Fixed Income Arbitrage
What is Arbitrage?
Arbitrage happens when an investor buys and sells an asset at the same time but in different markets or different forms with the aim to gain profit from an existing price difference on similar securities. The arbitrage techniques enable investors to self- regulate the market and aid in smoothing out fair price differences to ensure that securities continue to trade at fair market value. Arbitrage is a result of market inefficiencies and will not exist if all the market will be perfectly inefficient.
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Principally, arbitrage is purchasing in one market and concurrently selling in another, which helps in profiting from a minute and temporary difference. Thus, it is observed as a riskless profit for the investor or the trader. In the scene of the stock market, traders often attempt to exploit arbitrage opportunities.
For example, a trader buys a stock on a foreign exchange where the price has not yet fixed because of the constantly fluctuating exchange rate. Now, the price of the stock on the foreign exchange is therefore undervalued with comparison to the price and the local exchange. So, the trader makes a profit from this difference.
Fixed Income Arbitrage
Fixed-income arbitrage is an investment strategy that is usually used by hedge funds and leading investment banks. While using this strategy it is assumed by the investor that the opposing positions in the market take the benefits of small price differences which reduces the interest rate risk. It is a Market Neutral strategy. It means a strategy that is plotted in such a way that it lets the investor make profits (even if it’s off too small amount) in any case, whether the overall bond market will get higher or fall in the future.
Usually, here an investor purchases security at a low price and resale it at a higher price in just a few seconds. Fixed-income arbitrage requires fast trading and expertise in investment. Thus, we should consult a Hedge Fund manager before investing via this strategy.
Fixed-income arbitrage is created in such a way that it provides the investors with a fixed return for an agreed period of time. Meanwhile, in this agreed time the investors receive a fixed regular income. After this period gets over the initial amount that is borrowed will be repaid.
Such strategies tend to give very small returns and sometimes also cause huge losses. There is a risk that the price of security decreases which results in a loss. Sometimes it may also happen that the issuer is not able to pay the fixed payments or repay the investment in full at the end of the period.
Fixed Income Arbitrage is usually referred to as “picking up nickels in front of a steamroller”
Fixed income securities
These are issued by borrowers who require funds for long periods of time. These are the simple debt instruments that are either issued by private or public entities which in return are supposed to give a fixed income. These funds are fixed income instruments like government bonds, corporate bonds, municipal bonds, mortgage-backed securities (MBS). CDS (Credit Default Swaps) are also used sometimes. CDS are complex instruments that provide the buyer with protection against specific risks just like the insurance contracts.
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Some common Fixed Income Arbitrage Strategies
- Swap-Spread Arbitrage: It is the most used fixed-income arbitrage strategy. It consists of taking up opposing positions in an interest rate swap, a Treasury bond, and a repo rate to earn profits between the swap spread. It is between the fixed swap rate and the coupon rate of the treasury par bond and the floating spread (the difference between London Interbank Offered Rate and the repo rate). LIBOR i.e. London Interbank Offered Rate gives the globally accepted key benchmark interest rate that shows borrowing costs between banks. In other words, it gives the interest rate that banks charge to each other for lending loans.
- Yield Curve Arbitrage: It is the graphical representation that compares yields on bonds of different maturities. The flat yield curve indicates that the shorter and longer-term yields are close. The heavily sloped yield curve tells that there is a greater gap between short- and long-term yields. Here, the profit is gained when there is a shift in the yield curve by taking long and short positions in securities of various maturities.
- Capital Structure Arbitrage: This strategy gains profit from the price differences between various claims on a company, like its debt and stocks. An investor who believes that a company’s debt is overpriced compared to its stock, might reduce the company’s debt and buy the company’s stocks.
Given the advancement of technology, it has become very difficult to profit from the manipulation of prices in the market. Many traders have computerized trading systems to set monitor fluctuations in similar financial instruments. Any inefficient pricing setups are most of the time acted upon very quickly and the opportunity is often put to an end in a matter of seconds.
Author- Disha Agrawal
About the Author: Disha Agrawal is an Economics graduate and presently pursuing an MBA with a specialization in Financial Administration from the Prestige Institute of Management and Research, Indore. She is a keen learner and is intrigued by financial markets. She is committed to her work and strives for continuous improvement.