FIXED INCOME ARBITRAGEJake Caldwell – Colgate Finance Club Fall 2010

An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity

- Investopedia

Part I: Fixed Incomes

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”

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

1. Government2. Corporate3. Municipal 4. Institutional

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

owner

The simultaneous purchase and sale of an asset in order to profit from a difference in the price

- Investopedia

Part II: Arbitrage

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 short-term, 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

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

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

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

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

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)