Suppose you are a strategist for a hedge fund. Your research indicates that the quality spread...

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Suppose you are a strategist for a hedge fund. Your researchindicates that the quality spread for BBB bonds and AAA bonds is150 basis points in periods of economic slowdown and only 100 bp inperiods of economic expansion. Currently, the economy is in arecession, and one- and two-year zero coupon bonds for AAA and BBBbonds are trading at 6% and 7.5%. Leading economic indicators,though, strongly point to the economy hitting its trough relativelysoon and then expanding over the next year.
Given the economic growth forecast, construct a quality spreadfor your hedge fund formed by going short in one of the bonds withthe proceeds used to purchase the other. Assume perfectdivisibility.
Show what your hedge fund’s profit or loss could be if youclosed your position a year later and the economy were growing andyields on AAA bond had increased to 7% and the quality yield spreadnarrowed to 100 basis points as you predicted. Assume a flat yieldcurve.
Show what you hedge fund’s position would be if yields on AAAbond had instead decreased to 5%, but the quality yield spread werestill 100 basis points as you predicted.
What would happen to your profit or loss if the yield spreadwidened instead of narrowing?

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3.6 Ratings (432 Votes)

All financials below are in Face value FV of bonds have been assumed to be 1000 which is a standard assumption for question of this kind Price of 2 year zero coupon bond ZCB FV 1 S22 For AAA rated bond S2 6 hence price of 2 year AAA rated ZCB 1000 1 62 89000 For BBB rated bond S2 75 hence price of 2 year BBB rated ZCB 1000 1 752 See Answer

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Suppose you are a strategist for a hedge fund. Your researchindicates that the quality spread for BBB bonds and AAA bonds is150 basis points in periods of economic slowdown and only 100 bp inperiods of economic expansion. Currently, the economy is in arecession, and one- and two-year zero coupon bonds for AAA and BBBbonds are trading at 6% and 7.5%. Leading economic indicators,though, strongly point to the economy hitting its trough relativelysoon and then expanding over the next year.Given the economic growth forecast, construct a quality spreadfor your hedge fund formed by going short in one of the bonds withthe proceeds used to purchase the other. Assume perfectdivisibility.Show what your hedge fund’s profit or loss could be if youclosed your position a year later and the economy were growing andyields on AAA bond had increased to 7% and the quality yield spreadnarrowed to 100 basis points as you predicted. Assume a flat yieldcurve.Show what you hedge fund’s position would be if yields on AAAbond had instead decreased to 5%, but the quality yield spread werestill 100 basis points as you predicted.What would happen to your profit or loss if the yield spreadwidened instead of narrowing?