Can some one explain how an arbitrage opp. is created using Long off the run and Short on the run bonds? And why in case of LTCM the spread increased and how it resulted in the loss? Thanks
the simple idea is a convergence in spreads. if you assume the simple case that usually on the run trade at a higher price than off the run, then you can long the off the run and short the on the run to speculate on mean reversion. however, during the russian crisis there was a huge run towards ‘liquidity’ meaning ppl bought more on the run than off the run thus widening the spread. if you are leveraged up to 1xx billion, then if the spread widens just a few bp it can break you. if you want more insight: http://delong.typepad.com/sdj/2008/04/the-on-the-run.html
thanks it helps…