Case Report of Swap Spreads, 2010

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 rate, the benefit of this leg can be locked since both are fixed rates. So, as long as LIBOR is bigger than OIS rate, entering the trade can make arbitrage profit.

In this case on Friday, August 13, 2010, using the data in the article, we get the payoff=(3.875%-3.445%)+(0.369%-0.165%)=0.63%

The positive payoff is a proof to recommend GIC do the bond/swap trade, but there also exists some risks.

The first risk that needs to be concern is the rolling position of repo. If the repo rate, which tracks the effective Fed funds rate, goes up, GIC needs to pay more and more money for the old debt before it can borrow new. 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...