Relative-value arbitrage is an investment strategy that seeks to take advantage of price differentials between related financial instruments, such as stocks and bonds, by simultaneously buying and selling the different securities, thereby allowing investors to potentially profit from the “relative value” of the two securities on the assumption that the value of the securities will eventually move back into line because the market is efficient.
The trouble is that is like a double or quits strategy at the roulette table. You place a chip on red, and if that fails to win, you follow that with two, four etc. The flaw in the strategy is that you get wiped out a succession of blacks or 0 (or 00) that is n spins long where 2n+1-1 is more moolah than you can lay your hands on. That in a nutshell was what happened to Long term Capital Management. Their bets looked like winners but the timing was wrong.
Now the boot is on the other foot. A paper from the US National Bureau of Economic Research claims to have identified by academic research in fixed income markets the “largest arbitrage ever”, saying that prices for US Treasury inflation-linked securities – government bonds that provide protection against rising prices – and regular Treasury bonds were thrown out of sync by as much as 23 cents on the dollar following the collapse of Lehman Brothers two years ago this week.
“The arbitrages reported are stunning in magnitude,” the researchers said. “What makes these findings even more dramatic is that the Tips (Treasury inflation-protected securities) and Treasury markets are two of the most liquid and largest financial markets in the world ... The sheer magnitude of this mispricing presents a serious challenge to conventional asset pricing theory.”
The NBER said the arbitrage had narrowed during 2009 to more normal levels, but for a small group of traders the widest pricing discrepancies led to one of the most successful hedge fund trades in recent memory.
One of the biggest winners was the smallish $450m Barnegat fund, founded in 1999. Barnegat acquired Tips bonds just after the collapse of Lehman Brothers and then shorted regular Treasury bonds of the same maturity. As the discrepancy narrowed, the fund realised huge gains, returning 132.6% to investors in 2009.