Relative-value arbitrage is a hedge fund strategy that seeks to exploit price discrepancies between highly correlated financial instruments by taking opposing long and short positions and seeking to profit from the relative value of the two securities. With the use of fundamental and technical analysis, fund managers identify the mispricing and implement relative-value arbitrage, which, in fact, encompasses a wide variety of different strategies pertaining to different underlying securities, such as dividend arbitrage, and options arbitrage.
Fund managers use a relative-value arbitrage strategy to profit from the relative mispricing between similar financial instruments. The underlying assumption is that the fund manager goes long on a security that he assumes it will appreciate, and he simultaneously goes short on a security he assumes it will depreciate. Relative-value arbitrage is also known as pairs trading because fund managers invest in a pair of securities with a high correlation, which tends to move in the same direction, such as debt and equity, stocks and bonds, options and futures, and so on. They may also invest in securities from the same industry or in two securities issued by the same company.
A Quick Example
A fund manager invests in a two municipal bonds issued by the same corporation. One bond has a coupon of 5%, and the other bond has a coupon of 8%. Both bonds have a face value of $5,000 and the same maturity. However, the 5% bond is trading at $5,150, and the 8% bond is trading at $5,190. The fund manager considers that relative value arbitrage can be a good strategy to generate a profit from the difference in the bond trading. Therefore, the fund manager takes a long position in the 8% bond and a short position in the 5% bond to capitalize on the price discrepancy.
Fund managers construct diversified portfolios that allocate risk on different asset classes and seek for investment opportunities globally. When using fundamental analysis, they look for a company’s return on equity (ROE), price-to-earnings (P/E) ratio, price-to-book ratio (P/B) ratio, changes in operating cash flows, dividend payments, dividend yield, and more. By using accurate historical modelling and properly interpreting the ratios, fund managers can identify price discrepancies between similar securities and generate profits.
Relative-value arbitrage enables fund managers to realize high returns in sideways markets, i.e. markets that have not a clear upward or downward direction (also known as non-trending markets). To that end, the strong correlation between the two mispriced securities generates a relative value that produces strong profits if the risk is hedged. Furthermore, the strategy incurs no directional risk as it has the ability to profit independent of the market direction as it only depends on the correlation between the two securities.
Because the relative-value arbitrage is mostly used in non-trending markets, it incurs the risk that the market changes direction abruptly. The fund manager cannot accurately predict the direction of a sideways market because the price activity is wavering between a fairly narrow range without establishing any discrete trends. Furthermore, a sideways market often leads to losses of trading capital. Since funds managers use the technical analysis to identify trends, it is difficult to predict the trend of a market that has no clear direction. The only way to profit from a relative-value arbitrage strategy a fund manager needs to possess the skills to evaluate the market and to be highly sophisticated to predict the movement of individual securities.
The Bottom Line
Relative-value arbitrage strategy is appealing due to its ability to generate profits in sideways markets where other strategies cannot. On the other hand, to use relative value arbitrage, a fund manager needs to be experienced and highly-skilled to understand the risks involved and capitalize on price inefficiencies to generate high returns.