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June 06, 2005

Deep Pockets

Brad Setser writes:

Brad Setser's Web Log: So will the proliferation of hedge funds end with a bang or a whimper: To take an example from LTCM: if you are betting on the convergence of the price of a 29 and 30 year Treasury bond -- shorting say the on-the-run 30 year and going long the off-the-run 29 year -- you are hedged against rising interest rates, but not against a widening of the differential between the price of a 29 and 30 year Treasury bond...

But--if you are well enough capitalized--a widening differential between 29 and 30 year Treasury bonds is not a risk but an opportunity. You're long the 29-year and short the 30-year because the 29-year was underpriced. If the price of the 29-year drops relative to the price of the 30-year, it's even more underpriced--and the appropriate response is to double up your position. As long as you are well enough capitalized to be able to hold them both to maturity if necessary--as long as you can wait as long as it takes for their prices to converge--you're still fine.

I have been told that the people who took over LTCM's positions in the fall of 1998 did very well with them indeed.

Posted by DeLong at June 6, 2005 08:48 PM