Fixed income arbitrage

economic-dictionary

Fixed income arbitrage is a relative value strategy applied in financial markets to fixed income instruments.

Being a relative value strategy, we deduce that it tries to exploit inefficiencies. Understanding by inefficiency something that is irregular, which theoretically should not be the case. The inefficiencies fixed income arbitrage tries to exploit are mathematical in origin. In other words, they are irregularities derived from the analysis of the theory of the time structure of interest rates. This theory establishes mathematical relationships between interest rates of different terms. In such a way, that when these relationships are not fulfilled, an irregularity is occurring that can be exploited.

Types of fixed income arbitrage

There are several ways to apply arbitrage techniques on fixed income instruments. Depending on where the inefficiency is considered to exist, one type of operation or another will be applied:

  • Arbitration of bases: The base is the difference between the price of the futures market and the spot market. When the prices differ, it can be said that there is an inefficiency.
  • Asset swaps: An asset swap combines an interest rate swap with a bond. For example, buying a bond swap. In other words, buying a bond and covering the collection of its coupons with a swap for which it is paid fixed and received variable.
  • TED spread: It refers to the spread between the IRR of government bonds and the pair swap rate in the same currency.
  • Yield curve arbitrage: They are formed by the set of techniques that take long and short positions at different points on the IRR curve. The purpose is to exploit inefficiencies in relative prices. For example, the two-month Euribor future must have the same interest as the sum of the 1-month Euribor for the next two months, if not, you can arbitrate and obtain immediate benefits.

Likewise, it should be noted that relative value strategies regarding convertible bonds and mortgage-backed securities are also part of fixed-income arbitrage. However, since they are products with characteristics that make them unique, they deserve a different treatment. That is, although theoretically they are relative value strategies in fixed income, due to their importance and dimension they deserve a separate treatment.

The above strategies are highly complex mathematical and financial strategies. They are primarily run by hedge funds, also known as hedge funds. Although there are prop trading companies and individual traders dedicated to it.

Fixed Income Arbitrage Risks

One of the most striking characteristics of fixed income arbitrage is its low exposure to risk. In some cases, the risk may appear to be zero, but it is not. It cannot be overlooked that the inefficiency discovered may not be an inefficiency. That is, the models may not correspond to reality. In any case, the main sources of risk are:

  • Credit rating risk
  • Insolvency risks
  • Credit risk
  • Exchange rate risks
  • Model risk (the model is not always accurate)
  • Tail risks (very unlikely events in the model)
  • Liquidity risk
  • Monetary policy risk

Difference between fixed income arbitrage and statistical arbitrage

It cannot be overstated that fixed income arbitrage is not comparable to statistical arbitrage. Statistical arbitrage attempts to take advantage of statistical inefficiencies. Meanwhile, fixed income arbitrage attempts to identify inefficiencies of mathematical origin. Put in even simpler terms, statistical arbitrage is based on what you consider historically probable. For its part, fixed income arbitrage is based on what it should theoretically be.

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