Arbitrage Bond - Explained
What is an Arbitrage Bond?
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Table of ContentsWhat is an Arbitrage Bond?How Does an Arbitrage Bond Work?Academic Research on Arbitrage Bond
What is an Arbitrage Bond?
An Arbitrage bond is a bond issued by a municipality to refinance an existing higher-rate bond with a lower-rate bond prior to the call date of the former. Arbitrage bonds are issued by municipalities when they want to take advantage of the difference in the price of lower-rate security and higher rate security. Proceeds that emanate from the sale of the lower-rate bonds are put into the treasuries the higher-rate bonds reach their call date.
How Does an Arbitrage Bond Work?
An Arbitrage difference exists between bonds with lower interest rates and those with higher interest rates. When municipalities use the arbitrage bond strategy, it helps them hedge a decline in the interest rates on existing bonds. Arbitrage bonds also reduce the cost of borrowing for municipalities. Municipal bonds have the embedded call option, an attribute that allows municipalities to redeem bonds before their maturity or call date. When a municipality issues bonds with a lower rate, the goal is to use the proceeds to refinance the existing higher-rate bonds at a lower rate. Usually, when municipalities use the arbitrage bonds strategy, it entails purchasing U.S. Treasury bills which bond with lower interest rates that can be used to refinance the existing higher-rate bonds prior to the call date.
Academic Research on Arbitrage Bond
- Inflation expectations and risk premiums in anarbitragefree model of nominal and realbondyields, Christensen, J. H., Lopez, J. A., & Rudebusch, G. D. (2010). Inflation expectations and risk premiums in an arbitragefree model of nominal and real bond yields.Journal of Money, Credit and Banking,42, 143-178. Differences between yields on comparablematurity U.S. Treasury nominal and real debt, the socalled breakeven inflation (BEI) rates, are widely used indicators of inflation expectations. However, better measures of inflation expectations could be obtained by subtracting inflation risk premiums (IRP) from the BEI rates. We provide such decompositions using an affine arbitragefree model of the term structure that captures the pricing of both nominal and real Treasury securities. Our empirical results suggest that longterm inflation expectations have been well anchored over the past few years, and IRP, although volatile, have been close to zero on average.
- Arbitrage-freebondpricing with dynamic macroeconomic models, Gallmeyer, M. F., Hollifield, B., Palomino, F., & Zin, S. E. (2007).Arbitrage-free bond pricing with dynamic macroeconomic models(No. w13245). National Bureau of Economic Research.
- Risk and return in convertiblearbitrage: Evidence from the convertiblebondmarket, Agarwal, V., Fung, W. H., Loon, Y. C., & Naik, N. Y. (2011). Risk and return in convertible arbitrage: Evidence from the convertible bond market.Journal of Empirical Finance,18(2), 175-194. In this paper, we identify and document the empirical characteristics of the key drivers of convertible arbitrage as a strategy and how they impact the performance of convertible arbitrage hedge funds. We show that the returns of a buy-and-hedge strategy involving taking a long position in convertible bonds (CBs) while hedging the equity risk alone explains a substantial amount of these funds' return dynamics. In addition, we highlight the importance of non-price variables such as extreme market-wide events and the supply of CBs on performance. Out-of-sample tests provide corroborative evidence on our model's predictions. At a more micro level, larger funds appear to be less dependent on directional exposure to CBs and more active in shorting stocks to hedge their exposure than smaller funds. They are also more vulnerable to supply shocks in the CB market. These findings are consistent with economies of scale that large funds enjoy in accessing the stock loan market. However, the friction involved in adjusting the stock of risk capital managed by a large fund can negatively impact performance when the supply of CBs declines. Taken together, our findings are consistent with convertible arbitrageurs collectively being rewarded for playing an intermediation role of funding CB issuers whilst distributing part of the equity risk of CBs to the equity market.
- Arbitrage opportunities in arbitrage-free models of bond pricing, Backus, D., Foresi, S., & Zin, S. (1998). Arbitrage opportunities in arbitrage-free models of bond pricing.Journal of Business & Economic Statistics,16(1), 13-26. Mathematical models of bond pricing are used by both academics and Wall Street practitioners, with practitioners introducing time-dependent parameters to fit arbitrage-free models to selected asset prices. We show, in a simple one-factor setting, that the ability of such models to reproduce a subset of security prices need not extend to state-contingent claims more generally. We argue that the additional parameters of arbitrage-free models should be complemented by close attention to fundamentals, which might include mean reversion, multiple factors, stochastic volatility, and/or non-normal interest-rate distributions.
- On the feasibility of arbitrage-based option pricing when stochastic bond price processes are involved, Cheng, S. T. (1991). On the feasibility of arbitrage-based option pricing when stochastic bond price processes are involved.Journal of Economic Theory,53(1), 185-198. There are many options which are based on interest rate sensitive assets. For example, debt options and currency options are best priced when a stochastic bond price process is included. However, not all stochastic bond price processes are feasible for use in pricing options by standard arbitrage techniques. This work draws on the results of Harrison and Kreps (J. Econ. Theory20(1979), 381408) and relates them to pricing in the presence of stochastic bond price processes. Examples of feasible and infeasible bond price processes are given.