Case Report
Autor: YINZHI HUANG • December 4, 2016 • Term Paper • 1,391 Words (6 Pages) • 772 Views
1.Given the economic and political turmoil that took place in 1998, what bet would have earned John Meriwether and his team of arbitrageurs the highest profits?
US Yield spread widen: in 1998 the spread between Treasury and mortgage was highly widen. And also as a result of Asian tiger effect, the sound fixed in come investment like US Treasury decrease their yield this lead to a bigger spread between the different risk level investment.
John Meriwether would earn the highest profits if he bet in fix income investment at beginning of the 1998, and take short position when the market go back to the normal.
2.Suppose the yield on a two-year Treasury note was 4%, and the yield on a five-year Treasury note was 6%. If you expected this yield spread to widen, explain the spread trade you would execute.
The yield spread between the two-year Treasury note and five-year Treasury note is 6%-4%=2%. If the yield spread would become widen, then the 6% should increase or 4% decrease, which means that the price of five-year Treasury will decrease and two-year Treasury will increase. So, we should sell five-year Treasury and buy two-year Treasury.
a. After a year, suppose the yield on a two-year Treasury note fell to 3.5%, and the yield on a five-year Treasury note rose to 6.5%. Would you profit or lose on your trade? Explain.
The yield spread between two-year Treasury and five-year Treasury rise to 6.5%-3.5%=3%, then we would earn profit on the trade. Because of the 0.5% increase in five-year Treasury yield, the price of this note would be decrease more. The 0.5% decrease in two-year Treasury yield would cause the price of note increase more. So, the spread position would be increase to make profit.
b. After a year, suppose the yield on a two-year Treasury note rose to 6% and the yield on a five-year Treasury note fell to 5.5%. Would you profit or lose on your trade? Explain.
The yield spread between two-year Treasury and five-year Treasury fall to 6%-5.5%=0.5%, then we would loss on the trade. Because of the 0.5% decrease in five-year Treasury yield, the price of this note would be increase a little bit. The 2% increase in two-year Treasury yield would cause the price of note decrease. So, the spread position would be decrease to make loss.
3.Using the information for Exhibit 8.2, calculate the return on assets and the return on equity if LTCM had earned only a 1% net return (instead of a 5% net return) on the investment assets purchased with borrowed funds.
Equity(Millions $) | Assets(Millions $) | Dollar Return on Assets(Million $) | Return on Equity | Return on Assets |
5,000 | 125,000 | 50+1,200=1250 | 1,250/5,000=25% | 1,250/125,000=1% |
4.Why did LTCM have difficulty raising its level of risk?
LTCM could not raise its portfolio’s risk level to the desired height. One reason LTCM found this task to be so difficult was because it was engaged mainly in spread traders, which are inherently less risky than outright positions. Another reason for LTCM’s inability to increase its level of portfolio risk can be traced to the fund’s size. LTCM was so large that, when an opportunity presented itself, the fund would quickly try to build a position, but in doing so, LTCM would buy and sell in such volumes that market prices would change and erode the potential profits. As a result, LTCM’s ability to make large trades was curtailed. Finally, LTCM had difficulty increasing its level of risk because success breeds imitators. Imitators with similar strategies and portfolios began to dot the financial landscape like dandelions in spring, Competition made the markets more competitive, which reduced the opportunity to earn returns on misprices assets.
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