MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
the specific risks of Short Selling (shorting risk) connected to the fact that the short seller has to borrow stock (e.g. short squeezes, execution risk). (These risks will be discussed in detail in the section about Short Selling strategies.)
Generally, markets with high and rising volatility combined with decreasing interest rates are the most favourable for Convertible Arbitrage strategies. In these circumstances being long volatility and long gamma pays off. In cases where the manager keeps a positive overall delta, rising equity markets produce better returns, while falling equity markets lead to losses. Generally, rising interest rates and decreasing volatility create a negative environment for the strategy. Extreme volatility combined with a flight to quality environment and a liquidity crisis can be very damaging for the strategy.
Different forms of pure, i.e. market neutral, Fixed Income Arbitrage are as follows:
■ Arbitrage between similar bonds (e.g. long underpriced 7-year duration US T-bond and short overpriced 7.1 Y duration US T-bond). This often involves cheapest-to-deliver bonds underlying a Futures contract on the bond or on- the-run vs. off-the-run issues.
■ Butterflies (e.g. long cheap 7 year and 9 year, short expensive 8 year). Relative mispricings along the yield curve often occur due to high institutional demand for certain benchmark bonds. The strategy is also referred to as ‘yield curve arbitrage’.
Figure 3.3 displays an example of a profitable yield curve arbitrage situation.
■ Basis trading is an arbitrage between physical securities and their Futures (e.g.
short overpriced US 10-year note Future, long underpriced US 10-year note).
Bond Futures have a delivery option and a wild card option, which can lead to pricing inefficiencies and provides for arbitrage opportunities.
■ TED spread, i.e. spread between Treasury bill Futures and Eurodollar Futures (this can be seen as a credit spread trade: government debt versus AA rated inter-bank debt).
■ Arbitrage between on-the-run and off-the-run bonds (e.g. short the latest government issue of a 10-year note and long the second most recent issue).
Other, non-market neutral, strategies include the following:
■ Yield curve spread trading based on a forecast of the directional change of the yield curve. An example could be going long the short end of the curve (up to 3-year maturities) and going short the long end (i.e. 10–15 years) anticipating a steeper yield curve in the future.
■ Credit arbitrage or credit spread trading capturing a credit-pricing anomaly and profiting from yield curve differentials for papers with different (but generally closely related) credit qualities (e.g. short an AAA rated bond with a spread to T-bonds of 50bp and long an AA rated bond with a spread of 80bp).
Sometimes a ‘credit barbell’ strategy is employed, a technique whereby managers assume credit risk in short and intermediate maturities and use safe government issues with long maturities.
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■ Asset-Backed Securities (ABS), e.g. credit card receivables, auto loans or mortage debt, offer enhanced returns for investors, which assume exposure to the
embedded option features (prepayment, call option) and accept lower liquidity and possible credit risk of the ABS. Examples for ABS arbitrage strategies are:
– Spread position ABS against T-bonds (e.g. long government secured Fannie Mae or Freddie mortgage-backed securities (MBS) and short US Treasuries with similar duration).
– Spread position of MBS against collateral mortgage obligations (CMO). An example is selling certain tranches of a CMO and buying a plain pass- through MBS.
– Arbitraging between different CMO classes. Two examples are: going long interest-only tranches (IOs) and shorting principle-only tranches (POs);
shorting a Principal Amortization Class (PAC) tranche and going long a support tranche.
The hedging of prepayment risk is rather complex but nevertheless commonly employed within ABS Arbitrage strategies.
MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
0 3 3.5 4 4.5 5 5.5 6
5 10 15 20 25 30
Years
Yield
10 9
8 7
4.86 4.9 5 5.1 5.2
Years
Yield
Short $100 8Y Bond Long $50 7Y Bond
Long $50 9Y Bond
FIGURE 3.3■Profitable Fixed Income Arbitrage situation 8409 Chapter 3 p38-110 11/4/02 1:13 PM Page 50
The spreads available for Arbitrage strategies in fixed income markets tend to be small. In order to earn attractive returns, most Fixed Income Arbitrage strategies must employ a high level of leverage, which may range from 10 to 25 (in some cases even higher) times the asset base and is created through borrowing, repo (repur- chase) transactions or the use of options, Futures or swaps. A creditworthy investor with good dealing relationships might be able to transact $100 million notional value while putting up less than $1 million collateral. The simpler strategies (e.g.
basis trades) are generally more highly leveraged than trades that are systematically exposed to more risk and specific risk factors (e.g. ABS strategies).
