Fixed Income Arbitrage as a Day Trading Strategy
Lots of day traders use arbitrage as one of their strategies for profiting from the stock and securities markets. There are a number of ways to approach arbitrage, including arbitrage in the fixed income securities market.
Fixed income securities are bonds, notes, and related securities that give their owners a regular interest payment. They are popular with conservative investors, especially retirees, who want to generate a regular income from the quarterly interest payments. They are considered to be safe, predictable, long-run investments, but they can fluctuate wildly in the short term, which makes them attractive to arbitrageurs.
Interest rates are the price of money, and so they affect the value of many kinds of securities. Fixed income securities have a great deal of interest-rate exposure because they pay out interest. Some stocks have interest-rate exposure, too.
Trading in foreign exchange is an attempt to profit from the changing price of one currency relative to another, and that’s usually a function of the difference in interest rates between the two countries. Derivatives have a regular expiration schedule, so they have some time value, and that’s measured through interest rates.
With so many different assets affected by changes in interest rates, arbitrageurs pay attention. With fixed-income arbitrage, the trader breaks out the following:
The time value of money
The level of risk in the economy
The likelihood of repayment
The inflation-rate effects on different securities
If one of the numbers is out of whack, the trader constructs and executes an arbitrage trade to profit from it.
Buying bonds outright is rarely practical for a day trader. Instead, day traders looking at fixed income arbitrage and other interest-rate sensitive strategies usually rely on interest rate futures, offered by the CME Group.
How would such a trade work? Think of a day trader monitoring interest rates on U.S. government securities. He notices that two-year treasury notes are trading at a lower yield than expected — especially relative to five-year treasury notes.
He sells futures on the two-year treasury notes and then buys futures on the five-year treasury notes. When the difference between the two rates falls back where it should be, the futures trade will turn a profit.