Intro to Rates Relative Value Trading
[CODE] Academic research on rates RV, creating zero and forward curves, and historical failures with Rates RV
Hello!
Today, we will be exploring yield curve construction and various interpolation methods. This work is required in the rates relative value trading business.
We will also be covering academic papers that suggest superior interpolation methods, as well as the rise and fall of a famous firm that implemented rates relative value trading.
Let’s get into it.
Fall of Long Term Capital Management
Long-Term Capital Management launched in 1994 and quickly became a star. The fund delivered strong net returns in its first four years, with about 21 percent in 1994, 43 percent in 1995, 41 percent in 1996, and 17 percent in 1997. By early 1998 the fund had roughly 4.7 billion dollars of equity, a balance sheet near 129 billion dollars, and more than a trillion dollars of interest rate derivatives notional.
The core business was rates relative value. They bought Treasuries or swaps that looked cheap, shorted those that looked rich, and waited for prices to move back toward a smooth curve.
The turn came in August 1998 after the Russian default. Investors rushed into the most liquid Treasuries and away from everything else. On-the-run issues got richer and off-the-run issues got cheaper, while swap spreads widened and funding haircuts increased.
Losses mounted quickly, reaching several billion dollars within months. With margin calls rising and markets thin, the fund could not scale down without worsening prices. A group of large banks injected capital in a deal arranged by the New York Fed to avoid a disorderly unwind. The lesson for rates relative value is straightforward. These trades can work well when liquidity is ample and funding is stable, and they can fail when the need for liquidity overwhelms the expected convergence.