The article Swap Spreads:2010 talks about a financial abnormity that the 30-year swap spread has kept negative since late 2008 for a long time, and an arbitrage opportunity based on the bet that LIBOR would never fall below equivalent government bond interest rates.
Question1: Would you recommend that GIC do the bond/swap trade discussed in the case? Why or why not?
The arbitrage portfolio is to enter into a 30-year LIBOR swap to pay fixed and receive floating interest payment, to long a 30-year government bond, and to take rolling short positions in 3-month T-bills. In practice, the 3-month T-bills are replaced by taking a rolling short position of repos daily and entering into a 3-month OIS to receive floating and pay fixed (OIS rate) interest payment.
Thus, Payoff = (Government Bond Rate- Swap Rate)+(LIBOR-OIS rate)
Because at present the government bond rate is bigger than swap ...view middle of the document...
And there would be increasing difficulty to finance in repo market, because as interest rate goes up, the value of government bonds goes down, and since the government bond is collateralized to avoid credit risk, the loan amount would be less and less. One way to avoid such risk is to take a long position of Eurodollar futures in order to hedge the increase in Feds fund rate.
The second risk is the cost of financing. The repo market requires paying the bid/ask spread everyday, which might form a big cost relative to the financing amount.
Finally, although the article says that the LIBOR-OIS spread is little changed, it cannot guarantee that the spread won’t be volatile in the 30-year time.
To sum up, the trade is feasible, but there are still some things that need to be concerned.
Question2: What would be the internal rate of return on the trade over 30 years?
Suppose there are no transaction cost, the value of government bonds does not change very much, the notional amount is 1 billion US dollars.
The payment is delivered every 3 months, there are 120 deliveries in total. N=120.
Payment at time 0 is -1.5%*1,000,000,000=-15,000,000
Payment at each delivery time
Thus, the IRR=11.33%*4=45.32%
Question3: Why do you think the 30-year swap spreads are negative? What type of financial institution would want to receive fixed versus paying LIBOR at these rates?
There are two reasons why the swap spread is negative. First of all, people are more risky. The swap spread is the difference between LIBOR swap rate and governmental bonds rate of the same horizon. So it can also been seen as the premium at which large financial institutions can borrow. Investors now think sovereign credits as riskier than highly rated corporates. Second, liquidity is very low in the long end of swaps. The low liquidity is mainly driven by hedging of exotic derivatives.
Pension funds would be willing to would want to receive fixed versus paying LIBOR at these rates, as they are more likely to receive fixed payments.