Escolar Documentos
Profissional Documentos
Cultura Documentos
and
Fixed-income Arbitrage
Outline
Part I
• Forward rate
Part II
• Bond is a debt used for borrowing money and is one type of fixed-income
securities
• Par/Face value is the amount that investors will get back per bond at
maturity (usually $1000)
Bonds (cont’d)
• Accrual interest: If an investor wants to buy the bond before the next coupon
dates, he needs to pay the previous holder the amount of interest accrued
during his ownership
• Clean price: Bond price with a whole coupon period – Accrued interest
• Bonds are usually quoted on a clean basis but settled on a dirty basis
• Day-count convention: A/360, A/365, 30/360 (Eg. Mar 15, 2005 to Jun 15, 05 is
counted as 92/360=0.2556 in A/360 basis)
Yield-at-maturity
• YTM can be used to compute bond price, so it is often used as a market quote
(per annum)
• YTM is equivalent to the internal rate of return on the bond, i.e., the rate that
equals the value of the discounted cash flows (coupons C and principle F) on
the bond to its current (dirty) price
C C C +F
P= + +L+
(1+Y / m) (1+Y / m)2
(1+Y )N
• Coupon rate is an obligated (fixed) return rate and does not change during
the life of the bond
• YTM is NOT fixed and changes over time as long as the price changes
• Although both can be regarded as the measure of the return rate of a bond,
they must be interpreted differently:
– Coupon rate is the return rate of holding a bond if you purchase at par, i.e,
bond price = face value, and hold up to maturity
– YTM is the return rate of a bond at the time you purchase
• Both coupon rate and YTM are the “average rates” since cash flows (coupon
payments) in a bond are received at different dates and should be discounted
at corresponding rates
Credit Risk
• If the issuer of a bond fails to fulfil his obligation (default or bankruptcy), the
investors are subject to credit risk
• Current level of interest rate and market expectation would change YTM, i.e, a
higher interest rate, a higher yield and vice versa
• Eg. If the coupon of a bond is 4.5%, but the current market rate moves up by
1%, 4.5% coupon is not longer attractive to investors unless there is a
discount on bond price, resulting a higher yield
• If an investors buy a bond and sell it before maturity, he may incur a loss due
to interest risk
• Eg. Suppose an investor bought a bond 1 year ago at $100 with coupon of 4%
p.a. (annual). After one year, the bond price drops to $94. So his net position
is $94 + $4 - $100 = -$2 (a loss!)
• Yield curve (or term structure of yield) is a graph that indicates the
relationship between the yield of a bond and its time-to-maturity
• A yield curve is only an indicator of current interest rate level, and it does
evolve over time
• Yields usually increase over time, i.e., a longer maturity, a higher yield
• But the curve does not continue to slope upwards, all the way to 30-year
mark (why?)
• As a result, the price of a long-term bond is forced upwards, and this moves
the yield down to below what it should be
• So it implies the level of trading for the future (or at least what the market
thinks will be happening in the future)
• All market participants in the debt capital markets are interested in the
current shape and level of the yield curve and use it to decide their
investment decisions
• Market exhibits that a yield curve can have four basic shapes:
– Humped: yields are high with the curve rising to a peak in the medium-
term maturity, and then sloping downwards at longer maturities
• So bond investors would sell off long-term bonds and the yield at long end
should increase, producing an upward-sloping shape again
• A flat curve is usually more influenced by supply and demand than anything
else
• A low-coupon bonds pay a higher portion of their cash flows at later date
than high-coupon bonds of the same maturity
• Given the same prices and same maturity, a low-coupon bond has a higher
yield (at discount) while the high-coupon bond has a lower yield (at premium)
• Cash flows are not discounted at the “appropriate rate” for the bonds in the
group being used to construct the curve
• High-low coupon effect could distort the shape of yield curve and this could
lead to a wrong implication
• To compensate for this, some bond analysts construct a coupon yield curve,
i.e., yield curve constructed from a group of bonds with the same coupon
• A bond is traded at par if the yield is equal to coupon rate, or, the bond price
equals face value
• If bonds in the market are trading substantially away from par, the resulting
yield curve will be distorted
• Par yield curve can be constructed directly from bond yields when bonds are
trading at or near par
• Theoretically, a zero yield curve can be derived from the conventional bonds
• If zeros are traded in the market, the observed zero curve could be different
from theoretical one
Forward Yield
• Forward rate to a bond is the spot bond yield at the future date
(1 + R (T + 1) )
T +1
= (1 + R ( T ) ) (1 + F ( T , T + 1 ) )
T
F ( T , T + 1) =
(1 + R ( T + 1 ) )T + 1 −1
(1 + R ( T ) )T
• Forward rates that exist at one time point reflect everything that is known in
the market up to that point (efficient market hypothesis)
• The instant after they have been calculated, new market knowledge may
become available that alters the markets view of future interest rate
• But forward rates are still important because they are required to make
prices for trading today but settling at a future date
• For example, a bank may wish to fix today the interest rate payable on a loan
that begins in one year from now (payable in arrear)
• Forward rate is used by market makers to quote prices for dealing today, and
is the best expectation of future interest rates , given everything that is
known in the market up to now
• If traders happen not to agree with this market view, they will decide trading
strategy accordingly
• Spot and forward rates are calculated from the current market rates based on
the no-arbitrage principle, i.e., no profit opportunity arises if the actual spot
rate at future date equals forward rate
• Forward rates are somehow a “market-view” rate that will be (or should be!)
in the future
• If we compare the today 3-month forward curve with the yield curve 3
months from now, they are certainly different (market participants cannot
predict future interest rate 100% correct!)
