In the case study, investment manager Albert Mills is challenged on making the decision, when given the opportunity, on how to develop a trade and how much to appropriate for such trade structuring. This case study also discusses fixed-floating swaps, interest rates, and the different types of spreads (LIBOR, TED spread, swap spread), and financing arrangements.
Ryan D. Taliaferro, Stephen Blyth
Harvard Business School (211051-PDF-ENG)
Jan 18, 2011 (Revision: Jun 22, 2011)
Case questions answered:
- What is the TED spread? How would you compute it empirically?
- What is the swap spread?
- Why is the swap spread so low? a. Describe potential scenarios that can cause the spread to turn negative.
- Explain the swap trading strategy that Mills is studying. a. What are the components? (Hint: Consult Exhibit 4 of the case) b. How will this strategy make money? i. Describe market situations that will benefit this trading strategy. ii. Describe market situations that will hurt this trading strategy
- How is the strategy financed? a. Explain the capital that is tied up by this strategy. b. How does this capital requirement change over time as the swap spread becomes more positive (or more negative)?
- What are the main risks in the trade that Mills is about to undertake?
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Fixed Income Arbitrage in a Financial Crisis (C): TED Spread and Swap Spread in November 2008 Case Answers
This case solution includes an Excel file with calculations.
1. What is the TED spread? How would you compute it empirically?
The TED spread refers to the treasury-eurodollar spread, and is empirically calculated as:
Ted Spread = 3 months LIBOR – 3 months Treasury Bills Yield (typically denominated in basis points)
As the difference between the London Interbank Offered Rate (LIBOR), the unsecured borrowing rate of financial intermediaries, and the “risk-free” rate the US government borrows at, the TED Spread gives an indication of the varying credit risks in the general economy.
A widening TED spread would imply an increased risk of credit default by commercial banks relative to the US government and vice versa.
2. What is the swap spread?
The swap spread refers to the difference between the fixed rate paid on the fixed leg of a fixed-floating swap and the yield of the on-the-run comparable treasury with a similar maturity.
Typically a premium over the US treasury, it reflects the associated risk of trading with a private counterparty, by comparing the fixed payment to a “risk-free”…
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