The financial marketplace has evolved significantly over the years.
Traditionally, businesses would build capital using debt via bonds or loans or invest in stocks, real estate, etc.
Fixed income arbitrage strategies have emerged in the past two decades and are an area of great opportunity for businesses.
Large-scale traders and investors, such as institutional participants and hedge funds, use arbitrage tactics to make money in addition to trading assets in the financial markets.
In this blog, we talk about what fixed income arbitrage is and related strategies.
What is fixed income arbitrage?
Fixed income arbitrage is a trading strategy that aims to exploit pricing inefficiencies in fixed income markets.
This approach requires investors to go long on one security while simultaneously shorting another to profit from the price differential.
These strategies are usually market-neutral, meaning investors can profit regardless of how the market moves in the future.
Because price discrepancies in fixed income assets rarely remain for lengthy periods, an investor who wishes to use fixed income arbitrage must do so within a short period of time, after conducting fixed income research.
Two fundamental conditions must be met for fixed income arbitrage methods to perform correctly.
- Fixed income assets must be liquid if they are to be bought and sold in the market with relative ease.
- The securities employed in the arbitrage method preferably need to be very similar to one another, with just minor variances if any.
Fixed income arbitrage strategies
The following are the four of the fixed income arbitrage strategies most often utilised:
1. Swap spread arbitrage (SS)
Swap spread arbitrage is one of the most popular arbitrage strategies and has two legs.
In the first leg, the arbitrageur engages in a par swap, receiving a fixed coupon rate in return for paying the floating LIBOR rate.
In the second leg, the arbitrageur shorts the same maturity par Treasury bond as the swap and then invests the money in a margin account that pays the repo rate.
The second leg’s cash flow includes paying the Treasury bond’s fixed coupon rate and receiving the repo rate.
Thus, the strategy is a straightforward bet on whether the received fixed annuity in the first leg is greater than the cash flow of the second leg.
The strategy is profitable if the first leg is greater than the cash flow of the second leg.
2. Yield curve arbitrage (YC)
In this strategy, investors have to take long and short positions simultaneously at contrasting points along the instrument’s yield curve to make profits. This method entails identifying points on the yield curve where there is a pricing mismatch, which results in rich or cheap points.
Investors will re-model the bond to identify where the actual yield differs from the model-implied yield and speculate on the curvature’s reversion.
3. Volatility arbitrage (VA)
In volatility arbitrage strategy, one can profit from pricing disparities that occur between the instrument’s predicted future price volatility and the implied volatility of options.
Here, the individual must determine whether the implied volatility of the fixed income security is overpriced/underpriced.
4. Capital structure arbitrage (CS)
In a capital structure arbitrage strategy, investors profit from the mispricings in a single company’s asset classes.
Arbitrageurs try to make money by exploiting mispricing in these securities.
Like other arbitrage tactics, the arbitrageur buys inexpensive securities and sells overpriced securities.
This method is specifically designed to profit from a company’s debt and other instruments being mispriced.
Companies using fixed income arbitrage strategies must be prepared to take on some risk. This is because fixed income arbitrage often yields returns but can result in large losses.
Furthermore, it is useful for large institutional investors with significant assets, due to the restricted profits and high risks.
In conclusion, fixed income arbitrage may be a solid investment alternative, but it is best suited for institutional investors with substantial assets and a willingness to take risks. Companies would, however, need to conduct fixed income research before ploying any strategy.
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