Fixed income arbitrage: What is its strategy & example

Fixed income arbitrage is a strategic approach that exploits price differences in fixed-income securities to create profits. 

Fixed Income Arbitrage is one of the ways through which market stability and efficiency are achieved by taking advantage of market inefficiencies. It is one of the important practices in financial markets because it helps investors maximize their returns and, at the same time, minimize their risks. 

This article will go further into what Fixed Income Arbitrage means and its significance in the financial environment, with examples to illustrate how it works.

What is fixed income arbitrage?

Fixed income arbitrage is an investment strategy that involves buying a security at a low price and selling it at a higher price within seconds to profit from small differences in interest rates between fixed-income securities. The strategy involves taking a short position on the issue that appears to be overpriced and a long position on the security that is underpriced. 

Fixed-income arbitrage is a market-neutral strategy whose intention is to generate profits, regardless of whether the overall bond market will go up or down in the future. Fixed income arbitrage funds attempt to generate profit by:

• Rectify inefficiencies and price variations between related fixed income securities
• Limiting volatility by hedging out exposure to the market and interest rate risk 

Fixed income arbitrage strategies can potentially generate returns in both rising and falling markets. For instance, fixed income arbitrage hedge funds eke out returns from risk-free government bonds, eliminating credit risk. You can also use fixed income arbitrage in a financial crisis.

How does fixed income arbitrage work?

To make fixed-income arbitrage strategies successful, there are two main requirements that should exist.

• For the fixed income securities to be liquid enough to enable you to easily buy and sell them in the market.
• Ideally, while implementing the strategy of arbitrage, these securities should be alike or similar to each other with minimal differences.

After fulfilling these conditions, the next step is taking a long position on the security that’s overpriced and also taking up a short position on the security that’s underpriced. Having done both of them at once would result in tying up the price difference. 

Thereafter, when there is a reversal in the prices of the two securities, both trades could be closed out to realize the gain.

With that being said, let’s analyze a fixed income arbitrage example in order to have a better understanding of the topic.

Example of fixed income arbitrage

Let’s say an investor notices that the yield on a 10-year government bond is higher than the fixed rate on a 10-year interest rate swap contract. In this scenario, the investor could execute the following arbitrage strategy:

1. Step 1: Borrow funds to purchase the government bond.
2. Step 2: Simultaneously enter into an interest rate swap agreement to receive fixed payments and pay floating payments.
3. Step 3: Hedge the interest rate risk by selling short an equivalent duration of government bond futures.
4. Step 4: Earn the higher yield from the government bond while simultaneously receiving fixed payments from the interest rate swap contract.
5. Step 5: Close out the positions when the price difference narrows or reaches the desired profit level.

By engaging in this fixed income arbitrage strategy, the investor can profit from the temporary mispricing between the government bond and the interest rate swap, regardless of the overall direction of interest rates or bond prices.

Fixed-Income Arbitrage Strategies

Here are five widely used fixed-income arbitrage strategies:

1. Swap Spread (SS) Arbitrage

Swap Spread Arbitrage is a strategy where an investor takes positions in an interest rate swap and corresponding treasury securities. The goal is to exploit pricing inefficiencies in the swap market. 

For instance, if the swap spread (difference between swap rate and treasury yield) is unusually high or low, an arbitrageur could enter into a swap and take the opposite position in treasury securities, expecting the spread to revert to its mean, thus making a profit.

2. Yield Curve (YC) Arbitrage

Yield Curve Arbitrage involves taking positions in bonds of different maturities to exploit changes in the yield curve’s shape. 

If the yield curve is expected to change, an investor could buy long-term bonds and sell short-term bonds, or vice versa.

The strategy profits when the yield curve changes as predicted. It’s a sophisticated strategy used by hedge funds and institutional investors, requiring a deep understanding of interest rates and financial markets.

3. Mortgage (MA) Arbitrage

This strategy involves taking positions in mortgage-backed securities (MBS) and related securities to exploit pricing inefficiencies. 

If an MBS is undervalued compared to the underlying mortgages, an investor could buy the MBS and sell the individual mortgages, or vice versa. 

The strategy profits when the price discrepancy corrects itself. It requires a deep understanding of the mortgage market and is typically used by sophisticated investors like hedge funds.

4. Volatility (VA) Arbitrage

In this strategy, an investor takes positions in options or other derivatives to exploit differences between implied and realized volatility. 

If the implied volatility of an option is higher than the investor’s forecast of future realized volatility, the investor could sell the option, expecting to profit when the volatility decreases. 

This strategy requires sophisticated risk management and an understanding of options pricing.

5. Capital Structure Arbitrage

Capital Structure Arbitrage involves taking positions in different securities of the same firm, like bonds and stocks, to exploit pricing inefficiencies between them. 

If the firm’s stock is overvalued compared to its bonds, an investor could sell the stock and buy the bonds, or vice versa. The strategy profits when the price discrepancy corrects itself.

Conclusion

The fixed income arbitrage offers a valuable strategy for investors to capitalize on opportunities in the bond market which contribute to making the market more efficient and stable.

You can enhance your investment returns while managing risks effectively if you understand and use this approach. Consider checking out StockGro to expand your investment skills further.

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