Friday, September 24, 2010

Hedge funds reap rewards from Treasuries

Research by the National Bureau of Economic Research, the foremost economic think-tank in the US, says markets have been beset by “astonishing” pricing anomalies, the opportunities on which relative value arbitrage depends, since the collapse of Lehman Brothers in 2008.

“The arbitrages reported are stunning in magnitude and likely the largest ever documented in any fixed-income market,” says NBER – referring, specifically, to anomalies in US Treasuries, the world’s deepest and most liquid bond market...

The group’s most profitable trade was the startling anomaly in the Treasuries market identified by the NBER. The prices of inflation-linked Treasury bonds, known as Tips, and the prices of regular Treasury bonds – even when matched for maturity – were diverging sharply.

Since both securities had identical default risk profiles, there was no obvious reason for the divergence. Even once the effect of inflation expectations had been split out from the Tips yield, the bonds’ prices differed hugely.

For Barnegat the opportunity was clear: the fund bought Tips bonds and went short on regular Treasury bonds of a matched maturity, hedging out the effect of inflation along the way with a swap contract. The result was a trade that would make money if the divergent prices between the two securities converged.

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