lending, and repurchase agreements, that support relative-value strategies. Careful attention is paid to the bond math calculations that support the protagonist's analysis and decision. All quoted prices in the case are real and historical, and corresponding Bloomberg commands are provided for each as footnotes.

Learning Objective: This case may be used: to review bond valuation and associated measures of bonds' price-sensitivities to interest rates; to review the Law of One Price (LOOP) and resulting opportunities when LOOP fails; to describe the mechanics of exploiting violations of LOOP; and to describe hedge fund financing arrangements, particularly short-selling, margin lending, and repurchase (repo) agreements. The case also may be used: to discuss the causes of anomalous securities prices during the 2008 crisis; to explore causes and consequences of the 2008 crisis generally; and to discuss possible interventions by government, central banks, and other oversight bodies.