Risk and Return in Fixed Income Arbitrage
In the May 2007 Review of Financial Studies, Duarte, Longstaff and Yu examine the risk/return characteristics of commonly used fixed-income arbitrage strategies. They find that the strategies that require high levels of modeling produce significant positive excess returns even after adjusting for risk, transaction costs and management fees.
Fixed income arbitrage strategies tend to exploit small differences between intrinsic value and market prices for securities. There has been some debate as to whether they are truly low risk arbitrage or whether the small positive returns most frequently earned are offset by infrequent but dramatic losses.
Of five strategies tested, the ones requiring the greatest intellectual capital - yield curve, mortgage and capital structure arbitrage - produced the highest excess returns after controlling for risk and costs. Swap spread arbitrage also produced positive risk adjusted returns.
Volatility arbitrage, or selling options on fixed income instruments and hedging the underlying asset exposure, produced positive excess returns but also had periods of significant losses.
For more information, see all articles on: Active Management, Alternative Assets, Fixed income investments, Hedge Funds, Investing in bonds, Investment Returns, Performance Measurement, Risk Management See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
