Fixed income arbitrage

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Fixed-income arbitrage is a group of market-neutral-investment strategies that are designed to take advantage of differences in interest rates between varying fixed-income securities or contracts (Jefferson, 2007). Arbitrage in terms of investment strategy, involves buying securities on one market for immediate resale on another market in order to profit from a price discrepancy. [1]

Contents

Fixed-income securities are debt instruments issued by a government, corporation, or other entity to finance and expand their operations. [2] The purchasing of any fixed-income security is known as a loan from the investor to the issuer. These ‘loans’ made from the investor to the borrower are in exchange for regular income payments to the investor, as well as the investor receiving the capital returned upon maturity of the loan. [3]

The mechanics of the agreement are similar across all variations of fixed-income instruments, whereby there is a fixed tenor and schedule of income payments. Repayment of capital at maturity is expected and will only not occur if the issuer defaults or becomes insolvent. The following are examples of fixed-income securities:

The mechanics of the strategy are to purchase a fixed-income security and resell it at a higher price. The strategy is used when there are signs of mispricing of fixed-income securities in the market, whereby, for example, fixed-income arbitrage funds will take a short or long position on the security to benefit when the price is later corrected in the market. [4] Fixed-income securities differ from equities, whereby for fixed-income securities dividends are non-discretionary. [5] The strategy is most commonly used by investment banks and hedge funds globally. See also Fixed-income relative-value investing.

Fixed-Income Arbitrage Strategies in the Market

Swap Spread Arbitrage

Within the fixed-income markets, an interest-rate swap is a derivative that exchanges the cash flows generated from a fixed-rate loan (a fixed-income security) to the cashflows generated from a floating-rate loan. [6] The group receiving the fixed-rate (E.g. receiving the fixed-rate on a Treasury Bond), better known as the Yield to Maturity Swap Rate (‘YTMsr’), pays the floating Bank Bill Swap Rate (‘BBSW’). For every time period, the arbitrageur's net payment is the YTMsr – BBSW, then this is multiplied by the notional principal amount (E.g. A$10,000) and the time between payments (E.g. 6 months). [7] The group paying the fixed-rate, which is the owner of the Treasury bond financed at the repurchased rate, will also receive a fixed-coupon on the yield to maturity (E.g. yield to maturity of the treasury bond), whilst paying interest on the repurchase agreement, known as repo financing. [7] The swap spread is the yield to maturity on the Treasury bond minus the fixed-rate of the swap.

Swap Spread = Yield to Maturity of Swap – Yield to Maturity of Treasury Bond

The result of this equation is most often positive. Since the swap's floating rate is the BBSW, we find that the swap will be above the yield to maturity of the Treasury Bond as the swap is almost always above the repurchase rate [8] (RBA, 2021). This is because the BBSW is used as a benchmark for the pricing of AUD derivatives and securities, hence the repurchase rate of the Treasury Bond should be higher.

Yield Curve Arbitrage

Yield Curve Arbitrage involves taking long and short positions at different points along the yield curve. This strategy involves identifying points on the yield curve that show a mismatch in pricing, this mismatch results in either rich or cheap points. This will involve investors re-modelling to see points in which the bond's actual yield differs from the model-implied yield and will bet on the reversion of the curvature. [7] Once this has been identified the investor will seek to profit off either the rich or cheap points on the yield curve by going short or long bonds. They will hold these investments until the trade converges, and then the trade can be liquidated for profit. In taking short and long term positions on the yield curve the investor is hedging their investments. An example of this would be betting against a government bond, whilst also buying two bonds on either side of the original bet (Karsimus, 2015). [9]

Mortgage Arbitrage

Mortgage Arbitrage strategy is used by fixed-income traders, whereby they trade what are known as Mortgage-backed securities (MBS's). MBS's are securities that are a grouping of mortgages that are collateralized by real estate and guaranteed by an agency. An agency in this case is where the principal has hired the agent to perform a service on their behalf, [10] in this case of MBS's, a bank could be the agent for the security. Collateralization is when the value of an asset is used to secure a loan, whereby if a default occurs, the issuer of the loan can seize the asset and consequentially sell the asset, [11] in this case of MBS's, it would be the selling of the real estate assets to offset the losses from the loan.

