Investments, tenth edition

A

B

 Figure 26.1 

A pure play.  Panel A,  unhedged position.  Panel B,  hedged position.  

 An apparently market-neutral bet misfired badly in 1998. While the 30- versus 29½-year 

maturity T-bond strategy (see Example 26.1) worked well over several years, it blew up 

when Russia defaulted on its debt, triggering massive investment demand for the safest, 

most liquid assets that drove up the price of the 30-year Treasury relative to its 29½-year 

counterpart. The big losses that ensued illustrate that even the safest bet—one based 

on convergence arbitrage—carries risks. Although the T-bond spread had to converge 

eventually, and in fact it did several weeks later, Long Term Capital Management and 

other hedge funds suffered large losses on their positions when the spread widened 

temporarily. The ultimate convergence came too late for LTCM, which was also facing 

massive losses on its other positions and had to be bailed out.  

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