An arbitrage strategy, at its simplest, is an attempt to take advantage of any pricing discrepancy in any two markets for the same good or closely related goods. In the case of a “fixed income” discrepancy, this refers only to bonds and related devices, since the “fixed income” refers to the cash flow provided by an interest rate.
In technical terms, “arbitrage” refers to the price of the same, identical asset in two markets. The point is to make a profit by trading while the same asset is under two prices. The difference is then pocketed. For fixed income strategies, it refers to the same class of bonds that respond to the same types of market forces. Hedge funds are the main practitioners of arbitrage. This is largely because these funds are made up of powerful investors with often global reach. Their ability to follow many different international markets make them perfect for arbitrage trading.
For the briefest of moments, a market compensates for the same asset in two different markets. Since markets are not identical in how they value the same bond—or type of bond—there is a brief period of differential in the price. Since information moves so quickly, these discrepancies are quickly equalized. Some traders, however, seek to cash in on that period of discrepancy and pocket the difference. The concept is to gain money from the same asset without the slightest risk. Since the buying and selling of the asset must be simultaneous, there is no market risk at all.
For a fixed income arbitrage strategy, several things have to occur. First, the asset involved needs to be based on interest, such as bonds. Second, the assets need to be closely related, such as two bond types that float together. Third, the sale of the asset must be simultaneous, to allow profiting from the discrepancy with little risk in most circumstances. However, high risk in rare circumstances is possible, In general, disaster can strike when the prediction of price movement proves to be false. Since most fixed income arbitrage strategies include borrowed funds, large amounts of money can be lost rapidly.
An investment firm, for example, will track two bond types that have been moving together within the market in the same way – they are usually related and are dependent on the same factors. An example here might be a government-backed treasury bond and a currency bond connected to the same interest rate. Using regression time-series analysis, an investment firm can tell when a run on demand—or supply—will temporarily, sometimes for seconds only, push the two prices away. With this information, the firm will borrow for one security and buy the other. This is called a long-short position. It will buy the more expensive option and borrow the less expensive one. They will be sold at the same time just before the two streams re-converge. The less expensive loan will be paid off with the proceeds from selling the bought bond. Thus, a small profit will be realized with almost no market risk under most circumstances. Large investment banks with the most sophisticated statistical and regression software can predict these divergences and quickly take their relative positions.