Long-Term Capital Management (LTCM) implemented a convergence trading strategy involving corporate bonds and U.S. Treasuries. Expecting the spread between corporate bond yields and Treasury yields to narrow over time, LTCM took large leveraged positions, going long (buying) corporate bonds and short (selling) Treasuries. However, the 1998 Russian debt crisis triggered a flight to quality, causing corporate bond prices to fall and Treasury prices to rise, leading to a divergence of the spreads and massive losses for LTCM's trades. On July 1, 1998, LTCM initiated a convergence trade by going long $100 million notional of Baa-rated 10-year corporate bonds with a yield of 7.5% and coupon rate of 7%, and shorting $100 million notional of 10-year U.S. Treasury bonds with a yield of 5.5% and coupon rate of 5%. a. Explain LTCM's rationale for going long corporate bonds and short Treasuries in their convergence trade. What were the underlying assumptions behind this strategy? b. Calculate LTCM's expected profit from this convergence trade if yield spread goes to 100 basis points. c. However, in August 1998, the Russian debt crisis triggered a flight to quality. By September 1, 1998, the spread between Baa-rated corporate bonds and Treasuries had widened to 300 basis points (3%). Calculate LTCM's loss on this trade.

Long-Term Capital Management (LTCM) implemented a convergence trading strategy involving corporate bonds and U.S. Treasuries. Expecting the spread between corporate bond yields and Treasury yields to narrow over time, LTCM took large leveraged positions, going long (buying) corporate bonds and short (selling) Treasuries. However, the 1998 Russian debt crisis triggered a flight to quality, causing corporate bond prices to fall and Treasury prices to rise, leading to a divergence of the spreads and massive losses for LTCM's trades. On July 1, 1998, LTCM initiated a convergence trade by going long $100 million notional of Baa-rated 10-year corporate bonds with a yield of 7.5% and coupon rate of 7%, and shorting $100 million notional of 10-year U.S. Treasury bonds with a yield of 5.5% and coupon rate of 5%. a. Explain LTCM's rationale for going long corporate bonds and short Treasuries in their convergence trade. What were the underlying assumptions behind this strategy? b. Calculate LTCM's expected profit from this convergence trade if yield spread goes to 100 basis points. c. However, in August 1998, the Russian debt crisis triggered a flight to quality. By September 1, 1998, the spread between Baa-rated corporate bonds and Treasuries had widened to 300 basis points (3%). Calculate LTCM's loss on this trade.

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter3: Evaluation Of Financial Performance

Section: Chapter Questions

Problem 12QTD

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