1 / 17

Fixed Income Arbitrage

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?.

nevaeh
Download Presentation

Fixed Income Arbitrage

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Fixed Income Arbitrage Jake Caldwell – Colgate Finance Club Fall 2010

  2. 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

  3. 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 investor • 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”

  4. 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 • Government • Corporate • Municipal • Institutional

  5. 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

  6. 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

  7. 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 owner

  8. Part II: Arbitrage The simultaneous purchase and sale of an asset in order to profit from a difference in the price - Investopedia

  9. 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

  10. 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 short-term, but not in the long-term (we are talking about the difference between seconds and minutes)

  11. 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 http://www.youtube.com/watch?v=wuq54vDFeqU

  12. Fixed Income Arbitrage

  13. 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)

  14. 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 tax-exempt interest on the Muni. Bonds – the difference between these two is his profit

  15. Mathematically • 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

  16. 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

  17. Conclusion • 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)

More Related