Wednesday, March 31, 2010

Swaps and noise

Here is an example from the FT about how arbitrage opportunity may be squeezed by noise.

In the wake of the financial crisis, the use of collateral backing derivative trades in order to appease counterparty credit concerns has continued to expand.

This means that once a swap trade is executed, more margin is required if the trade starts losing money.

This daily management of margin also makes it harder to maintain an arbitrage over time as the value of any trade between swaps and Treasuries changes constantly.

Analysts at Credit Suisse say: “This makes it increasingly harder to hold arbitrage strategies to termination as arbitrageurs are forced to realise not just gains but also losses through margin calls resulting in frequent stop outs [forced exits from the trade].

The risk that the trade will move further in the wrong direction before convergence is achieved will limit those willing to take the risk and create some sort of threshold on arbitrage. This may be like a threshold error correction model similar to that seen in PPP.

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