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Fixed Income in a Financial Crisis (A): US Treasuries in November 208

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Fixed Income in a Financial Crisis (A): US Treasuries in November 208
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 that the difference in duration between the two bonds does result in different theoretical yields, 2.899% for Bond4.25 and 2.639% for Bond10.625. However, the theoretical yield spread should be -26 basis points instead of the observed 35 basis points. Hence, we conclude that while difference in duration does result in a difference in yield, the observed yield spread of 35 basis points cannot be explained by duration. Further, the 61 basis points difference between the observed and theoretical yield spreads indicates that Bond10.625 is underpriced relative to Bond4.25 and the proposed strategy of long Bond10.625 and short Bond4.25 can work.
In the second part of our report, we investigate if Franey’s duration-neutral strategy is immune to shifts in yield curves. We perform illustrative examples that show that the value of the arbitrage portfolio increases in the event of a steepening yield curve and decreases in the event of a flattening yield curve. Additionally, we highlight that even with a duration-neutral strategy, parallel shifts in the yield curve will still affect the portfolio’s value due to the effect of convexity. Further, as the overall portfolio’s convexity is negative, any parallel shift in the yield curve will lead

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