Fixed Income Securities
Ted Spread and Swap Spread in a Financial Crisis
Due April 12, 2012
Please complete these questions in groups of 2, to hand in. The grade is calculated as part of your participation grade, so participation, as with the last case, can improve your score substantially, even if your calculations aren’t all perfect!
Should Albert Mills do this trade? Back up your answer with the following analyses:
1. Write out the initial transaction and cash flows for the trade based on entering
the swap, purchasing the Treasury bond, and borrowing using the repurchase
agreement. Assume $1 billion notional principal for the swap and $1 billion face
value for the Treasury bond. You may be very precise in your calculations or use
the rounded numbers presented in the case. Assume that initial LIBOR is set at
2.51% and is fixed for three months (through February 2009), beginning the swap
date (November 5, 2008). Be sure to take into account the 2% haircut on the repo.
KTC is a fixed rate leg/payer and as that it pays fixed and receive floating rates. Moreover, KTC purchased a U.S. treasury bond of the same maturity and financed it with an overnight repo. Thus, the initial transactions should include the swap agreement which initially costs nothing and the purchased treasury bonds for which he would pay $21 million while the rest of the $1.04 billion which would be needed in order to buy $0.97 billion face amount of treasury bonds which will make TKC to be neutral with respect to change in the market’s interest rates it would be borrowed by the broker paying overnight repo rate. Thus, the initial investment is $21 million. The cash flows are more complicated and we will assume that all of them are paid in a quarterly base. Let us start with the cash flows that KTC is going to receive. From the swap trade KTC is going to receive $1 billion * 2.51% (libor)= 25,100,000 and $0.97 * 4.5%/2 = 21,825,000 from the treasury...
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