• When constructing a forward curve, we are using current term structure (all
information includes market view, political and economic factors)
• As mentioned before, the market evolves over time with the latest
(unpredictable) information and this is why forward rates are not agree with
future interest rates
• When analyzing yield curves, bear in mind that they DO NOT contain
complete market information and it is frequently to observe anomalies not
explained by conventional theories
• It is quite strange that long-term yield have not risen much in the face of 14
straight increases (from 1% to 4.5%, raise 0.25% each time) in the Fed funds
rate
• Historically, longer-term interest rates usually have been higher that short-
term rates because investors required compensation for expected future
inflation (likely to be volatile)
• Some analysts suggest that calculus has changed because of the Federal
Reserve's success in keeping core inflation both low and less volatile
• They argue flattening of the yield curve over the past 19 months (since June
2004) isn't signaling a significant slowdown in U.S. economic growth, much
less a near-term recession
• The bond risk premium on the 10-year Treasury note is unusually low
around zero -- compare the 10-year yield to expected future short-term
interest rates
• But the collapse in the volatility of inflation relative to the volatility of real
rates is a much more compelling explanation
• Over the past 15 years, volatility of the core personal consumption price
index consistently has been much lower than that of inflation-adjusted
short-term interest rates
• U.S. budget and current-account deficits both reach a record high and this
would normally make the dollar depreciate and result a high inflation
• But the situation now is that these unsustainable deficits appear sustainable
due to great demand of U.S. treasuries from Asian central banks (holding
more than $1 trillion treasuries)
• Due to the great demand from Asian central banks, the shortage has raised
the price and reduced the yield on long-term bonds
• This keeps bond yields low, the dollar up and enables U.S. customers to live
beyond their means
• Another force to push up the yield is that the Treasury Department has
reduced the supply of long-term bonds since Oct 2001 by ending the sale of
30-year bonds* and financing more of the growing budget deficit with
shorter-term bonds
• This shortage has raised the price and reduced the yield on long-term
bonds
* The $14 billion sale of long-term bond is resumed on Feb 9, 2006, giving the U.S. government a new
tools to finance the expanding deficit and responding the resisted calls from Wall Street
Recession Predictor
• Traditionally, the relationship between the shape of the yield curve acts as a
predictor of recessions
• If the bond risk premium is zero, then the curve would be flat when Fed
policy is in a “neutral'' position (neither stimulating nor restraining
economic activity)
• Some supporters of the above views argue that, in the past, when inverted
yield curves did foretell recessions because it took a tight monetary policy
to invert the yield curve, but that isn't the case today
• Their points is that even if core inflation were to accelerate , the bond risk
premium wouldn't necessarily increase so long as investors remained
confident that the inflation rise would be limited and temporary
• Consequently, they think that long-term rates are too low based on
economic fundamentals
• As core inflation rises above the Fed's `”comfort zone,” the Fed would raise
its current overnight lending rate and this implies a sell-off at the long-end
of the curve, so that the yield curve will steepen once again
Hedge Fund
• A loosely regulated investment pool for affluent and institutions with less
transparency
• Typically, hedge funds charge 2% of the assets per year and 20% of the
profits
• Unlike mutual funds, hedge funds can use a wide range of investment
strategies:
– Holding derivatives, futures, swaps, etc
– Financial leverage
– Short selling
• Hedge funds had a good time to earn huge profit over the past decade, but
the days of easy money are over
• Hedge funds have returned more than 10% in one of the last five year,
compared with four of the five years through 1999 (source: CSFB/Tremont
Hedge Fund Index)
• The average fund worldwide was up 7.4% in 2005, but the return declined to
5.99% while the average return of 31% was posted in the golden years like
1999 (source: Hedge Fund Research Inc.)
