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Please explain this! I dont understand.Please explain using a hypothetical situation if possible.

Thread starter #1
LTCM was long U.S. interest rate swaps and short U.S. government bonds at a time when these spreads were at historically high levels. Over the life of the trade, this position will make money as long as the average spread between the London Interbank Offered Rate (LIBOR) at which swaps are reset and the repurchase agreement (RP) rates at which government bonds are funded is not higher than the spread at which the trade was entered into. Over longer time periods, the range for the average of LIBOR-RP spreads is not that wide , but in the short run, swap spreads can show large swings based on relative investor demand for the safety of governments versus the higher yield of corporate bonds (with corporate bond issuers then demanding interest rate swaps to convert fixed debt to floating debt).
 

ShaktiRathore

Well-Known Member
Subscriber
#2
Hi,
If its hard for u understanding like this you can think of this IRS position of long Libor and short Repo as long a libpr as a position in bond(X) with average libor over the period equal to yield say y1=<libor> for the bond X + a short position in the repo govt. Bond (Y)with yield average of RR of y2=<RR>.Now spread of position=y1-y2 is the yield of the hypothetical Bond (X-Y) and value of this Bond(X-Y) over a period of time is value of X-value of Y(total money made) with net yield of y1-y2. Now if spread y1-y2 increases or to say yield of our hypothetical bond increases that decreases the value of our hypothetical bond(yield and prices of Bond are inversely related) that results in conclusion that as spread of position becomes higher the position shall not make any money(value of X-value of Y<=0) results in a loss. But on the other hand if there is net decrease in spread of y1-y2 that means yield of our hypothetical Bond decreases which results in the increase in the value of the hypothetical bond or to say that our position shall make money a positive value(value of X-value of Y>=0).
According to property of mean reversion of spreads over long term the spreads tends to even out and trader can utilize the spread for his gain over the short term only not long term per se. Over short term demand can fluctuate widely for the libor and govt. bonds so that spread can fluctuate widely so that there can be chances of making good money by entering in to IRS sorts of instruments.
thanks
 
#4
Hi everyone! I was wondering if maybe some practitioner could kindly explain the logic behind this strategy ..read through Shakhti's reply before and searched the forum but still cannot get this.
My understanding is as follows: there is a long position in a swap (+floating LIBOR, - fixed interest rate on a high-quality US corporate bond). Then there is a short repo-like position in a US Treasury bond: + fixed payments on the government bond, - floating LIBOR. At the transaction date, the swap rate is in excess of the US T-bond rate by more than is normal (due to temporary market disruptions). LTCM anticipated mean reversion which means that this spread is going to decline as corporate bonds get less risky. Is this a somewhat correct explanation?
 
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Flashback

Active Member
#5
LTCM was long more risky and less liquid bonds while was shorting liquid bonds.
They made small percentage unit profits on large volumes and high frequencies based on spread deviations and mean reverting between those bonds. They did not anticipate mismatch in correlations due to market contagion caused by Asian crisis nor default on Russian sovereign bonds. In the attempt to response on withdrawals, they were forced to sell off liquid bonds which caused further market crisis. Thus, that being said, exactly they did not anticipate mean reversion taking into account all risk factors.
 
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