In 1998, a New York hedge fund named Long-Term Capital Management nearly brought about the collapse of the global financial system. It was bailed out by the Federal Reserve and others in order to avoid a global financial meltdown. How did one hedge fund nearly crash the world economy? The firm's use of highly leveraged arbitrage trading for fixed-income securities was to blame.
There are a number of arbitrage strategies for fixed-income securities. One of the most widely used is called the swap spread arbitrage strategy and it involves exposure to LIBOR, which stands for the London Interbank Offer Rate. LIBOR is the average interest rate which large international banks charge each other to lend money in different currencies. Swap spread arbitrage is complex and involves a combination of an interest rate swap and Treasury bond purchase for a tiny profit. It generally requires a high leverage in order to realize substantial benefit.
Swap spread arbitrage requires taking positions in an interest rate swap contract, a Treasury bond, and a repo rate (a repo rate is the cost of borrowing to fund the purchase of the Treasury bond, where the bonds are used as a collateral). There are two parts to the strategy. The first leg of the strategy, called the swap spread, is the the spread between the fixed swap rate and the coupon rate of Treasury par bond. The second leg of the strategy, called the floating spread, is equal to the difference between LIBOR and the repo rate. The direction of the positions on the instruments involved in the strategy depends on the difference between the swap spread and the floating spread. (For more, read Arbitrage Strategies With Changing Interest Rates)
If the swap spread is higher than the floating spread, then the arbitrage can be implemented as follows: the investor (called the arbitrageur in arbitrage trades) enters into an interest rate swap contract where she pays a fixed swap rate in the exchange of LIBOR. Simultaneously, she purchases a Treasury par bond with the same maturity as the swap contract, but with the coupon rate that is less than the fixed rate in the swap contract. The purchase of the bond is financed by borrowing at a repo rate which is deemed to be less than the LIBOR rate.
This sounds complicated, and it is. Let’s looks at the illustration below for a more thorough explanation.
- The arbitrageur, represented in the green box below, enters into an interest rate swap agreement where she pays a fixed 6.5 percent rate and pays LIBOR.
- Simultaneously, she borrows money at the repo rate to purchase a 6 percent par Treasury bond with the same maturity as the swap. Traditionally, repo rates have been lower than the LIBOR rate and the spread was stable. Let’s assume that the repo rate is less than the LIBOR rate by 80 basis points.
Thus, in net terms, the arbitrageur will pay the swap spread and receive the floating spread.
In this example, the swap spread is 50 basis points (6.5% — 6% = 0.5%). The floating spread is 80 basis points (repo rate – LIBOR = floating spread of .8%). The net profit from the strategy is thus 30 basis points.
Net profit = floating spread (80) – swap spread (50) = 30 basis points
If the swap spread is higher than floating spread, the arbitrageur can use the reverse strategy, as shown in the illustration below. In this strategy, the arbitrageur enters into a swap agreement where she receives a fixed swap rate and pays LIBOR. Simultaneously, she shorts par treasury bonds and invests the proceeds at a repo rate. For example, imagine that the arbitrageur enters into a swap agreement to receive a 6.5 percent fixed rate and to pay LIBOR. At the same time, she shorts government par bonds yielding 5.8 percent and invests the proceeds at a repo rate which is less than LIBOR by 50 basis points.
In this strategy, in net terms, the arbitrageur receives the swap spread and pays the floating spread. In other words, she receives 70 basis points and pays 50 basis points, thus netting 20 basis points.
Net profit from arbitrage = swap spread (70) – floating spread (50) = 20 basis points
As our two examples illustrate, this type of arbitrage strategy provides a very small return. Thus swap spread arbitrageurs use highly leveraged positions to earn substantial profits at the cost of increased risk. Swap spread arbitrage strategy does inherit a risk, therefore, is not a true arbitrage strategy as traditionally accepted. The swap spread strategy is risky because if the repo rate converges to, or exceeds, LIBOR rates, the arbitrageur will incur losses. Historically, however, repo rates have been lower than LIBOR which enabled institutions such as hedge funds to implement this strategy.
The Bottom Line
The swap spread arbitrage strategy is traditionally used as a form of fixed-income arbitrage. Even when trades are executed correctly, it yields a tiny profit in the form of the stable spread between LIBOR and the repo rate. However, the strategy is not a traditional arbitrage by nature, because it carries significant risk losses. Leverage is crucial to earn any substantial profits using swap spread arbitrage.