What Is Fixed Income Arbitrage?
Arbitrage in finance mostly refers to the purchase of a security in one market with the immediate resale in another market to profit from the two-market pricing discrepancy. Fixed-income arbitrage uses a broader definition to also include the simultaneous buying and selling of two related fixed-income securities in their respective markets to profit from any potential mispricing in each security. Such pricing discrepancies are often subjective, as judged by arbitrageurs analyzing potential mispricing, and also small and temporary if they are ever true. To increase profit, arbitrage transactions may involve the use of leverage, and as a result, the risk from an unsuccessful arbitrage can be high.
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Credit Arbitrage
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Credit arbitrage bases its buying and selling on the changing creditworthiness of individual fixed-income securities from different issuers. Investment managers of credit-arbitrage operations often conduct extensive fundamental credit analysis on issuers to evaluate the likelihood of an improvement or deterioration in their creditworthiness. If an arbitrageur believes in a potential credit upgrade on an issuer, he will buy its issuance, expecting a drop in the required rate of return on the security by the market, or a rise in its trading price. On the contrary, the arbitrageur will short sell a security and later profit from the security's price decline.
Capital-Structure Abitrage
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The term capital structure relates to the use of different classes of debt securities by an issuer. Based on liquidation claiming rights, fixed-income securities from an issuer are primarily classified as senior debt and subordinate debt. Because of the different degree of investment guarantee implied by claiming priority, there is a different risk perception for subordinate debt and senior debt. Price discrepancy may exist for both securities. When investors overreact to the riskiness of a subordinate debt, its price as traded in the market can become undervalued, providing arbitrageurs a buying opportunity. When investors overplay the safety of a senior debt, its price can become overvalued, providing arbitrageurs a short selling opportunity
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Yield-Curve Abitrage
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The yield curve is a graphical representation of different yields for fixed-income securities of different maturities, with the vertical axis marking the yield and the horizontal axis denoting the maturity. In normal circumstances, the yield curve is an upward slope, with securities of shorter maturities depicting lower yields and securities of longer maturities showing higher yields. Yields on securities of various maturities change relative to each other from time to time as market interest rates change. By anticipating shifts in the slope of the yield curve, arbitrageurs can buy securities of certain maturities and sell securities of other maturities to profit from their expected rate change, and thus changing in security prices.
Derivative Arbitrage
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Sometimes fixed-income arbitrage may involve the use of fixed-income derivatives such as options and credit default swaps, equivalent to insurance that investors of a fixed-income security buy from another party to protect against potential default by the issuer. The two most commonly used fixed-income derivative arbitrage are the volatility arbitrage and the swap spread arbitrage. A derivative arbitrage transaction may be more complex, but the fundamental mechanism of arbitrage remains the same -- to anticipate movements on rates and profit from corresponding price change. Volatility arbitrage is to predict potential price volatility on a security, and then buy or sell an option of the security accordingly. The swap spread arbitrage involves the comparison between the rate received from the invested security and the rate paid on the swap insurance. A profit can be made if the rate spread moves as anticipated when credit conditions change.
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