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'''Fixed-income arbitrage''' is a group of market-neutral-investment strategies that are designed to take advantage of differences in interest rates between varying fixed-income securities or contracts (Jefferson, 2007). Arbitrage in terms of investment strategy, involves [[Finance:Law of one price|buying securities on one market for immediate resale on another market]] in order to profit from a price discrepancy.<ref>{{cite web|last=superadmin|title=Understanding Fixed-Income Arbitrage|url=https://www.barclayhedge.com/insider/hedge-fund-strategy-fixed-income|access-date=2021-05-10|website=www.barclayhedge.com|language=en}}</ref>

Fixed-income securities are debt instruments issued by a government, corporation, or other entity to finance and expand their operations.<ref>{{cite web|title=RBC Dominion Securities|url=https://www.rbcds.com/|access-date=2021-05-10|website=www.rbcds.com|language=en}}</ref> The purchasing of any fixed-income security is known as a loan from the investor to the issuer. These ‘loans’ made from the investor to the borrower are in exchange for regular income payments to the investor, as well as the investor receiving the capital returned upon maturity of the loan.<ref>{{cite web|last=nabtraderedesign|title=Fixed Income Investments - nabtrade|url=https://www.nabtrade.com.au:443/investor/products/investments/fixed-income|access-date=2021-05-10|website=www.nabtrade.com.au|language=en}}</ref> 

The mechanics of the agreement are similar across all variations of fixed-income instruments, whereby there is a fixed tenor and schedule of income payments. Repayment of capital at maturity is expected and will only not occur if the issuer defaults or becomes insolvent. The following are examples of fixed-income securities:

* Treasury bills
* Corporate bonds
* Municipal bonds
* Credit default swaps

The mechanics of the strategy are to purchase a fixed-income security and resell it at a higher price. The strategy is used when there are signs of mispricing of fixed-income securities in the market, whereby, for example, fixed-income arbitrage funds will take a short or long position on the security to benefit when the price is later corrected in the market.<ref>{{Cite journal|last1=Doukas|first1=John A.|last2=Kim|first2=Chansog (Francis)|last3=Pantzalis|first3=Christos|date=2010|title=Arbitrage Risk and Stock Mispricing|url=https://www.jstor.org/stable/40930459|journal=The Journal of Financial and Quantitative Analysis|volume=45|issue=4|pages=907–934|doi=10.1017/S0022109010000293|jstor=40930459|s2cid=201376465|issn=0022-1090}}</ref> 
Fixed-income securities differ from equities, whereby for fixed-income securities dividends are non-discretionary.<ref>{{cite web|title=Fixed income arbitrage|url=https://capital.com/fixed-income-arbitrage-definition#:~:text=Fixed%20income%20arbitrage%20is%20an|access-date=2021-05-10|website=capital.com}}</ref> The strategy is most commonly used by investment banks and hedge funds globally.
See also [[Finance:Fixed-income relative-value investing|Fixed-income relative-value investing]].