Through the securitization, the group of mortgages held by the group, e.g. a bank, is then grouped into a MBS and then sold off to investors as units or certificates. This process of passing on the group of mortgages to the investor is known as a ‘pass-through security’. [12] The cash flows generated from the mortgages, net of the commissions charged by the originator of the mortgages, pass through the original financial institution through to the now, owner, of the security. Simply speaking, the now, owner of the security receives their share of the overall mortgage payments, by payment of both interest and principal. Mortgage pass-throughs differ from bonds as each cashflow from a mortgage pass-through will include both interest and principal, whereas typical bonds pay only interest, with the principal returned at the end of the tenor. [13] Another key difference is that as the principal is reduced, the payments for each cashflow differ with time, hence the amount of interest received on each cashflow will decrease as the amount of capital declines on the principal. [14] Hence since the security is self-liquidating, once all mortgages in the MBS's are paid, the investment is completed. This strategy is focused on traders receiving income rather than capital gains. [15]

In terms of mortgage arbitrage strategy, the trader invests in long term MBS's and hedges the risk on the interest rate by shorting government bonds or swaps. This is an attempt to profit from the MBS's yield being higher than the government bond yield. [13] The reason that MBS's tend to have a higher yield is because of the general risk that the assets that they are secured by pose. This risk is default risk. [13]

Low interest rates pose a negative impact to MBSs. An environment with lower interest rates allows those with mortgages to make more prepayments, which consequently reduces the maturity of the loan, as well as the principal, resulting in less interest being earned from the asset, [16] higher interest rates also negatively affect MBS, as an increase in interest rates effect the ability for individuals to make payments on their mortgage, which increases the risk of default. [16] Lastly, the strategy can also face liquidity risks. [16] An example of increased liquidity risk occurring would be in a climate whereby a crisis occurred (E.g. the GFC in 2008), whereby market liquidity begins to drop, subsequently making it more difficult for individuals or groups to borrow.

Volatility Arbitrage

Fixed-income volatility arbitrage is a strategy designed to profit from pricing differences in a fixed income security's forecasted future price-volatility and the implied volatility of options based on the same asset. [17] Similar to the case of finding the real price of a stock, in this strategy the arbitrageur must make a judgement on whether implied volatility of a security is overpriced or under-priced. An example of this would be in the opportunity in which a stock option is considerably under-priced because the implied volatility of the asset was too low, in a move to profit off the mispricing the arbitrageur would subsequently choose to open a long call option combined with a short position in the underlying stock. [13]

Capital Structure Arbitrage

Capital structure arbitrage is a strategy used globally in finance, designed to profit from current market mispricings in security classes issued from a single company. It is in the mispricing of these securities that arbitrageurs attempt to profit from. Such mispricings occur when an arbitrageur buys undervalued securities and sells overpriced securities, like other arbitrage strategies. [18]

This strategy is specifically designed to profit from the mispricing of a company's debt and its other securities. In employing this strategy it is common for arbitrageurs to use a structural model to measure the richness and cheapness of credit default swap spreads. The structure model is designed to calculate the fair value of such credit default swap spreads (CDS spread) based on a Company's debt and other securities. If the model indicates that the current market CDS spread is materially different than that of the predicted spread, the arbitrageur must decide whether the market misprices equity value of the CDS market is not producing fair prices. [19] different mispricing cases, in both instances the arbitrageur will attempt to profit from identifying such mispricings by selling credit protection and delta-hedge it by selling short delta equities and expect convergence to occur. [19] Assuming that CDS bid-ask spreads and equity prices move in the same direction, [20] if either the CDS spread widens or the equity price increases, the equity position can cushion the loss on the CDS position. Similarly, the CDS position can cushion the loss on the equity position. In the case that the CDS spread is materially lower than the predicted spread from the structured model, then one would buy credit protection and hedge such a position through purchasing delta shares. [19]

Who uses it? Why?

Fixed-income arbitrage is a strategy that involves a substantial level of risk. The strategy itself provides relatively small returns that can be offset with huge losses given varying market conditions and poor judgement calls. Due to the risk-return nature of the strategy, it is not often used by common investors. It is more often used by asset rich groups, such as hedge funds and investments banks that have significant capital that can be deployed to capitalise on the smaller-riskier returns.

Related Research Articles

In economics and finance, arbitrage is the practice of taking advantage of a difference in prices in two or more markets – striking a combination of matching deals to capitalise on the difference, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the underlying. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.

