July 27th, 2007, 12:28 pm
You're trying to replicate the 5yr swap rate 2yrs fwd. Say you're receiving on spreads. Ideally, if there were a 2yr term market on repo, you could borrow a few different 7yr bonds (spread out your risk) for 2yrs, sell the bonds in cash, and receive on matched-maturity fwd starting swaps. Then the main source of risk in two years (I think) would be that the bonds might be rich to CT5.Since there's no term repo market, you can't exactly do that. Off the top of my head, I'd say that you could roll the bonds overnight (or roll term) and hedge out the funding risk by buying Eurodollars. Fed funds would be better than Eurodollars (less basis risk), but there isn't much liquidity past 6 months. The thing that sucks about this idea is that you're now exposed to the LIBOR-Funds basis widenting, the Funds-GC basis widening, or the bonds' getting really special. You can hedge out the LIBOR-Funds basis with basis swaps (I would), but there's nothing you can really do about the other two.