Fixed Income Arbitrage

Jake Caldwell – Colgate Finance Club Fall 2010
Part I: Fixed Incomes
An investment that provides a return in the form
of fixed periodic payments and the eventual
return of principal at maturity
- Investopedia
Fixed Incomes – What are they?
“Fixed” – they offer returns at regular intervals –
monthly, quarterly, annually, etc.
Generally, they have “fixed” returns – predictable return on
investment (not always the case)
“Income” – they provide a source of income to an
Created as a product that an investor can rely on to
produce returns
Who might be extremely interested in this?
Retired Investor
Often referred to as a “Fixed-Income Security”
The Bond
The most common Fixed-Income Security
Debt-Instrument – Sell the Debt to an Investor
Investor gives the entity capital and is paid interest on
the debt he/she takes on – Interest rate of the Bond
Terminology of FI or Bond
Issuer – Company Issuing the Debt-Instrument
Coupon – Interest the investor receives
Bond Principal – The Cost of the Bond
Maturity Date – Expiration of the Bond – Investor
receives the principal back
Interest Rate or Coupon
The Payoff
Determined by the quality of the debt/credit and
the duration of the product
Quality – Determined by a Rating Agency
Duration – Differs by product
The Coupon is generally paid out semi-annually, but
is referred to as a annual rate
Interesting FIs
Structured Note
 Adjusts
to favorable increases for investor – increases
returns/ coupon rate, medium-term
Commercial Paper
 Short-term
(less than 270 days) debt note to investors
backed by no hard assets – can only be used for
variable assets (inventories) not fixed assets (plant)
Bank Obligations
 CDs
– Certificate of Deposit – pays out interest to
Part II: Arbitrage
The simultaneous purchase and sale of an asset
in order to profit from a difference in the price
- Investopedia
How It Works
An investor/trader sits on his desk in NY.
He is trading a commodity – Oil.
Oil is traded on Mercantile Exchanges globally
This trader is looking at Crude Oil Future prices on the
NYMEX and the CME
He sees that Crude Oil is trading at $100 a barrel on the
NYMEX and $100.05 on the CME
He shorts 1,000 Futures on the NYMEX and buys 1,000
Futures on the CME
He profits from the price discrepancy and makes 1,000 x
$.05 – (.01x1,000) = $40
This example is on a small scale, but it costs the trader
nothing to do this
Is this practical?
Although this may seem like an easy way to make
money, you will not find a price discrepancy of .05
on any futures
Arbitrage relies on market imperfections
This acts as a system of “checks & balances”
These price discrepancies may occur in the shortterm, but not in the long-term (we are talking about
the difference between seconds and minutes)
The Role of Technology
The ability to exploit price differences is a
result/bi-product of the revolution in technology on
trading floors
 The emergence of trading floors/market places for
assets (NYSE Euronext) allows traders to find this
price differential
 Ultimately, the trader with the fastest technology
and the most market information is the winner
 Perfect Market Information is an imperfection of the
markets – it does not exist
Fixed Income Arbitrage
Muni. Bond Arbitrage Case
This is one example of Fixed Income Arbitrage
Deals with Municipal Bonds and Interest Rate Swaps
Underlying Assumptions/Facts:
Municipal Bonds are tax-exempt
 Municipal Bonds are correlated with Interest Rate Swaps
 Interest Rate Swaps (remember “fixed-to-floating”) are a
type of Corporate Bonds – involves the swap by two
companies to decrease costs and obtain the best rates
 IRS/CB are not tax-exempt
 Looking for these to share same maturity date (duration)
Muni. Arbitrage Case cont.
Trader is long NJ/NY Municipal Bonds for the new
Giants Stadium
In order to protect himself, he wants to hedge his
risk – specifically, the duration risk
He chooses to short corporate bonds – i.e., Interest
Rate Swaps with the same maturity
When these reach maturity, he pays the interest/tax
on the corporate bonds, but receives the taxexempt interest on the Muni. Bonds – the difference
between these two is his profit
Long 1,000 2-year Muni. Bonds at $200
1,000 x $200 = $200,000 of risk (unhedged)
 They payout 6% annually interest rate – or 3% semi.
 Duration is 2 years, after 2 years I receive the principal
 After my first year, how much have I made assuming I choose
to reinvest the interest in a different asset?
 $200,000 x .03 = $6,000 x 2 = $12,000
 After 2 years, I will have made $24,000
 But I am at risk the entire time of the municipal bond not being
paid back or not receiving my interest – I want to hedge this
duration risk
Mathematically cont.
The trader shorts Interest Rate Swaps for two
companies that pays out 6% annual interest rate
(3% semi-annually) and is taxed at 5%.
$200,000 x .03 =$6,000 x 2 = $12,000 x (0.95)
= $11,400 x 2 = 22,800
Now if this is what the trader pays out, then we
must subtract this from the interest made on the
Municipal Bond: $24,000-$22,800 = $1,200
As you see, arbitrage takes advantage of the
imperfections of the markets and acts as a safety
net to keep prices close together
Each asset class/product can be traded differently
to take advantage of these
In our example of Fixed Income Arbitrage, the
trader focuses on hedging his duration and uses
differences in interest rates (based on taxes)