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Household’s spreads had widened to 800 basis points over Libor in the five-year bond and 1,000bp in the three-year in October, while its share price rose $6 to $26.
Boaz Weinstein, head of credit derivatives trading for the Americas at Deutsche Bank, decided to make the most of this by going long credit, which he did by buying $10 million-worth of five-year bonds at 75 cents on the dollar. He estimated that the recovery rate for Household’s debt would be 45 cents and so had 30 points of downside to protect. Against this default risk, Weinstein sold short $2.5 million-worth of equity – 96,000 shares – at $26, resulting in a partial hedge.
The trades took place on October 23 and 24. A week later, Household’s spread tightened from 800bp to 600bp and its equity price fell from $26 to $23. Weinstein held out, believing there was more tightening to come. One week after that, Household was bought by HSBC. Its spreads tightened to 200bp while its equity rose to $28. Weinstein cashed in. Selling the bonds – which rose to 100 cents on the dollar – made him $2.5 million. He lost $192,000 on the equity short. Total profit was $2.3 million.
