JWBT729-bapp02 JWBT729-Chincarini Printer: Yet to Come June 19, 2012 20:5 Trim: 6in × 9in

APPENDIX B

The Mechanics of the

Swap Spread Trade

If you work at that which is before you, following right reason seriously, vigorously,
calmly, without allowing anything else to distract you, but keeping your divine
part pure, as if you should be bound to give it back immediately; if you hold to
this, expecting nothing, fearing nothing, but satisfied with your present activity
according to nature, and with heroic truth in every word and sound which you
utter, you will be happy. And there is no man who is able to prevent this.
—Marcus Aurelius

LTCM constructed many strategies to trade swap interest rate spreads over
government security interest rates. The firm implemented these within coun-
tries, across countries, and across different parts of the yield curve. In trading
terms, a bet that the spread between swap interest rates and government in-
terest rates will widen is called being long the spread.1 A bet that the spread
between swap interest rates and government interest rates will shrink is called
being short the swap spread. The mechanics of going long or short a spread
apply to any spread, not only to those between swaps and government yields.

The Long Swap Spread Trade

A long swap trade profits when swap spreads widen.

Box B.1 shows the basic steps in constructing a long swap trade. The
transaction flows are shown in Figure B.1 and represent the steps in creating
The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal, First Edition.
Ludwig B. Chincarini. 361
© 2012 Ludwig B. Chincarini. Published 2018 by John Wiley & Sons, Inc.
JWBT729-bapp02 JWBT729-Chincarini Printer: Yet to Come June 19, 2012 20:5 Trim: 6in × 9in

362 Appendices

FIGURE B.1 Example of Flows from Long Swap Spread Trade

S
i

L
i

the position. The diagram’s left shows LTCM’s repo transaction with coun-
terparty B. LTCM borrowed cash in exchange for a bond. The diagram’s right
shows LTCM’s swap agreement with counterparty A. LTCM will pay a fixed
interest rate over time of i S and receive a floating interest rate determined at
the time of i L ’s payment.2
At the figure’s bottom, LTCM buys the bond with the cash from the
repo transaction. Typically, dealers require haircuts on these transactions—
the buyer’s collateral value is more than the cash value. LTCM, however, paid
nothing extra on its positions, so financing this trade was very cheap.

Box B.1 Steps to Creating a Long Swap Spread

Position on $100 Million Notional

Step 1: Enter into a 10-year swap position to pay fixed (i S ) and receive LIBOR
(i L ) on a notional of $100 million.
Step 2: Use $100 million to purchase a 10-year U.S. Treasury bond.
Step 3: Repo the U.S. Treasury bond to a counterparty for a (1-) $100 million
loan at the repo rate (i R ), where  is the haircut.

The Short Swap Spread Trade

A short swap spread trade profits when swap spreads narrow. Traders create
one by following steps that are exactly the opposite of those used to make a
long swap trade (Box B.2). To execute a short swap spread trade, LTCM does
JWBT729-bapp02 JWBT729-Chincarini Printer: Yet to Come June 19, 2012 20:5 Trim: 6in × 9in

The Mechanics of the Swap Spread Trade 363

a reverse repo with counterparty B and receives the repo rate, then short sells
the government bond. LTCM pays floating interest and receives fixed interest
on a swap with counterparty A.

Box B.2 Steps to Creating a Short Swap Spread

Position on $100 Million Notional

Step 1: Enter into a 10-year swap position to pay floating (i L ) and receive fixed
(i S ) on a notional of $100 million.
Step 2: Reverse repo to obtain a U.S. Treasury bond from a counterparty and
pay cash of (1-) $100 million in exchange for the repo rate (i R ), where  is
the haircut.
Step 3: Short $100 million of 10-year U.S. Treasury bonds. Use proceeds to pay
cash position in reverse repo.