Fixed Income Arbitrage

Fixed income arbitrage is a certain type of a hedge fund strategy. In general, three different kinds of hedge fund strategies are distinguished: market neutral strategies, event driven strategies, and opportunistic strategies.

Fixed income arbitrage belongs to the group of market neutral strategies, as is the case with convertible arbitrage strategies and equity market neutral strategies.

Market neutral strategies aim at exploiting pricing inefficiencies in capital markets without incurring systematic, that is, nondiversifiable, risk. Nevertheless, gains are not riskless as suggested by the term “arbitrage,” but investors hope to be more than adequately compensated for the risk taken.

Fixed income arbitrage strategies are designed to exploit relative mispricing in fixed income financing instruments as implied by inconsistencies of the term structure of interest rates, observed credit spreads, and/or liquidity spreads.

Five of the most widely used fixed income strategies are swap spread arbitrage, yield curve arbitrage, mortgage arbitrage, volatility arbitrage, and capital structure arbitrage.

Swap spread arbitrage combines entering a par swap with a fixed coupon rate against paying the floating LIBOR rate while at the same time shorting a par Treasury bond with the same maturity as the swap and investing the proceeds at the repo rate. Yield curve arbitrage is characterized by taking long and short positions for different maturities along the term structure.

A mortgage backed security arbitrage emerges by buying mortgage backed securities pass-throughs, that is, mortgage backed securities that pass all (remaining) cash flows of a pool of mortgages through to the investors, and hedging their interest exposure with swaps.

Fixed income volatility arbitrage attempts to make use of the difference between the implied volatility of financial instruments and the subsequently realized volatility by selling options and delta hedging the exposure of the underlying asset.

Capital structure arbitrage (also called credit arbitrage) tries to exploit mispricing between a company’s debt and its other financial instruments. In 2004, about 7% of the total value of hedge fund investments were managed according to fixed income arbitrage strategies (see Garbaravicius and Dierick, 2005).

The most important hedge funds strategies are long/short equity strategies, an example of opportunistic investment strategies of hedge funds (32% market share in 2004), and event driven strategies (19% market share in 2004). Fixed income arbitrage strategies lead to mean–variance return combinations that may be interesting for investors with rather high risk aversion.

Although in Figure 1 the mean–variance profile of fixed income arbitrage is dominated by that which is achievable by equity market neutral strategies, fixed income arbitrage strategies may be an important component of an overall portfolio of hedge funds for an investor because of diversification effects.