1. FIXED INCOME ARBITRAGE Jake Caldwell – Colgate Finance Club Fall 2010

2. An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity - Investopedia Part I: Fixed Incomes

3. Fixed Incomes – What are they?  “Fixed” – they offer returns at regular intervals – monthly, quarterly, annually, etc.  Generally, they have “fixed” returns – predictable return on investment (not always the case)  “Income” – they provide a source of income to an investor  Created as a product that an investor can rely on to produce returns  Who might be extremely interested in this? Retired Investor  Often referred to as a “Fixed-Income Security”

4. The Bond  The most common Fixed-Income Security  Debt-Instrument – Sell the Debt to an Investor  Investor gives the entity capital and is paid interest on the debt he/she takes on – Interest rate of the Bond 1. Government 2. Corporate 3. Municipal 4. Institutional

5. Terminology of FI or Bond  Issuer – Company Issuing the Debt-Instrument  Coupon – Interest the investor receives  Bond Principal – The Cost of the Bond  Maturity Date – Expiration of the Bond – Investor receives the principal back

6. Interest Rate or Coupon  The Payoff  Determined by the quality of the debt/credit and the duration of the product  Quality – Determined by a Rating Agency  Duration – Differs by product  The Coupon is generally paid out semi-annually, but is referred to as a annual rate

7. Interesting FIs  Structured Note  Adjusts to favorable increases for investor – increases returns/ coupon rate, medium-term  Commercial Paper  Short-term (less than 270 days) debt note to investors backed by no hard assets – can only be used for variable assets (inventories) not fixed assets (plant)  Bank Obligations  CDs – Certificate of Deposit – pays out interest to owner

8. The simultaneous purchase and sale of an asset in order to profit from a difference in the price - Investopedia Part II: Arbitrage

9. How It Works  An investor/trader sits on his desk in NY.  He is trading a commodity – Oil.  Oil is traded on Mercantile Exchanges globally  This trader is looking at Crude Oil Future prices on the NYMEX and the CME  He sees that Crude Oil is trading at $100 a barrel on the NYMEX and $100.05 on the CME  He shorts 1,000 Futures on the NYMEX and buys 1,000 Futures on the CME  He profits from the price discrepancy and makes 1,000 x $.05 – (.01x1,000) = $40  This example is on a small scale, but it costs the trader nothing to do this

10. Is this practical?  Although this may seem like an easy way to make money, you will not find a price discrepancy of.05 on any futures  Arbitrage relies on market imperfections  This acts as a system of “checks & balances”  These price discrepancies may occur in the short- term, but not in the long-term (we are talking about the difference between seconds and minutes)

11. The Role of Technology  The ability to exploit price differences is a result/bi-product of the revolution in technology on trading floors  The emergence of trading floors/market places for assets (NYSE Euronext) allows traders to find this price differential  Ultimately, the trader with the fastest technology and the most market information is the winner  Perfect Market Information is an imperfection of the markets – it does not exist http://www.youtube.com/watch?v=wuq54vDFeqU

12. Fixed Income Arbitrage

13. Muni. Bond Arbitrage Case  This is one example of Fixed Income Arbitrage  Deals with Municipal Bonds and Interest Rate Swaps  Underlying Assumptions/Facts:  Municipal Bonds are tax-exempt  Municipal Bonds are correlated with Interest Rate Swaps  Interest Rate Swaps (remember “fixed-to-floating”) are a type of Corporate Bonds – involves the swap by two companies to decrease costs and obtain the best rates  IRS/CB are not tax-exempt  Looking for these to share same maturity date (duration)

14. Muni. Arbitrage Case cont.  Trader is long NJ/NY Municipal Bonds for the new Giants Stadium  In order to protect himself, he wants to hedge his risk – specifically, the duration risk  He chooses to short corporate bonds – i.e., Interest Rate Swaps with the same maturity  When these reach maturity, he pays the interest/tax on the corporate bonds, but receives the tax- exempt interest on the Muni. Bonds – the difference between these two is his profit

15. Mathematically  Long 1,000 2-year Muni. Bonds at $200  1,000 x $200 = $200,000 of risk (unhedged)  They payout 6% annually interest rate – or 3% semi.  Duration is 2 years, after 2 years I receive the principal  After my first year, how much have I made assuming I choose to reinvest the interest in a different asset?  $200,000 x.03 = $6,000 x 2 = $12,000  After 2 years, I will have made $24,000  But I am at risk the entire time of the municipal bond not being paid back or not receiving my interest – I want to hedge this duration risk

16. Mathematically cont.  The trader shorts Interest Rate Swaps for two companies that pays out 6% annual interest rate (3% semi-annually) and is taxed at 5%.  $200,000 x.03 =$6,000 x 2 = $12,000 x (0.95) = $11,400 x 2 = 22,800  Now if this is what the trader pays out, then we must subtract this from the interest made on the Municipal Bond: $24,000-$22,800 = $1,200

17. Conclusion  As you see, arbitrage takes advantage of the imperfections of the markets and acts as a safety net to keep prices close together  Each asset class/product can be traded differently to take advantage of these  In our example of Fixed Income Arbitrage, the trader focuses on hedging his duration and uses differences in interest rates (based on taxes)