• This can be done between different maturities on the fixed income yield
curve, or between different types of fixed income instruments
• Enter into a par swap and receive a fixed coupon rate CMS and floating
LIBOR Lt
• Short a par treasury bond with the same maturity as the swap: pay coupon
rate CMT and invest the proceeds in a margin account to earn repo rate rt
• Indirect default risk: It can be negative when the banking sector has
increasing default risk, resulting a significantly high LIBOR
• Collect a set of swap and treasury data and fit a mean-reverting process to
the floating spread
• Determine each month whether swap spread differs from the expected value
of floating spread over the life of strategy
• Close out the trade if the swap spread converges to the floating spread or
until the maturity of the swap
• If the difference becomes widen, should the trader unwind his position (cut
loss) or wait for the convergence? It is simply based on the trader’s
confidence on his view and market condition
Volatility Arbitrage
• This strategy aims at earning a profit from the volatility of the underlying -- an
excess return proportional to the gamma of the option times the difference
between the implied variance and the realized variance of the underlying
• Let V(F,t) be any function of the futures price and time. By Ito’s lemma, the P&L
from delta hedging with a constant volatility in a stochastic volatility market is
given by
F 2 ∂ 2V ( F , s;σ ) 2
T
P & L = ∫ e r (T − s ) (σ − σ 2 ( s )) ds
t
2 ∂F 2
• This strategy usually focuses on selling cap and delta hedging the position
using Eurodollar futures
• These two strategies have identical P&L with the notional scaled by
F2 x gamma / 2
• Yield spread arbitrage is not market-directional trading, but the view on the
shape of a yield curve or the spread between two particular points on the
curve
• The yield curve may be flattening or steeping when rates are both falling or
rising
• Suppose a trader believes that the yield curve is going to flatten, but has no
particular strong view on whether this flattening would occur in falling or
rising interest rates
• If he thinks that the flattening would be most pronounced in the 2-year and 10-
year buckets, he can take short position on 2-year bond and long position on
10-year bond
• He needs to use the price value of a basis point (PVBP) to determine the
weight in this spread trade (duration-hedging)
• PVBP is the change of the bond price if the yield changes by 1 basis point
1 ∆P
PVBP =
100 ∆Y
• This quantity is the change of 10-year bond with respect to the change in the
change of 2-year bond, so it can be used to hedge against parallel shift
risk, i.e., both 2-year yield and 10-year yield change in the same direction
• For example, if ΔY10 = ΔY2 = 0.01% (no change in spread size), the change in
10-year bond price is ΔP10
• If the trader holds ΔP10 / ΔP2 units of 2-year bond, then the change is
∆P10
⋅ ∆P2 = ∆P10
∆P2
• This implies that there is no P&L (offset the delta risk) if 2-year and 10-year
yields have parallel shift
• Butterfly trade: Short position (sell) in one T2-year bond and long position
(hold) in two bonds with maturities T1 (< T2) and T3 (> T2)
• Traders would use this trading strategy if he believes that, for example, 2-year
bond would outperform 3-year and 5-year bonds
• His view reflects that the short end of the curve would steepen relative to the
“middle” of the curve while the long end would flatten
• Intellectual Capital: Require a yield curve model to identify points that are
either “rich” or “cheap”, i.e., to explore arbitrage opportunities (model risk!)
• If the 2Y swap is more than a certain amount (say 5 or 10 bps) above the
fitted 2Y point, a trade is structured by receiving fixed on a 2Y swap and
shorting a 1Y and 10Y swaps for delta-neutral
• The trade will be held for 12 months or until the 2Y swap converges to the
model value
• Trading strategies are typically based on the investment view of hedge fund
manager and the availability of market instruments
Convertible Arbitrage
• Intuitively, if the stock increases in price, the bonds will appreciate and if
the stock falls, the short position will make money
• They take advantage of stock price movements to adjust their short stock
hedge positions -- maintain a market neutral position to capture profits
• Equity risk: At higher share price, the price of a CB behaves like pure
equity; at low share price, the value of CB falls to a lower level and flattens
out to a constant level and CB is likely to redeem at maturity
• Interest rate risk: This risk is usually hedged with treasury futures or
interest rate swaps
• Credit risk (omicron): A lower credit rating leads to a lower equity price and
a widening in credit spread, resulting a lower price of a CB and is hedged
with longing CDS/shorting a plain bond or equity (a structural model is
needed!)
• Liquidity risk: Long position not being liquid as expected or short position
being called in/short squeezed and this risk cannot be hedged away
• In this hedge, delta risk is neutralized but not the interest rate risk and the
long position in vega exposure
• If the implied volatility level decreases or stays the same, the position will
benefit just from the income flow from convertible’s yield and the short
interest rate’s rebate
Risk Analysis
• Delta risk: CB moves towards the ITM position as delta tends to 1 and
moves towards the OTM position as delta tends to 0
• Gamma risk: Deep OTM/ITM results a lower gamma and ATM gives the
largest gamma, so gamma is associated with the rebalancing frequency of a
delta-hedged portfolio
• Vega risk: ITM/OTM possesses lower vega and ATM presents higher vega
• Theta risk: A lower theta when ITM/OTM (less conversion premium to lose)
and a higher theta when ATM
• Rho risk: CB reaches its maximum rho when OTM and minimum when ITM
• Omicron risk: A higher omicron when OTM and a lower omicron when deep
ITM, and OTM CB is more influenced by omicron than any other greek
• A high gamma
• Is it merely a strategy that earns small profit most of the time, but occasionally
experiences dramatic losses?
• Is it really market-neutral?
• Is there a link between hedge fund returns and hedge fund capital?
• Empirical findings:
• Models only tell you the time to enter into a trade, but don’t give you any hint
when to terminate if the market situation is against hedge fund managers’ view
• As the number of hedge funds and the asset under management with similar
styles across the world are rapidly growing, it would heighten financial system
instability (create another risk!)