Fixed Income Arbitrage

1. Fixed Income Arbitrage Jake Caldwell – Colgate Finance Club Fall 2010

2. Part I: Fixed Incomes An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity - Investopedia

3. Fixed Incomes – What are they? • “Fixed” – they offer returns at regular intervals – monthly, quarterly, annually, etc. • Generally, they have “fixed” returns – predictable return on investment (not always the case) • “Income” – they provide a source of income to an investor • Created as a product that an investor can rely on to produce returns • Who might be extremely interested in this? • Retired Investor • Often referred to as a “Fixed-Income Security”

4. The Bond • The most common Fixed-Income Security • Debt-Instrument – Sell the Debt to an Investor • Investor gives the entity capital and is paid interest on the debt he/she takes on – Interest rate of the Bond • Government • Corporate • Municipal • Institutional

5. Terminology of FI or Bond • Issuer – Company Issuing the Debt-Instrument • Coupon – Interest the investor receives • Bond Principal – The Cost of the Bond • Maturity Date – Expiration of the Bond – Investor receives the principal back

6. Interest Rate or Coupon • The Payoff • Determined by the quality of the debt/credit and the duration of the product • Quality – Determined by a Rating Agency • Duration – Differs by product • The Coupon is generally paid out semi-annually, but is referred to as a annual rate

7. Interesting FIs • Structured Note • Adjusts to favorable increases for investor – increases returns/ coupon rate, medium-term • Commercial Paper • Short-term (less than 270 days) debt note to investors backed by no hard assets – can only be used for variable assets (inventories) not fixed assets (plant) • Bank Obligations • CDs – Certificate of Deposit – pays out interest to owner

8. Part II: Arbitrage The simultaneous purchase and sale of an asset in order to profit from a difference in the price - Investopedia

9. How It Works • An investor/trader sits on his desk in NY. • He is trading a commodity – Oil. • Oil is traded on Mercantile Exchanges globally • This trader is looking at Crude Oil Future prices on the NYMEX and the CME • He sees that Crude Oil is trading at $100 a barrel on the NYMEX and $100.05 on the CME • He shorts 1,000 Futures on the NYMEX and buys 1,000 Futures on the CME • He profits from the price discrepancy and makes 1,000 x $.05 – (.01x1,000) = $40 • This example is on a small scale, but it costs the trader nothing to do this

10. Is this practical? • Although this may seem like an easy way to make money, you will not find a price discrepancy of .05 on any futures • Arbitrage relies on market imperfections • This acts as a system of “checks & balances” • These price discrepancies may occur in the short-term, but not in the long-term (we are talking about the difference between seconds and minutes)

11. The Role of Technology • The ability to exploit price differences is a result/bi-product of the revolution in technology on trading floors • The emergence of trading floors/market places for assets (NYSE Euronext) allows traders to find this price differential • Ultimately, the trader with the fastest technology and the most market information is the winner • Perfect Market Information is an imperfection of the markets – it does not exist http://www.youtube.com/watch?v=wuq54vDFeqU

12. Fixed Income Arbitrage

13. Muni. Bond Arbitrage Case • This is one example of Fixed Income Arbitrage • Deals with Municipal Bonds and Interest Rate Swaps • Underlying Assumptions/Facts: • Municipal Bonds are tax-exempt • Municipal Bonds are correlated with Interest Rate Swaps • Interest Rate Swaps (remember “fixed-to-floating”) are a type of Corporate Bonds – involves the swap by two companies to decrease costs and obtain the best rates • IRS/CB are not tax-exempt • Looking for these to share same maturity date (duration)

14. Muni. Arbitrage Case cont. • Trader is long NJ/NY Municipal Bonds for the new Giants Stadium • In order to protect himself, he wants to hedge his risk – specifically, the duration risk • He chooses to short corporate bonds – i.e., Interest Rate Swaps with the same maturity • When these reach maturity, he pays the interest/tax on the corporate bonds, but receives the tax-exempt interest on the Muni. Bonds – the difference between these two is his profit

15. Mathematically • Long 1,000 2-year Muni. Bonds at $200 • 1,000 x $200 = $200,000 of risk (unhedged) • They payout 6% annually interest rate – or 3% semi. • Duration is 2 years, after 2 years I receive the principal • After my first year, how much have I made assuming I choose to reinvest the interest in a different asset? • $200,000 x .03 = $6,000 x 2 = $12,000 • After 2 years, I will have made $24,000 • But I am at risk the entire time of the municipal bond not being paid back or not receiving my interest – I want to hedge this duration risk

16. Mathematically cont. • The trader shorts Interest Rate Swaps for two companies that pays out 6% annual interest rate (3% semi-annually) and is taxed at 5%. • $200,000 x .03 =$6,000 x 2 = $12,000 x (0.95) = $11,400 x 2 = 22,800 • Now if this is what the trader pays out, then we must subtract this from the interest made on the Municipal Bond: $24,000-$22,800 = $1,200

17. Conclusion • As you see, arbitrage takes advantage of the imperfections of the markets and acts as a safety net to keep prices close together • Each asset class/product can be traded differently to take advantage of these • In our example of Fixed Income Arbitrage, the trader focuses on hedging his duration and uses differences in interest rates (based on taxes)