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Bonds/Swaps/Futures Funding Arbitrage

Please note, as ART Consulting/Research is a fee based service, in the following the results have been "sanitised" to disguise the specific markets, trading factors, strategy parameters and many other essentials.  Of course, all of the analyses is based on real market conditions and real world trading considerations (trans cost, funding, etc).  For access to the "un-sanitised" results, and for analysis tailored to your needs please submit an email via  Request More Information.

 

Even apparently simple, and what is otherwise considered well understood trading may lead to arbitrage opportunities.  For many years the "markets" had not fully accounted for the "delivery option" in US Bond Futures, providing arbitrage opportunities.  In a similar manner, the funding relationship in the Bond/Swap/Bond-Futures complex may also give rise to conditions that are arbitragible. 

 

This type of arbitrage arises due to a variety of factors involved in the "arbitrage free" mechanism built into fair value pricing, and importantly also due to the way in which the funding process is managed/traded.  In the real world, the funding process is almost never consistent with the assumptions of the pricing mechanism.

 

This abridged note provides only a cursory illustration of just a few holding period P&L results using different rebalancing and structuring strategies under real market conditions.  In each case, some combination of bond/swap/bond-future position was examined with different funding strategies.

 

As is customary at the ARBLab, PaR analysis is performed on various structuring and rebalancing strategies.  Other examples of PaR analysis and the  Pr/rO software are provided in the ARBLab Samples section, such as ARBLab: P&L Optimal Options Rebalancing - 1, while all of TG2RM1st - Chapter 12 is dedicated to the introduction of PaR analysis.

 

The image to right (click to ENLARGE) shows an interpolated surface for 1809 net-P&L's resulting from 1809 trades, each being held and rebalanced as required by the structure/strategy under consideration.  The quality of the data is critical.  Here only two of the many "dimension"  (Factors X & Y) are shown.  These factors are real world measurable quantities such as prices, vols, moving averages, etc.  This surface already illustrates that funding process is "too expensive" due to the various interactions of the funding trades, implied repos vs. actual repos, holding period mandates, and important correlations (most of which are not accounted for in traditional valuation and risk methodologies).

An alternate set of strategies/funding process are shown in the image to the right.  This surface is the interpolation of 2421 trades.  It has a very different character compared to the surface above.  Here too, the funding process is inefficient.

However, consider that these two strategies/positions could be taken on simultaneously and to offset one another.  In this case, though not purely risk free, it is a very low risk trade which produces an average return comparable to nearly risk free consistent 1-2/32'nds per contract in bond/bond-futures terms. 

Notably, some of the approaches to exploit such arbs are better suited to large trading operations and market makers, where there are large frequent flows, and low transactions costs.

As usual, caution is required.  The analysis here, though including thousands of trades, and incorporating many real world factors cannot be taken as any perfect predictor of the future, and additional specific analysis may be required for your due diligence.

  

For detailed research results on this issue please Request More Information and please feel free to indicate specifics of interest to you.

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1 For example, a "Bond + Warrant" is often included in the CB family of trades, but this is not a strict CB.  With a strict CB, you may only own one or the other security at any one time, while with a B+W it is possible to end up holding both shares and bonds simultaneously.

2 "Easy to trade" instruments are those that are easily accessible, liquid, low transaction and warehousing costs, and so forth.

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Last modified: July 25, 2011