Fixed income arbitrage

Resources Fixed-income arbitrage is an investment strategy that exploits pricing differentials between fixed-income securities. Arbitrage, at its most simplest, involves buying securities on one market for immediate resale on another market in order to profit from a price discrepancy.

Fixed income arbitrage

Scholes left and Robert C. Merton were principals at LTCM. Scholes and Robert C.

Primer: Fixed Income Arbitrage | Seeking Alpha

With the help of Merrill Lynch, LTCM secured hundreds of millions of dollars from business owners, celebrities and even private university endowments and later the Italian central bank. The bulk of the money, however, came from companies and individuals connected to the financial industry.

Since bonds of similar maturities and the same credit quality are close substitutes for investors, there tends to be a close relationship between their prices and yields. Whereas it is possible to construct a single set of valuation curves for derivative instruments based on LIBOR-type fixings, it is not possible to do so for government bond securities because every bond has slightly different characteristics.

It is therefore necessary to construct a theoretical model of what the relationships between different but closely related fixed income securities should be.


For example, the most recently issued treasury bond in the US — known as the benchmark — will be more liquid than bonds of similar but slightly shorter Fixed income arbitrage that were issued previously.

Trading is concentrated in the benchmark bond, and transaction costs are lower for buying or Fixed income arbitrage it. As a consequence, it tends to trade more expensively than less liquid older bonds, but this expensiveness or richness tends to have a limited duration, because after a certain time there will be a new benchmark, and trading will shift to this security newly issued by the Treasury.

One core trade in the LTCM strategies was to purchase the old benchmark — now a Over time the valuations of the two bonds would tend to converge as the richness of the benchmark faded once a new benchmark was issued. If the coupons of the two bonds were similar, then this trade would create an exposure to changes in the shape of the yield curve: It would therefore tend to create losses by making the year bond that LTCM was short more expensive and the This exposure to the shape of the yield curve could be managed at a portfolio level, and hedged out by entering a smaller steepener in other similar securities.

It was also necessary to access the financing market in order to borrow the securities that they had sold short. In order to maintain their portfolio, LTCM was therefore dependent on the willingness of its counterparties in the government bond repo market to continue to finance their portfolio.

Fixed income arbitrage

If the company was unable to extend its financing agreements, then it would be forced to sell the securities it owned and to buy back the securities it was short at market prices, regardless of whether these were favourable from a valuation perspective.

The fund also invested in other derivatives such as equity options. UBS Investment[ edit ] Under prevailing US tax laws, there was a different treatment of long-term capital gains, which were taxed at The earnings for partners in a hedge fund was taxed at the higher rate applying to income, and LTCM applied its financial engineering expertise to legally transform income into capital gains.

It did so by engaging in a transaction with UBS Union Bank of Switzerland that would defer foreign interest income for seven years, thereby being able to earn the more favourable capital gains treatment.

This transaction was completed in three tranches: Put-call parity means that being short a call and long the same amount of notional as underlying the call is equivalent to being short a put. James Surowiecki concludes that LTCM grew such a large portion of such illiquid markets that there was no diversity in buyers in them, or no buyers at all, so the wisdom of the market did not function and it was impossible to determine a price for its assets such as Danish bonds in September It also broadened its strategies to include new approaches in markets outside of fixed income:The swap spread arbitrage strategy is traditionally used as a form of fixed-income arbitrage.

Even when trades are executed correctly, it yields a tiny profit in the form of the stable spread. What is 'Fixed-Income Arbitrage' Fixed-income arbitrage is an investment strategy that attempts to profit from pricing differences in interest rate securities.

When using a fixed-income arbitrage. The weak link in the trade, like almost all arbitrage trades, was that there was a funding leg to the trade.

Fixed income arbitrage - Wikipedia

Since funding is a fixed income instrument, people should have realised that such. The most essential thing for the fixed income investors for the past month is definitely the TNX repulsion from the 3% yield mark, despite that the Fed is expected to increase its Funds Rate by another % during the following September meeting.

Fixed-income arbitrage is an investment strategy that exploits pricing differentials between fixed-income securities.

Fixed income arbitrage

Before we explain that, let’s review the concept of arbitrage. Fixed-income arbitrage is an investment strategy that attempts to profit from pricing differences in interest rate securities. When using a fixed-income arbitrage strategy, the investor assumes opposing positions in the market to take advantage of small price discrepancies while limiting interest rate risk.

The Fast-Paced World of Libor & Fixed Income Arbitrage | Investopedia