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Hedge funds are among the most sophisticated investment vehicles in financial services, and these investment vehicles are overseen by some of the best traders in the world. Fund managers often take on excessive risk in attempts to create profits that are abnormally high. Fixed income arbitrage is one of those risky strategies that hedge funds have historically used. In this strategy, fund managers attempt to capitalize on pricing inefficiencies in bonds, which are debt instruments issued by corporations, governments, or municipalities that fall in the fixed income asset class.
Fixed income arbitrage investing is not for the faint of heart, nor is it for the inexperienced trader. Professional traders invest in the financial markets for years before obtaining the experience that allows these investors to recognize opportunity in fixed income arbitrage. Even then, only the most knowledgeable traders have the discernment to identify a price discrepancy in a financial instrument that could occur not only in bonds but also derivative instruments, including options and futures contracts. The process requires identifying a potential value discrepancy in a fixed income instrument, dismantling the debt instrument, and analyzing its true worth before rebuilding and responding by applying the trade.
When successful, fixed income arbitrage trading can be highly rewarding for traders and can generate lucrative profits. This trading strategy is also controversial in some circles and has been blamed for triggering inefficiencies in other markets and financial securities. In order to optimize returns, traders might add leverage, or debt, to individual trades by borrowing money from a prime broker. If the trade goes bad, however, the losses are similarly amplified.
Long Term Capital Management was a hedge fund that traded using fixed income arbitrage and was blamed for nearly triggering a financial meltdown in the world markets in the late 1990s. The trouble began after layers of debt were added to trades, and the fixed income markets took an unexpected turn when Russia defaulted on debt and left the hedge fund firm unable to cover its positions. The U.S. government stepped in to prevent a colossal failure of the financial system, but the hedge fund was closed.
Professional hedge fund managers are not known for disclosing trading secrets, but there are industry indexes that track performance in fixed income arbitrage funds. These indexes track monthly and yearly returns or losses based on the number of fund managers who choose to report portfolio performance to the index firm. Performance in an arbitrage index gives market participants a sense of how successful this trading strategy is in different market conditions.
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