== Fixed-Income Arbitrage Strategies in the Market ==

=== Swap Spread Arbitrage ===
Within the fixed-income markets, an interest-rate swap is a derivative that exchanges the cash flows generated from a fixed-rate loan (a fixed-income security) to the cashflows generated from a floating-rate loan.<ref>{{cite journal|last1=Smith|first1=Clifford W.|last2=Smithson|first2=Charles W.|last3=Wakeman|first3=Lee Macdonald|title=The Market for Interest Rate Swaps|journal=Financial Management|year=1988|volume=17|issue=4|pages=34–44|doi=10.2307/3665765|jstor=3665765}}</ref> The group receiving the fixed-rate (E.g. receiving the fixed-rate on a Treasury Bond), better known as the Yield to Maturity Swap Rate (‘YTMsr’), pays the floating Bank Bill Swap Rate (‘BBSW’). For every time period, the arbitrageur's net payment is the YTMsr – BBSW, then this is multiplied by the notional principal amount (E.g. A$10,000) and the time between payments (E.g. 6 months).<ref name=":0">{{Citation|last1=SCHOLES|first1=MYRON|title=Fixed-Income Arbitrage|date=2015-04-13|url=http://dx.doi.org/10.2307/j.ctt1287knh.21|work=Efficiently Inefficient|pages=241–268|publisher=Princeton University Press|isbn=978-1-4008-6573-4|access-date=2021-05-10|last2=PEDERSEN|first2=LASSE HEJE|doi=10.2307/j.ctt1287knh.21}}</ref> The group paying the fixed-rate, which is the owner of the Treasury bond financed at the repurchased rate, will also receive a fixed-coupon on the yield to maturity (E.g. yield to maturity of the treasury bond), whilst paying interest on the repurchase agreement, known as repo financing.<ref name=":0" /> The swap spread is the yield to maturity on the Treasury bond minus the fixed-rate of the swap.

Swap Spread = Yield to Maturity of Swap – Yield to Maturity of Treasury Bond

The result of this equation is most often positive. Since the swap's floating rate is the BBSW, we find that the swap will be above the yield to maturity of the Treasury Bond as the swap is almost always above the repurchase rate<ref>{{cite web|title=Interest Rate Benchmark Reform in Australia|url=https://www.rba.gov.au/mkt-operations/resources/interest-rate-benchmark-reform.html}}</ref> (RBA, 2021). This is because the BBSW is used as a benchmark for the pricing of AUD derivatives and securities, hence the repurchase rate of the Treasury Bond should be higher.

=== Yield Curve Arbitrage ===
Yield Curve Arbitrage involves taking long and short positions at different points along the yield curve. This strategy involves identifying points on the yield curve that show a mismatch in pricing, this mismatch results in either rich or cheap points. This will involve investors re-modelling to see points in which the bond's actual yield differs from the model-implied yield and will bet on the reversion of the curvature.<ref name=":0" /> Once this has been identified the investor will seek to profit off either the rich or cheap points on the yield curve by going short or long bonds. They will hold these investments until the trade converges, and then the trade can be liquidated for profit. In taking short and long term positions on the yield curve the investor is hedging their investments. An example of this would be betting against a government bond, whilst also buying two bonds on either side of the original bet (Karsimus, 2015).<ref>{{Cite journal|last=Karsimus|date=2015|title=Yield Curve Arbitrage in the EUR Swap Rates Market Replicating the Strategies of Quantitative Arbitrageurs|journal=Aalto University School of Business}}</ref>

=== Mortgage Arbitrage ===
Mortgage Arbitrage strategy is used by fixed-income traders, whereby they trade what are known as Mortgage-backed securities (MBS's). MBS's are securities that are a grouping of mortgages that are collateralized by real estate and guaranteed by an agency. An agency in this case is where the principal has hired the agent to perform a service on their behalf,<ref>{{Citation|title=Definition, theory and observation|date=2013-08-30|url=http://dx.doi.org/10.1002/9781118484890.ch2|work=Theory of Addiction|pages=10–40|place=Chichester, UK|publisher=John Wiley & Sons, Ltd|doi=10.1002/9781118484890.ch2|isbn=978-1-118-48489-0|access-date=2021-05-10}}</ref> in this case of MBS's, a bank could be the agent for the security. Collateralization is when the value of an asset is used to secure a loan, whereby if a default occurs, the issuer of the loan can seize the asset and consequentially sell the asset,<ref>{{Cite journal|last1=CERQUEIRO|first1=GERALDO|last2=ONGENA|first2=STEVEN|last3=ROSZBACH|first3=KASPER|date=2016-05-11|title=Collateralization, Bank Loan Rates, and Monitoring|url=http://dx.doi.org/10.1111/jofi.12214|journal=The Journal of Finance|volume=71|issue=3|pages=1295–1322|doi=10.1111/jofi.12214|issn=0022-1082|hdl=11370/9c1634b5-b770-43dc-8171-dabb1784d6c5|hdl-access=free}}</ref> in this case of MBS's, it would be the selling of the real estate assets to offset the losses from the loan.

