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Please answer questions 1-3; question 4 is a bonus question
1) NEGATIVE BASIS TRADE (6 POINTS)
A) Describe a “negative basis trade” in 1 paragraph
Given the following information
i) Marriott hotel bond 5 year maturity; priced at par; yield (and coupon) 7%; $100mio available to be purchased by a hedge fund
ii) Marriott hotel bond could be repo financed at LIBOR plus 0.15% (15bps) at a haircut of 10%
iii) Protection could be purchase on the Marriott hotel bond for 5 years in the credit default swap market for an annual cost of 1%
iv) the 5 year swap interest rate swap fixed rate is 5% vs LIBOR (flat … not incremental spread)
v) for simplicity ignore day count fractions or to put it another way assume all calculations subsequently are done on a an annual 30/360 basis (ie the day count fraction equals 1)
B) Draw a “boxes and arrows” diagram of a negative basis trade on the Marriott hotel bond
C) Solve the following
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(i) Solve the return to the hedge fund (the equity the hedge fund has to put into this negative basis trade position) on a LIBOR plus basis
(ii) Solve the return to the hedge fund (the equity the hedge fund has to put into this negative basis trade position) on a LIBOR plus basis IF THE HAIRCUT ON THE REPO IS INCREASED TO 20%
(iv) Solve the return to the hedge fund (the equity the hedge fund has to put into this negative basis trade position) on a LIBOR plus basis IF THE SPREAD OVER LIBOR ON THE REPO IS INCREASED TO 2%
D) In addition to the changes in the repo terms, describe other risks to the hedge fund from the negative basis trade.
2)LONG SHORT EQUITY (5 POINTS)
Long short equity managers do ‘best” when stocks are not too correlated with each other (they need some stocks to be rising and some to be falling to make money). Using equity options, describe a “correlation” trade which might help the long/short manager do better when stocks are highly correlated with each other. A table and a diagram illustrating the trade (and a paragraph of explanation) is required in the answer. Why do you think Long/Short managers rarely put on “hedges” of this type (think of this in terms of clients who could apply the logic of the Miller Modigliani arguments in capital structure to this hedge)?
3)YIELD CURVE (5 POINTS)
A) Describe the Litterman Scheinkman model for the shape of the yield curve
Assume interest rate swaps for 2, 5 and 10 years where the 2 year swap rate is 1%, the 5 year swap rate is 3% and the 10 year swap rate is 4%. Using a “boxes and arrows” diagram, a rough payoff table, and an explanatory paragraph describe positions which will take advantage of the following scenarios
B) A rise in interest rates (ie show a position that will make money if rates rise)
C) A steepening of the yield curve (ie show a position that will make money if longer term interest rates rise relative to short term ones)
D) A twisting of the yield curve (ie show positions that will make money if the yield curve steepens from 5-10 years but flattens from 2-5 years)
E) Discuss any other structuring issues with these positions (ie carry, duration mismatch, counterparty risk etc)
4)CONVERGENCE VS DIVERGENCE (3 POINTS)
Discuss why certain “convergence” or “relative value” strategies might be like a sold out of the money option in some respects. Similarly, discuss why certain directional trades (CTAs, Global Macro etc) might be like a long option in some respects. Explain why this might or might not be so using a binomial tree and an explanatory paragraph.
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