Relative Value Arbitrage

Relative Value Arbitrage - Edessa waterfalls in Edessa, Greece
Relative Value Arbitrage

Relative value arbitrage not only defines a single strategy but also the combination of all arbitrage strategies such as merger arbitrage, fixed-income arbitrage (credit spread arbitrage, capital structure arbitrage, yield curve arbitrage, mortgage-backed securities arbitrage), volatility arbitrage, index arbitrage, split strike conversions, statistical arbitrage, stub trading, and convertible arbitrage.

Hedge fund managers pertaining to this strategy group execute spread trades to generate positive returns from relative price discrepancies among securities or financial instruments such as equities, fixed income, convertible bonds, options, subscription rights, and futures while simultaneously avoiding market risks.

Here a spread denotes the deviation of a security from its theoretical/fair value and its historical average or from the economic relation of two correlated securities. Once these temporary price anomalies are identified through statistical or fundamental analysis, the over-valued security is sold and simultaneously the undervalued security is purchased, taking into account the respective hedge ratio.

Upon a closer examination, the investments on the relative price relation between two securities independent from the current capital market condition lead to a minimization of directional bias—hence relative value arbitrage hedge funds are also known as "market neutral" hedge funds.

If at er spread trading, beta or market risk still remains, it can be neutralized through options or futures. However, market neutral must not be confused with no risk, as demonstrated in 1998 with the collapse of the widely known relative value hedge fund Long-Term Capital Management (LTCM).

In the current high technology era the spreads based on the violation of one price are very small and only of short-term existence; thus, hedge fund managers try to leverage their returns up to 100 times the company capital. As a result, the credit risk included rises as well. Relative value arbitrage generates profit as soon as the prices of the traded securities revert to their historical average.

Particularly in extreme market situations based on euphoria or panic, it may take a very long time until the prices based on the efficient market hypotheses are reached again. Conversely, it is possible as well for the price anomalies to widen.

Investigations of the performance of relative value arbitrage indices of important database providers show moderate but stable profits with a low correlation toward equity markets. Considering the return distribution, we nevertheless observe fat downside tails, leptokurtosis, and substantial negative skewness.