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What is a Fixed Income Hedge Fund Spread? (January 5, 1999)

A spread is a relationship between two securities, instruments, or markets. It is usually determined by the arithmetic difference between yields on two fixed income securities or between 2 prices for futures contracts.

For example, if a benchmark treasury bond is yielding 4.81 percent and the referenced mortgage backed security is yielding 5.00 percent then there is a 19 basis point (bp) pickup for owning the mortgaged backed instrument relative to owning the treasury bond. This 19 basis point difference is also the spread between the two instruments at that moment in time.

Assume that events are such that the treasury yield declined to 4.75 percent but the mortgage backed security sold off in price. This market decline in the MBS price would boost its yield to say 5.25 percent.

Then the new mark-to-market spread would be 50 basis points. Depending on the effective durations - or even maturities - of the two securities, there can be significant dollar swings.

What does this mean? Depending on the actual positions involved, an investor solely positioned in long treasuries would experience price appreciation. An investor who was only long the MBS would show a mark-to-market loss. If one was initially hedged by being long the mortgages and short the treasuries, then that person would lose on both legs or sides of the spread. These positions which were initially hedged would become displaced due to a disruption in their correlation.

The dollar impacts can be significantly different depending on the maturities, the durations, and the option adjusted durations. Let us analyze the simple 100 by 100 balance sheet positions. These are mentioned down below in the previous article. By substituting millions for units, it means that an account is long 100 million of one security and short 100 million of another. If the duration was 90 days like a 3 month treasury bill then each basis point change would be equal to $25 per million. This is comparable to the T-bill or eurodollar futures.

In the current example, this would indicate $2,500 ($25 per futures contract equivalents, or 25 x 100) for the 100 million. Since the basis or spread moved out to 50 bp from 19 bp, this 31 basis point change would be equal to $775 per million or $77,500 for the total portfolio.

If the simplified duration was three years, then the dollar impact would be $300 per basis point per million. For this illustration, the total swing for the $100 million portfolio would be $930,000.

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How does a Hedge Fund Operate?

Actually, the basic structure is quite simple. The positions are itemized in a balance sheet. The daily mark-to-market process contributes to the creation of a Profit and Loss (P&L) statement.

The long market oriented positions are the assets and the short positions are the liabilities. Therefore a purchase of a treasury bond put against an existing long treasury bond position would result in a hedged position.

The following simplified table highlights the concepts.

3 Month Paper2 2
Russian Bills3 0
Rubles0 3
Corporate Bonds15 14
Treasury Bonds10 11
Other AAA Bonds20 19
Mortgage Bonds50 51
TOTAL100 100

In actual practice, the positions would be more complex and detailed. Nevertheless, a cursory examination shows that the firm is hedged given properly weighted longs and offsetting shorts.

The hedge fund's other significant balance sheet would show assets of 100, liabilities of 96 and equity of 4. The fund could have assets of 100 because of borrowing and leverage. Banks and brokerage firms operate on the same principles of leverage or reserve requirements.

If "Sam Sez" is correct about the Russian default situation, then the decline of 3 units in the long position was not offset by the short ruble transaction. Therefore an immediate 3 unit loss was incurred which would reduce the shareholder equity to just 1 unit.

The above example could have shown 100 different categories each equally weighted. Nevertheless, only 3 percent placed in the Russian market would be sufficient to effectively level a hedge fund because of the leverage.

This is probably the tip of the iceberg in the world's major financial markets. It is likely that other borrowers have defaulted as well. But their demise has not yet been made public.

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