CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

35.5 A MORE COMPLEX TRADE: CONTINGENT YIELD CURVE STEEPENING

Beyond the simple directional and relative value trades just presented, global macro funds often look for unusual price fluctuations that can be referred to as far-from-equilibrium market conditions. These situations usually occur when a market's perceptions differ widely from the actual state of underlying economic fundamentals. They open the door to potentially profitable trades, provided that fund managers can find the adequate instruments to express their view.

As an illustration, consider the following trade. In February 1999, following the 1998 Russian default and the collapse of Long-Term Capital Management, financial markets were still experiencing tremendous volatility. The U.S. Federal Reserve had already lowered the federal funds rate twice in an effort to restore confidence and liquidity, but the European Central Bank (ECB) did not initially follow the second Fed cut. Although there was a high probability of further easing of interest rates in Europe should markets fail to stabilize, the implied volatility on two-year and 10-year German interest rates was priced at the same level. This essentially implied that markets had no opinion about whether the yield curve would steepen or flatten on a sell-off. This was clearly a statistical anomaly, as illustrated in Exhibit 35.2.

EXHIBIT 35.2 Regression between the 10-year German Swap Rate and the Spread between the 10-Year and Two-Year German Swap Rates

To arbitrage ...