Fixed Income Arbitrage

Difficulty expert

Overview

Fixed income arbitrage exploits pricing inefficiencies in bond markets and interest rate derivatives. These strategies typically have low market risk but require sophisticated modeling.

Strategy Types

Swap Spread Arbitrage

Swap Spread = Swap Rate - Treasury Yield

When spread is too wide:
- Receive fixed in swap
- Buy Treasury
- Profit from spread normalization

where: Swap Rate fixed leg of a matched-tenor interest-rate swap · Treasury Yield YTM on the matching-tenor Treasury. does: isolates the bank-credit / collateral / balance-sheet premium between swap and government curves. Used as a relative-value spread trade — mean-reverting in normal conditions but can dislocate sharply when dealer balance sheets shrink (2008, 2020).

Yield Curve Arbitrage

Exploit mispricing along the yield curve

Butterfly Trade:
- Short 2-year and 10-year
- Long 5-year
- Profit from curve reshaping

Basis Trade

Cash-Futures Basis = Cash Bond Price - (Futures Price × Conversion Factor)

When basis is negative (cheap):
- Buy cash bond
- Short futures
- Hold to delivery
- Profit from convergence

where: Cash Bond Price clean price of the deliverable Treasury · Futures Price quoted bond-futures price · Conversion Factor exchange-published factor adjusting for coupon and maturity differences. does: measures the gap between the cash market and the futures-implied price of the cheapest-to-deliver bond. Treasury basis trade is the canonical hedge-fund convergence play — high-leverage, low-vol in normal regimes, catastrophic in funding-stress events (Mar 2020).

Relative Value

Compare similar bonds:
- Same issuer, different maturities
- Different issuers, same maturity/credit quality
- On-the-run vs. off-the-run Treasuries

Interest Rate Models

Vasicek Model

dr_t = a(b - r_t)dt + σ dW_t

Mean-reverting short rate
Closed-form bond pricing

where: r_t instantaneous short rate · a mean-reversion speed · b long-run mean rate · σ instantaneous volatility · dW_t Brownian increment. does: Ornstein-Uhlenbeck SDE for the short rate. Admits closed-form zero-coupon bond prices, but allows negative rates — historically a flaw, now realistic for some sovereigns. Used to price interest-rate options and to fit yield curves analytically.

Cox-Ingersoll-Ross (CIR)

dr_t = a(b - r_t)dt + σ√r_t dW_t

Ensures rates stay positive
More realistic than Vasicek

where: √r_t rate-dependent volatility (CIR's key modification) · other parameters as in Vasicek. does: vol scales with the level of rates, which keeps the process strictly positive when 2ab ≥ σ² (Feller condition). Standard short-rate model for affine term-structure work and for pricing rate caps/floors in regimes where you need to enforce non-negativity.

Key Risks

Risk	Description	Mitigation
Model Risk	Wrong model assumptions	Multiple models, stress testing
Liquidity Risk	Can't exit positions	Trade liquid instruments
Basis Risk	Hedge doesn't perfectly match	Monitor basis closely
Funding Risk	Repo rate changes	Lock in funding
Counterparty Risk	OTC derivative counterparty	Use clearing, collateral

Practical Guidelines

1. Leverage Is Key — Spreads are small, leverage amplifies returns
2. Funding Costs Matter — Repo rates affect profitability
3. Model Carefully — Small pricing errors = large losses with leverage
4. Monitor Basis — Basis can widen before converging
5. Diversify — Multiple independent arbitrage positions
6. Capital Intensive — Requires significant balance sheet
7. Crowded Trades — Many funds run similar strategies

Next Steps

• Credit Trading — Credit market strategies
• Fixed Income — Bond market basics
• Statistical Arbitrage — Related strategies