Handbook of Hedge Funds

13

Fixed Income Arbitrage

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A trader

Fixed income markets are a particularly fertile territory for hedge funds, due to: (i) the lack of agreement on a standard absolute pricing model; (ii) the existence of multiple relative pricing relationships between various fixed income instruments; (iii) the influence of irrational but predictable supply and demand on specific asset prices; and (iv) the complex nature of some fixed income securities. The combination of these four elements opens the door to a broad set of strategies intended to exploit valuation differences and pricing anomalies between various fixed income securities. In the following, we will refer to them as fixed income arbitrage, although most of these strategies are not arbitrage in the purest sense. Some of them carry some risk and may actually lose money. But their risks are fundamentally different from the traditional buy and hold fixed income strategies, and they often mix long and short positions, therefore the name “arbitrage”.

In practice, one can distinguish three major investment styles in fixed income arbitrage strategies: relative value, “market” neutral and directional trading.

• Relative value strategies seek to construct a portfolio which takes advantage of a relative pricing anomaly between two or more fixed income securities while maintaining a diversified risk profile. Neutrality with regard to interest rate variations is not systematically targeted, as the ...