Sunday, November 25, 2007

Arbitrage Opportunity

Arbitrage is usually defined as an opportunity to make a profit that requires no initial net investment -no negative cash flow- and that presents no risk for the arbitrageur. Such opportunities regularly arise, although they are usually short-lived.

More lasting discrepancies are opportunities which do not fully satisfy the technical definition of arbitrage, since they are either not 100% certain or because they require some initial investments.

One of the more fascinating cases of profit opportunities which may not be 100% certain but are nevertheless fairly certain and which requires no initial net investments are in the U.S. bond market.

Whether you look at the latest 20 years or 5 years, the historical average for U.S. consumer price inflation has been 3%, and currently inflation likely stands at more than 4%. Yet the spread between the regular nominal U.S. treasury note and the treasury inflation protected securities of similar maturity is just 2.3% for the 5-year note. While that is up somewhat since the Fed's September rate cut, it is still irrationally low.

So, in other words, even as Helicopter Bernanke has rapidly accelerated the pace of inflating and shown his willingness to in effect throw the dollar to the wolves, the U.S. bond market is pricing in a significant decline in inflation in the coming years!

While that scenario may not be impossible, it certainly appears highly unlikely that inflation would fall under the current circumstances, and fall to less than 2.3%. It is much more likely that inflation will instead rise and stay at a level higher than 3% over the next 5 years.

So, here is a almost risk free arbitrage strategy that requires no initial net investment: first you sell short the nominal treasury notes. Then you use the proceeds from that to buy inflation protected treasury securities of the same maturity. Then you hold this position and watch the interest income to you come in at larger sums than the sums you have to pay to compensate the owner of the treasury notes you sold short. And as you've made no initial net investment, you won't face any exchange rate risk (except in the sense that the falling dollar will limit your gains, but it can't inflict direct losses on you).


Anonymous Anonymous said...

TIPS are no longer traded. How can one buy inflation protected securities.outside of 30k I bonds

12:01 AM  
Blogger stefankarlsson said...

See here

11:36 AM  
Anonymous Anonymous said...

That would no longer be a zero sum play.Too much risk.Much more than commisions involved.

5:28 PM  

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