<span class="mw-page-title-main">Bond (finance)</span> Instrument of indebtedness

In finance, a bond is a type of security under which the issuer (debtor) owes the holder (creditor) a debt, and is obliged – depending on the terms – to provide cash flow to the creditor. The timing and the amount of cash flow provided varies, depending on the economic value that is emphasized upon, thus giving rise to different types of bonds. The interest is usually payable at fixed intervals: semiannual, annual, and less often at other periods. Thus, a bond is a form of loan or IOU. Bonds provide the borrower with external funds to finance long-term investments or, in the case of government bonds, to finance current expenditure.

In finance, a convertible bond, convertible note, or convertible debt is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.

In finance, a swap is an agreement between two counterparties to exchange financial instruments, cashflows, or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.

Fixed income refers to any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year and repay the principal amount on maturity. Fixed-income securities can be contrasted with equity securities that create no obligation to pay dividends or any other form of income. Bonds carry a level of legal protections for investors that equity securities do not: in the event of a bankruptcy, bond holders would be repaid after liquidation of assets, whereas shareholders with stock often receive nothing.

Rational pricing is the assumption in financial economics that asset prices – and hence asset pricing models – will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.

Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like SOFR or federal funds rate, plus a quoted spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate for that day and adding the spread. A typical coupon would look like 3 months USD SOFR +0.20%.

<span class="mw-page-title-main">Mortgage-backed security</span> Type of asset-backed security

A mortgage-backed security (MBS) is a type of asset-backed security which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals that securitizes, or packages, the loans together into a security that investors can buy. Bonds securitizing mortgages are usually treated as a separate class, termed residential; another class is commercial, depending on whether the underlying asset is mortgages owned by borrowers or assets for commercial purposes ranging from office space to multi-dwelling buildings.

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.

Fixed income analysis is the process of determining the value of a debt security based on an assessment of its risk profile, which can include interest rate risk, risk of the issuer failing to repay the debt, market supply and demand for the security, call provisions and macroeconomic considerations affecting its value in the future. It also addresses the likely price behavior in hedging portfolios. Based on such an analysis, a fixed income analyst tries to reach a conclusion as to whether to buy, sell, hold, hedge or avoid the particular security.

A bond fund or debt fund is a fund that invests in bonds, or other debt securities. Bond funds can be contrasted with stock funds and money funds. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodic realized capital appreciation. Bond funds typically pay higher dividends than CDs and money market accounts. Most bond funds pay out dividends more frequently than individual bonds.

The Z-spread, ZSPRD, zero-volatility spread, or yield curve spread of a bond is the parallel shift or spread over the zero-coupon Treasury yield curve required for discounting a pre-determined cash flow schedule to arrive at its present market price. The Z-spread is also widely used in the credit default swap (CDS) market as a measure of credit spread that is relatively insensitive to the particulars of specific corporate or government bonds.

The following outline is provided as an overview of and topical guide to finance:

Fixed-income attribution is the process of measuring returns generated by various sources of risk in a fixed income portfolio, particularly when multiple sources of return are active at the same time.

In finance, par yield is the yield on a fixed income security assuming that its market price is equal to par value. Par yield is used to derive the U.S. Treasury’s daily official “Treasury Par Yield Curve Rates”, which are used by investors to price debt securities traded in public markets, and by lenders to set interest rates on many other types of debt, including bank loans and mortgages.

Fixed-Income Relative-Value Investing (FI-RV) is a hedge fund investment strategy made popular by the failed hedge fund Long-Term Capital Management. FI-RV Investors most commonly exploit interest-rate anomalies in the large, liquid markets of North America, Europe and the Pacific Rim. The financial instruments traded include government bonds, interest rate swaps and futures contracts.

<span class="mw-page-title-main">Option-adjusted spread</span>

Option-adjusted spread (OAS) is the yield spread which has to be added to a benchmark yield curve to discount a security's payments to match its market price, using a dynamic pricing model that accounts for embedded options. OAS is hence model-dependent. This concept can be applied to a mortgage-backed security (MBS), or another bond with embedded options, or any other interest rate derivative or option. More loosely, the OAS of a security can be interpreted as its "expected outperformance" versus the benchmarks, if the cash flows and the yield curve behave consistently with the valuation model.

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

Leverage is defined as the ratio of the asset value to the cash needed to purchase it. The leverage cycle can be defined as the procyclical expansion and contraction of leverage over the course of the business cycle. The existence of procyclical leverage amplifies the effect on asset prices over the business cycle.