Through the securitization, the group of mortgages held by the group, e.g. a bank, is then grouped into a MBS and then sold off to investors as units or certificates. This process of passing on the group of mortgages to the investor is known as a ‘pass-through security’.<ref>{{Cite journal|last1=Tanner|first1=Glenn|last2=Tanner|first2=Glen|date=2004|title=A Simpler Approach To Mortgage-Backed Securities|url=https://www.jstor.org/stable/41948449|journal=Journal of Financial Education|volume=30|pages=75–86|jstor=41948449|issn=0093-3961}}</ref> The cash flows generated from the mortgages, net of the commissions charged by the originator of the mortgages, pass through the original financial institution through to the now, owner, of the security. Simply speaking, the now, owner of the security receives their share of the overall mortgage payments, by payment of both interest and principal. Mortgage pass-throughs differ from bonds as each cashflow from a mortgage pass-through will include both interest and principal, whereas typical bonds pay only interest, with the principal returned at the end of the tenor.<ref name=":1">{{Cite journal|last1=Duarte|first1=Jefferson|last2=Longstaff|first2=Francis A.|last3=Yu|first3=Fan|date=2007|title=Risk and Return in Fixed-Income Arbitrage: Nickels in Front of a Steamroller?|url=https://www.jstor.org/stable/4494787|journal=The Review of Financial Studies|volume=20|issue=3|pages=769–811|doi=10.1093/rfs/hhl026|jstor=4494787|issn=0893-9454}}</ref> Another key difference is that as the principal is reduced, the payments for each cashflow differ with time, hence the amount of interest received on each cashflow will decrease as the amount of capital declines on the principal.<ref>{{Cite journal|last=Yu|first=Fan|date=2006|title=How Profitable Is Capital Structure Arbitrage?|url=https://www.jstor.org/stable/4480772|journal=Financial Analysts Journal|volume=62|issue=5|pages=47–62|doi=10.2469/faj.v62.n5.4282|jstor=4480772|issn=0015-198X}}</ref> Hence since the security is self-liquidating, once all mortgages in the MBS's are paid, the investment is completed. This strategy is focused on traders receiving income rather than capital gains.<ref>{{Cite journal|last=DUNNAN|first=NANCY|title=Mortgage-Backed Securities|date=1989|url=https://www.jstor.org/stable/20760449|journal=ABA Journal|volume=75|issue=4|pages=108–109|jstor=20760449|issn=0747-0088}}</ref>

In terms of mortgage arbitrage strategy, the trader invests in long term MBS's and hedges the risk on the interest rate by shorting government bonds or swaps. This is an attempt to profit from the MBS's yield being higher than the government bond yield.<ref name=":1" /> The reason that MBS's tend to have a higher yield is because of the general risk that the assets that they are secured by pose. This risk is default risk.<ref name=":1" />

Low interest rates pose a negative impact to MBSs. An environment with lower interest rates allows those with mortgages to make more prepayments, which consequently reduces the maturity of the loan, as well as the principal, resulting in less interest being earned from the asset,<ref name=":2">{{Cite SSRN|title=Systematic and Liquidity Risk in Subprime-Mortgage Backed Securities|last1=Dungey|first1=Mardi H.|last2=Dwyer|first2=Gerald P.|date=2011|ssrn=1925930|last3=Flavin|first3=Thomas}}</ref> higher interest rates also negatively affect MBS, as an increase in interest rates effect the ability for individuals to make payments on their mortgage, which increases the risk of default.<ref name=":2" /> Lastly, the strategy can also face liquidity risks.<ref name=":2" /> An example of increased liquidity risk occurring would be in a climate whereby a crisis occurred (E.g. the GFC in 2008), whereby market liquidity begins to drop, subsequently making it more difficult for individuals or groups to borrow.

