Friday, May 16, 2014

trading swap spread - LTCM case (with wrong intuitions

See Harvard Biz School case study 9-200-007 on LTCM. I feel this is a good simple scenario to develop analytic instinct/intuition about IRS.

I believe USD swap spread is similar to the TED (which is 3M). A very narrow TED means on the lower side T (i.e. treasury) yield too high and on the upper side fwd Libor too low.

T yield too high means T bonds too cheap. Therefore, LTCM would BUY T bonds.

Expected series of Libor cashflow is too low, so the equivalent fixed leg is also too low. Therefore LTCM would PAY the fixed rate. The par swap rate is the price you lock in today, which buys you the Libor stream, which you believe to be rising.

In the orange case, you as a Libor/orange buyer lock in a price today and you expect the oranges to get bigger soon.

For a 10Y swap, we are saying the forward Libor rates over 3->6M, 6->9M, ... 120->123M... are too low and may rise tomorrow. There are many wrong ways to interpret this view.

correct - Since the floating income will rise, we would want to receive those future Libor interests.

 
correct - We can think of the floating leg as a hen giving eggs periodically. The market now forecasts small eggs, but LTCM feels those eggs will be bigger, and the hen is under valued. So LTCM buys the hen by paying the (low) fixed rate.

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