The Yield Spread in the Global Market

Question One

During this period the yield spread had increased in the global market. In this case, the spread was between bond rates of US Treasury and mortgage rates, Treasury bond rates and corporates bond. Further, the spread had widened to the bond rate of B-rated and 3A-rated bond rate, the bond rate of emerging market and US Treasury bond rate. Thus, LTCM would have gained profit if the bet was yield spread to widen.

Question Two

(a) In this case, the investors may tend to prefer short-term bonds or long-term bonds as the latter have a positive risk premium. Thus, the upward sloping yield curve is expected to be steeper.

(b) On the contrary to option (a) above, the yield curve sloping downward would be less steep and in some cases, the upward slope would slightly positive. However, the upward slopes will slightly positive when there is a positive risk premium for the long term bonds.

Question Four

The major reason why the rising level of risks by LTCM failed was that their main activity includes spread trades. In this case, the trading activity is inherently less risky compared to other outright positions. Further, the size of the fund results was against the rising level of risk. The market position of LTCM was large that by selling or buying securities change the market prices reducing the potential profits. As a result, the option LTCM undertook was to take smaller positions than its potential as they were uncertain of liquidating such a position at a favorable rate.

Question Five

If LTCM was funded using most liquidity cash equivalent, the dealers could have been forced to sell off a lot of securities in an attempt to cover their derivatives trade. Further, as the lender had demanded a low haircut, the losses could have accrued while liquidating the collateral. Also, there was uncertainty on the decision of funding LTCM as to whether would have liquidated their collateral. However, such liquidations are fully acceptable under Bankruptcy Code, and it’s believed that long-term capital could have sought bankruptcy. As a result, lenders

Question Nine

The failure of LTCM was widely contributed by the use of Value at Risk (VaR), which is contrary to the method used currently to set the capital requirement in the banking sector. However, the method was inadequate to be employed as risk management tool. Further, the hedging model used by LTCM was unsuitable, and it can only be employed in cases of commercial banks. Thus, the time horizon set should relate to the liquidity of the asset or time sufficient to organize an orderly liquidation. Additionally, the period required to organize for additional funds should correspond to the time horizon. However, it is no easy as additional funds could only be required after a large loss of the funds.

Question Eleven

The major catalyst of a chain reaction that caused LTCM to fail includes exogenous macroeconomic shocks, hedge fund reactions, and feedback effects. It is as a result of this catalyst that affected LTCM’s creditworthiness and its funding sources. The exogenous shock widened yield spreads as a result of Asian and Russian crisis, economic and political unrest. Further, endogenous shock caused the market spreads shifted swiftly resulting in LTCM’s measure of risks principal which underrates the company’s risk exposures. Feedback shocks caused the LTCM competitors to protect themselves resulting in a reduction of market liquidity. Similarly, other LTCMs aggressively set market positions to gain from the failure of LTCM.

Chapter Nine

Question One

In this case, Amaranth would not have lost as much as it gained in the year 2005. Amaranth placed the bet out-of-the-money call options. Thus, the sum of its loss includes the premiums as well as sacrificed interest income.

Question Two

In this case, it is good to buy a futures contract and buy the commodity if there is an available seller. Further, since liquidity plays a critical part in trade, there must be a counterparty who is selling the contract which is buying or selling. Thus, on NYMEX I would sell future contracts if I am long or buy future contracts if I am short to the possible buyer or seller.

Question Three

It is not right for the Amaranth devastating losses, and the characterization would be inaccurate. Brian had sufficient knowledge of the natural gas derivatives market while Nick had a better understanding of the strategies implemented by Brian. However, the strategy adopted was related to price and spread shifts which did not occur.

Question Four

The initial investments made by Amaranth, most of them were conservative in nature. Further, energy index had made consistent returns of thirty percent annually. However, Hunter was able to make speculations positions on the future contract of natural gas. Further, Hunter invested in borrowed funds to place his bets.

Question Nine

In this case, Amaranth made speculations on uncovered natural gas contracts. However, US Congress has no definition of “excess speculation” or clarification on the unwarranted price changes. Thus, Amaranth could not have violated US law by making excessive speculations.

Question Ten

Manipulation of the price spreads may be done by affecting storage. Thus, Brian could have manipulated the prices by placing the bid on winter of future contracts in the year 2006/2007. Secondly, manipulation of prices can occur in playing prices between exchanges. In this sense, Hunter used NYMEX and ICE to make natural short positions before the expiration of future contracts in March 2006.

Question Twelve

In this case, implosion affects the participants. On the other hand, explosion affects the participants and bystanders. Thus, Amaranth has been considered to be an implosion rather than an explosion since it affected its investors, shareholders as well as employees. As a result, LTCM’s exposure of risk was high, and the operating risk management model was not sensitive to the demands of the company and its exposures.