=== Volatility Arbitrage ===
Fixed-income volatility arbitrage is a strategy designed to profit from pricing differences in a fixed income security's forecasted future price-volatility and the implied volatility of options based on the same asset.<ref>{{cite web|last1=personalfinancekid.com|first1=Full Bio Follow Linkedin Follow Twitter Lucas Downey is the founder of|last2=MAPsignals.com|first2=co-founder of|last3=Downey|first3=an Investopedia Academy instructor Learn about our editorial policies Lucas|title=Volatility Arbitrage|url=https://www.investopedia.com/terms/v/volatility-arbitrage.asp|access-date=2021-06-03|website=Investopedia|language=en}}</ref> Similar to the case of finding the real price of a stock, in this strategy the arbitrageur must make a judgement on whether implied [[Finance:Volatility|volatility]] of a security is overpriced or under-priced. An example of this would be in the opportunity in which a stock option is considerably under-priced because the implied volatility of the asset was too low, in a move to profit off the mispricing the arbitrageur would subsequently choose to open a long call option combined with a short position in the underlying stock.<ref name=":1" />

=== Capital Structure Arbitrage ===
Capital structure arbitrage is a strategy used globally in finance, designed to profit from current market mispricings in security classes issued from a single company. It is in the mispricing of these securities that arbitrageurs attempt to profit from. Such mispricings occur when an arbitrageur buys undervalued securities and sells overpriced securities, like other arbitrage strategies.<ref>{{cite web|title=Capital Structure Arbitrage - Definition|url=https://thebusinessprofessor.com/investments-trading-financial-markets/capital-structure-arbitrage-definition|access-date=2021-06-03|website=The Business Professor, LLC}}</ref>

This strategy is specifically designed to profit from the mispricing of a company's debt and its other securities. In employing this strategy it is common for arbitrageurs to use a structural model to measure the richness and cheapness of credit default swap spreads. The structure model is designed to calculate the fair value of such credit default swap spreads (CDS spread) based on a Company's debt and other securities. If the model indicates that the current market CDS spread is materially different than that of the predicted spread, the arbitrageur must decide whether the market misprices equity value of the CDS market is not producing fair prices.<ref name=":3">{{Cite journal|last=Visockis|first=Ričardas|date=|title=Capital Structure Arbitrage|url=http://arno.uvt.nl/show.cgi?fid=115341|journal=Tilburg University}}</ref> different mispricing cases, in both instances the arbitrageur will attempt to profit from identifying such mispricings by selling credit protection and delta-hedge it by selling short delta equities and expect convergence to occur.<ref name=":3" /> Assuming that CDS bid-ask spreads and equity prices move in the same direction,<ref>{{Cite journal|last=Marra|first=Miriam|title=Explaining co-movements between equity and CDS bidask spreads|journal=Review of Quantitative Finance and Accounting|year=2017|volume=49|issue=3|pages=811–853|doi=10.1007/s11156-016-0609-6|doi-access=free}}</ref> if either the CDS spread widens or the equity price increases, the equity position can cushion the loss on the CDS position. Similarly, the CDS position can cushion the loss on the equity position. In the case that the CDS spread is materially lower than the predicted spread from the structured model, then one would buy credit protection and hedge such a position through purchasing delta shares.<ref name=":3" />

== Who uses it? Why? ==
Fixed-income arbitrage is a strategy that involves a substantial level of risk. The strategy itself provides relatively small returns that can be offset with huge losses given varying market conditions and poor judgement calls. Due to the risk-return nature of the strategy, it is not often used by common investors. It is more often used by asset rich groups, such as hedge funds and investments banks that have significant capital that can be deployed to capitalise on the smaller-riskier returns.

==References==
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