Risk and return in fixed income arbitrage: Nickels in front of a steamroller?

35 Pages·2005·0.3 MB·English

Risk and return in (cid:222)xed income arbitrage Universit·e d(cid:146)Evry June 2005 1
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Risk and return in (cid:222)xed income arbitrage:
Nickels in front of a steamroller?
Jefferson Duarte
University of Washington
Francis Longstaff
University of California, Los Angeles
Fan Yu
University of California, Irvine
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Motivation
Fixed income arbitrage is a broad set of market-neutral
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investment strategies intended to exploit pricing differences
between various (cid:222)xed income securities.
Despite painful losses by LTCM and other hedge funds in 1998,
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(cid:222)xed income arbitrage has been resurrected as one of the most
popular hedge fund sectors in recent years.
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Risk and return in (cid:222)xed income arbitrage Universit·e d(cid:146)Evry June 2005 4
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Open issues
Is (cid:222)xed income arbitrage truly arbitrage?
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Is it merely a strategy that earns small positive returns most of
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the time, but occasionally experiences dramatic losses?
Were the large losses during the hedge fund crisis simply due to
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excessive leverage, or were there deeper reasons arising from
the inherent nature of these strategies?
Is there a link between hedge fund returns and hedge fund
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capital?
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List of strategies
We consider (cid:222)ve of the most popular (cid:222)xed income arbitrage
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strategies:
1. Swap spread arbitrage (SS).
2. Yield curve arbitrage (YC).
3. Mortgage arbitrage (MA).
4. Volatility arbitrage (VA).
5. Capital structure arbitrage (CS).
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Methodology
Like Mitchell and Pulvino (2001), we construct return indexes
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by following these strategies through time.
The advantages are:
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(cid:151) Transaction costs can be explicitly incorporated.
(cid:151) The effects of leverage can be held (cid:222)xed.
(cid:151) Returns can be studied over a longer horizon than would be
possible using limited hedge fund return data.
(cid:151) Back(cid:222)ll and survival biases in reported hedge fund returns
can be avoided.
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Swap spread arbitrage - intuition
An arbitrageur enters into a par swap and receives a (cid:222)xed
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coupon rate CMS and pays the (cid:223)oating Libor rate L .
t
He also shorts a par Treasury bond with the same maturity as
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the swap, paying coupon rate CMT and invests the proceeds
in a margin account earning the repo rate r .
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Swap spread arbitrage is thus a simple bet on whether the
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(cid:222)xed annuity of SS = CMS CMT received will be larger
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than the (cid:223)oating spread S = L r paid.
t t t
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Although SS S has been historically stable and positive, it
t
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can become negative when the banking sector has increasing
default risk.
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Swap spread arbitrage - implementation
Use swap and Treasury data from November 1988 to December
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2004.
Fit an O-U process to the (cid:223)oating spread S .
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Determine each month whether SS differs from the expected
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average value of S over the life of the strategy.
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Enter a trade if this difference exceeds 10 or 20 basis points.
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Close out the trade if the swap spread and the expected
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average value of the (cid:223)oating spread become equal, or until the
maturity of the swap.
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Swap spread arbitrage - index construction
Each month, there could be multiple open trades entered into
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at different points in the past.
Compute an equally-weighted average of the monthly return on
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all open trades.
Realistic swap, Treasury, and repo transaction costs are
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applied.
Initial capital is adjusted to achieve an annualized volatility of
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ten percent.
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