Sources of return
Pricing inefficiencies and arbitrage opportunities in fixed income markets occur for a variety of reasons including sudden market events, exogenous shocks to supply or demand, investors having maturity preferences or restrictions in certain fixed income investments (e.g. lower credit ratings), recent downgrade in credit ratings, complex options/callable features connected to a bond, deliverable charac- teristics for a Futures contract and complex cash flow properties. Most of these
‘pricing anomalies’ are related to certain risk premiums due to liquidity or credit risk. Fixed Income Arbitrage managers are often long and short equal amounts of securities with similar but not equal credit quality and liquidity. Thus the strategy earns a premium (the ‘spread’) for holding less liquid or lower credit quality instruments and hedges other risks (e.g. interest rates, duration) by selling short securities with higher liquidity and credit ratings. In an abstract sense, the strategy sells economic disaster insurance. Managers take positions that correspond to
‘short put positions’ on financial market turmoil.
The successful implementation of a Fixed Income Arbitrage strategy requires a very high degree of sophistication as prices of fixed income instruments depend on a large variety of factors with complex interactions: yield (spot, forward) curves, volatil- ity curves, (credit) spread curves, expected cash flows, prepayment features (for ABS) and option characteristics (e.g. call, put and prepayments schedules). A ‘complexity premium’ can be determined as one source of the return of Fixed Income Arbitrage
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MANAGING RISK IN ALTERNATIVE INVESTMENT STRATEGIES
strategies, as they are paid to understand complex pricing relationships that others do not follow and take the risks of mismodelling this complexity.
Risk factors
Fixed Income Arbitrage strategies are ‘short volatility’ strategies. Conceptually, they sell financial crisis insurances and subject themselves to ‘sudden event risk’. The risks of the strategy become apparent in market stress situations. For many years LTCM successfully executed a highly quantitative Fixed Income Arbitrage strategy, until it failed spectacularly in the weeks after the Russian default in August 1998.
Fixed Income Arbitrage is exposed to correlation breakdown risk, which is related to the event riskof ‘flight to quality’. Correlation breakdown is the sudden change of historical co-movement patterns between corresponding instruments which occurs due to changes in government policy, sovereign default (e.g. Russia in August 1998) or other economic shocks or dramatic events (e.g. the terrorist attacks on September 11, 2001), when interest rates move rapidly, credit spreads widen and liquidity dries up (‘flight to quality’ scenario). These ‘flight to quality’ events usually happen when many market participants want to liquidate positions at the same time (‘everybody running for the door’). They occur relatively infrequently, but when they do occur the value of Fixed Income Arbitrage portfolios can drop significantly on a mark to market basis resulting in losses of several standard deviations (tail risk).
In volatile markets the strategy can easily become a captive of the extreme leverage, where a single margin call on a position can destroy an entire portfolio.
Often fixed income arbitrageurs are short liquidity, i.e. they hold a long position in a comparably illiquid security and an offsetting short position in a relatively liquid asset, thereby earning a ‘liquidity premium’. Liquidity risk comes in two forms: the inability to meet margin calls (funding risk) and the (temporary) in- ability to unwind a position at normal bid/ask spreads (liquidation risk). Prime brokers may withdraw financing at particularly difficult times, which might neces- sitate the liquidation of the portfolio. This phenomenon should be taken into consideration when examining liquidity risk. Again, the failure of LTCM is an illustrative example of the liquidity problems a Fixed Income Arbitrage strategy faces in situations of market distress.
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The strategy is exposed to credit risk (spread risk, risk of change in rating, default risk) of the underlying bonds, which is sometimes hedged with credit derivatives. Fixed Income Arbitrage managers often hedge interest rate risk, but some managers (e.g. yield curve arbitrage) execute a particular view on the future shape of the yield curve. In such an approach the manager is therefore exposed to yield curve risk, the risk of change in level, slope and curvature of the yield curve.
Yield curve risk mainly stems from duration risk and convexity risk. Some strate- gies are contingent on low financing costs and are therefore affected by higher financing costs due to rising interest rates. Strategies that involve ABS are particu- larly exposed to prepayment risk (risk of not receiving cash flows at foreseen times). Prepayment risk is directly linked to the level and direction of interest rates and interest volatility.
Operational risks include model risk, execution risk and legal/tax risks. As many trading managers employ very complex quantitative models to find pricing discrepancies in different markets, they are exposed to model risk, i.e. the risk of mis-specification of the valuation method or risk models employed. Certain strategies take a large number of different positions simultaneously, which leads to execution risk(bad fills, slippage, clumsy order execution by the broker). Changes in tax laws or a financial or political change (tax or legal risk) can cause a stable relationship between two instruments to break up.
Fixed Income Arbitrage strategies perform well during times when there is a low likelihood of financial distress and in markets with constant or slowly chang- ing volatility and correlation between different fixed income instruments. In times of severe financial disorder (e.g. sovereign default, rapid increase of interest rates, political change), the strategy is exposed to potentially large losses.