Tuesday, October 28, 2008

Some riskless profit, and why it exists

Numerous commentators have pointed out the enormous yield spread between agencies debt (Fannie/Freddie) and US Treasuries.

Here are some links kindly provided by a reader: 10 yr Fannie/Treasury, 5 yr Fannie/Treasury, 10 yr Freddie/Treasury, and 5 yr Freddie/Treasury.

Currently their spreads are above 150 bp. Since the US government has nationalized Fannie and Freddie, this 150 bp is a riskless profit. As the blog Accrued Interest has pointed out, one reason this riskless profit exists is hedge fund deleveraging: nobody has the risk appetite to arbitrage this spread at a meaningful scale.

Brad Setser, a blogger at the Council of Foreign Relations, suggests that the Chinese government, who does have a lot of cash to benefit from this high yield, should go ahead and buy up these agencies debt. However, if you read the Chinese blogs and online comments, there is enormous internal pressure for the government to spend some of this money on infrastructure projects, social security, health care, etc., so I doubt that the Chinese government will have stabilizing the US mortgage market at the top of its agenda. As a result, arbitrageurs out there should have no fear that this opportunity will disappear any time soon.


Cesar said...

On a somewhat related topic, there have been some share class arbitrage opportunities in this market, in which the spreads between a company's class A stock and class B stock have been over 30%. Examples include GEF and GEF-B, and BBI and BBI-B. The only difference in the class A and class B of these companies is their voting rights (each class B share counts for 10 votes) otherwise there's no difference in their economic interest in the company.

Anonymous said...

Hello, I just recently found your blog and was very impressed and enjoyed your prior post. I was ondering if you had any thoughts of a trade that I have been hearing about, long GLD, short SPY.

Ernie Chan said...

Dear anonymous,
Actually, the trade is an arbitrage between GLD and GDX. Details can be found at this post http://epchan.blogspot.com/2006/11/reader-suggested-possible-trading.html, among others.

Steve M said...

Can you elaborate on how to implement this trade?

Argyn said...

"one reason this riskless profit exists is hedge fund deleveraging: nobody has the risk appetite to arbitrage this spread at a meaningful scale. "

IF it was riskless, then what risk appetite are you talking about?

it's NOT risk less.

Ernie Chan said...

The only risk I am aware of is that the US government will not guarantee the repayment of Agencies debt. That would be an extremely unlikely scenario. Are you aware of other risks?

Anonymous said...

If it is indeed riskless it is certainly not the lack of "risk appetite" that prevents hf to enter the trade, as this would be self-contradicting...
more realistically it might not be as simple as you said to "lock" the whole spread? esp. considering funding costs

Nicolas said...

Those arbitrage depends on the repo of those securities, no ?

Not only general repo, but also counterparty risk your lenders incurs.

So, unless you have that checked, forget about the riskless profits.