Editing Long-Term Capital Management (section)

=== Fixed income arbitrage ===

Fixed income securities pay a set of coupons at specified dates in the future, and make a defined redemption payment at maturity. Since bonds of similar maturities and the same credit quality are close substitutes for investors, there tends to be a close relationship between their prices (and yields). Whereas it is possible to construct a single set of valuation curves for derivative instruments based on LIBOR-type fixings, it is not possible to do so for government bond securities because every bond has slightly different characteristics. It is therefore necessary to construct a theoretical model of what the relationships between different but closely related fixed income securities should be.

For example, the most recently issued [[United States Treasury security#Treasury bond|treasury bond]] in the US – known as the benchmark – will be more liquid than bonds of similar but slightly shorter maturity that were issued previously. Trading is concentrated in the benchmark bond, and transaction costs are lower for buying or selling it. As a consequence, it tends to trade more expensively than less [[Market liquidity|liquid]] older bonds, but this expensiveness (or richness) tends to have a limited duration, because after a certain time there will be a new benchmark, and trading will shift to this security newly issued by the [[Bureau of the Public Debt|Treasury]]. [[Fixed income arbitrage|One core trade]] in the LTCM strategies was to  purchase the old benchmark – now a 29.75-year bond, and which no longer had a significant premium – and to [[Short selling|sell short]] the newly issued benchmark 30-year, which traded at a premium. Over time the valuations of the two bonds would tend to converge as the richness of the benchmark faded once a new benchmark was issued. If the coupons of the two bonds were similar, then this trade would create an exposure to changes in the shape of the typically upward sloping [[yield curve]]: a flattening would depress the yields and raise the prices of longer-dated bonds, and raise the yields and depress the prices of shorter-dated bonds. It would therefore tend to create losses by making the 30-year bond that LTCM was short more expensive (and the 29.75-year bond they owned cheaper) even if there had been no change in the true relative valuation of the securities. This exposure to the shape of the yield curve could be managed at a portfolio level, and hedged out by entering a smaller steepener in other similar securities.