References

  1. ↑ superadmin. "Understanding Fixed-Income Arbitrage". www.barclayhedge.com. Retrieved 2021-05-10.
  2. ↑ "RBC Dominion Securities". www.rbcds.com. Retrieved 2021-05-10.
  3. ↑ nabtraderedesign. "Fixed Income Investments - nabtrade". www.nabtrade.com.au. Retrieved 2021-05-10.
  4. ↑ Doukas, John A.; Kim, Chansog (Francis); Pantzalis, Christos (2010). "Arbitrage Risk and Stock Mispricing". The Journal of Financial and Quantitative Analysis. 45 (4): 907–934. doi:10.1017/S0022109010000293. ISSN   0022-1090. JSTOR   40930459. S2CID   201376465.
  5. ↑ "Fixed income arbitrage". capital.com. Retrieved 2021-05-10.
  6. ↑ Smith, Clifford W.; Smithson, Charles W.; Wakeman, Lee Macdonald (1988). "The Market for Interest Rate Swaps". Financial Management. 17 (4): 34–44. doi:10.2307/3665765. JSTOR   3665765.
  7. 1 2 3 SCHOLES, MYRON; PEDERSEN, LASSE HEJE (2015-04-13), "Fixed-Income Arbitrage", Efficiently Inefficient, Princeton University Press, pp. 241–268, doi:10.2307/j.ctt1287knh.21, ISBN   978-1-4008-6573-4 , retrieved 2021-05-10
  8. ↑ "Interest Rate Benchmark Reform in Australia".
  9. ↑ Karsimus (2015). "Yield Curve Arbitrage in the EUR Swap Rates Market Replicating the Strategies of Quantitative Arbitrageurs". Aalto University School of Business.
  10. ↑ "Definition, theory and observation", Theory of Addiction, Chichester, UK: John Wiley & Sons, Ltd, pp. 10–40, 2013-08-30, doi:10.1002/9781118484890.ch2, ISBN   978-1-118-48489-0 , retrieved 2021-05-10
  11. ↑ CERQUEIRO, GERALDO; ONGENA, STEVEN; ROSZBACH, KASPER (2016-05-11). "Collateralization, Bank Loan Rates, and Monitoring". The Journal of Finance. 71 (3): 1295–1322. doi:10.1111/jofi.12214. hdl: 11370/9c1634b5-b770-43dc-8171-dabb1784d6c5 . ISSN   0022-1082.
  12. ↑ Tanner, Glenn; Tanner, Glen (2004). "A Simpler Approach To Mortgage-Backed Securities". Journal of Financial Education. 30: 75–86. ISSN   0093-3961. JSTOR   41948449.
  13. 1 2 3 4 Duarte, Jefferson; Longstaff, Francis A.; Yu, Fan (2007). "Risk and Return in Fixed-Income Arbitrage: Nickels in Front of a Steamroller?". The Review of Financial Studies. 20 (3): 769–811. doi:10.1093/rfs/hhl026. ISSN   0893-9454. JSTOR   4494787.
  14. ↑ Yu, Fan (2006). "How Profitable Is Capital Structure Arbitrage?". Financial Analysts Journal. 62 (5): 47–62. doi:10.2469/faj.v62.n5.4282. ISSN   0015-198X. JSTOR   4480772.
  15. ↑ DUNNAN, NANCY (1989). "Mortgage-Backed Securities". ABA Journal. 75 (4): 108–109. ISSN   0747-0088. JSTOR   20760449.
  16. 1 2 3 Dungey, Mardi H.; Dwyer, Gerald P.; Flavin, Thomas (2011). "Systematic and Liquidity Risk in Subprime-Mortgage Backed Securities". SSRN   1925930.
  17. ↑ personalfinancekid.com, Full Bio Follow Linkedin Follow Twitter Lucas Downey is the founder of; MAPsignals.com, co-founder of; Downey, an Investopedia Academy instructor Learn about our editorial policies Lucas. "Volatility Arbitrage". Investopedia. Retrieved 2021-06-03.{{cite web}}: |first1= has generic name (help)
  18. ↑ "Capital Structure Arbitrage - Definition". The Business Professor, LLC. Retrieved 2021-06-03.
  19. 1 2 3 Visockis, Ričardas. "Capital Structure Arbitrage". Tilburg University.
  20. ↑ Marra, Miriam (2017). "Explaining co-movements between equity and CDS bidask spreads". Review of Quantitative Finance and Accounting. 49 (3): 811–853. doi: 10.1007/s11156-016-0609-6 .
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