Risk and Return in Fixed - Income Arbitrage

By Neel Ganguly

What is fixed income arbitrage?

Those who are familiar with hedge funds are no strangers to fixed income arbitrage. Though a common phenomenon, this investment strategy stays associated with the discovery of inefficiencies in bond prices and exploits to yield a fixed income stream contractually on a global basis.

These fixed income investments embrace both steady returns and low-volatility, thus encouraging interest-rate swaps by arbitrageurs. However funny it may sound, but picking up money from beneath the wheels of a moving steamroller involves lesser risks than practicing fixed-income arbitrage.

Risks and Returns of Fixed-income Arbitrage

The associated risks and returns of fixed-income arbitrage strategies require very high levels of expertise to produce a significant and positive excess return. It goes without saying that massive adjustments are required to put the risks, the transaction costs and the management fees in a proper order, still, the strategies of fixed income arbitrage have been found to exploit the small differences that securities hold between their respective market prices and intrinsic values. It is debatable whether the arbitrages are low risk or they incur dramatic losses, but this form of fixed income investments still rule the roost.

Tests have introduced that out of all the five strategies tested, there are the ones requiring great intellect as the only capital. These are the:

* Yield curve arbitrage.
* Mortgage arbitrage.
* Capital structure arbitrage.
* Swap spread arbitrage.
* Volatility arbitrage.

Among these five, the last one has been found to yield positive excess returns though umpteen examples can be cited where they incurred significant losses.

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