Financial Derivatives and Risk Management

OMOTOLA FUNMILOLA GRACE

32058572

DECEMBER, 2022
 TABLE OF CONTENTS

1. Introduction
2. Concept of Arbitrage
3. How Arbitrage is used in Credit Derivatives Markets
4. Constructing an Arbitrage Trade in Credit Derivatives Markets
5. Conclusion
INTRODUCTION

In financial accounting, arbitrage is universally considered as the simultaneous purchase

and sale in different markets at a point in time with the aim to achieve a certain profit. For
example, if crude oil is selling for $60 per barrel in Nigeria but only for $45 per barrel in Qatar,
we can say an arbitrage has existed by buying crude oil in Qatar and simultaneously sell in
Nigeria with the aim to make a $15 profit on every barrel of crude oil. Simply put, arbitrage
implies the form of trading that seeks to exploits the differences in price between similar assets
in two or more existing markets. Arbitrage occurs in financial transactions and plays a very
fundamental role in financial markets, especially in credit derivatives markets. This essay will
attempt to give an overview of the concept of arbitrage and discuss how arbitrage is used in
credit derivative markets. The essay will further elaborate how an arbitrage trade could be
constructed in credit derivative markets.

CONCEPT OF ARBITRAGE

The concept of arbitrage has been one of the common financial terms in the recent time.
Over the years, efforts have been made in defining the concept of Arbitrage. Today, there are
many definitions of arbitrage provided by different scholars. Even with numerous definitions of
arbitrage, it is noteworthy that arbitrage is universally considered as a financial strategy which
enables investors or business entities to take advantage of price variations in different markets
for the same products or assets. Etymologically, the word “arbitrage” is derived from a Latin
word “arbitrary”, which implies “to give judgment”. This is why Geoffrey (2009) insisted that
the concept of arbitrage is not about trading as generally perceived rather about judging what the
rates should be.

In its classical definition, arbitrage was seen as “a zero-cost trading strategy with positive
expected payoff and no possibility of a loss” (Bondarenko, Kogam and Lo, 2001). The
connotation is that the presence of arbitrage may not be a necessary condition for equilibrium
models. Ledoit (1995) made an attempt to provide a concise definition of arbitrage. According to
Ledoit (1995), arbitrage remains an investment strategy and nothing more. This strategy is often
used to determine price discrepancies in the same asset across markets.
 In the book, “The First Book of Arbitrage- Overview”, Debra Kawecki (1994) described
arbitrage as “the purchase of securities on one market for immediate resale on another in order
to profit from a price discrepancy.” Prior before this definition, Dybvig and Ross (1989) had
defined the concept to be “an investment strategy that ensures a positive payoff in some
contingency with no possibility of a negative payoff and no net investment”. What this implies is
that investors or business organisations can make profit without any cost. This may have
explained why Huberman (2005) agreed that the main reason for arbitrage strategy is to make a
profit from a situation where are at least two assets have the same value with different prices at
the same point in time. However, using the Arbitrage Pricing Theory (APT), Alam (2022)
explained that arbitrage does not connote a free-risk operation. It does provide a high probability
of success. It is therefore presumed that the “arbitrage pricing theory offers traders is a model
for determining the theoretical fair market value of an asset. Having determined that value,
traders then look for slight deviations from the fair market price, and trade accordingly.”

One of the prominent writers on the concept of arbitrage is Miyazaki (2013) who
contributed largely to the arbitrage strategy in the 2000s. Miyazaki (2013) in his book,
“Arbitraging Japan: Dreams of Capitalism at the End of Finance”, opined that arbitrage is “a
central category of financial economics and a widely deployed trading strategy.” According to
him, arbitrage is not just a trading strategy; it is both an individual action and a market
mechanism which must be utilised for financial gains and personal goals.

Arbitrage does not occur in vacuum. There must be an arbitrage opportunity for it to take
place. An arbitrage opportunity implies the possibility to make a profit from a negative amount.
It is a simple way of beating the market. In his own opinion, Hull (2006) asserted that “ an
arbitrage opportunity is a strategy that allows an investor to start with no money at all and end
up with a positive amount for some future scenario, with no risk of losses.” Huberman (2005)
posited that there must be an imbalance of asset prices in numerous and different markets.
Supporting this view, Basak and Croitoru (2000) agreed that mispricing must arise between two
assets or securities that are coequal. Contrarily, Hull (2006) opined that mispricing is not a full
condition for an arbitrage opportunity. Generally, the following conditions must be met if
arbitrage is to occur.
 i. Price imbalance: Where the same asset, in different markets, is traded at different
prices. In this case, a price of one of the assets must be lower than the other.
ii. Simultaneous trade execution: Where the purchase and sale of coequal assets
should be carried out simultaneously with the aim to capture the price differences.

HOW ARBITRAGE IS USED IN CREDIT DERIVATIVES MARKETS

David (2007) defined a credit derivative as “an agreement designed explicitly to shift
credit risk between the parties; its value is derived from the credit performance of one or more
corporation, sovereign entity, or security”. Indeed, it is a financial contract that enables different
parties to minimise unnecessary exposure to credit risk. Lynch (2011) also defined a derivative
as “a financial instrument whose value depends on or is derived from a secondary source such
as an underlying bond, currency or commodity”. This definition is an indication that a derivative
is not different from traditional investments. Unlike a traditional investment, assets are not being
purchased in derivative market rather an investor solely purchases a contract with another
institution or investor.

Credit derivatives markets are essential features of the banking sector. Today, credit
derivatives market remains one of the most crucial and fundamental markets in banking (Barrett
and Ewan, 2007). Statistics have shown that the credit derivatives markets have grown rapidly in
the recent time (Romain, 2001). Since 1996, the Credit derivatives market of $180 Million has
grown to $66.0 Billion in first quarter of 2022 (British Bank Association, 2022). The key players
in credit derivatives market include Hedge Funds, Pension Funds, banks and brokers. These
players buy and sell protection and retain risk that needs to be actively managed in credit
derivatives trading books (Romain, 2001).

It is important for players to use arbitrage in credit derivatives markets. How arbitrage
trade can be used in credit derivatives markets are not extensively discussed in the literature.
However, some scholars (such as Blanco, Brennan and Marsh, 2005; Zhu, 2006 and
Mayordomo, Peña and Romo, 2009) have analysed the use of arbitrage in different credit
derivatives markets. In credit derivatives market, arbitrage trades can be made in bond,
currencies, stocks or commodities. Arbitrage strategy can be used to identify the opportunity and
execute or implement the trades. These trades are performed using a few financial instruments
such as derivative contracts (which include forward contract, option contract, futures contract
and credit default swaps) and available synthetic credit instruments (Corporate Finance Institute,
2022).

In credit derivatives markets, an arbitrageur (who is known as an investor or trader)

simultaneously buys or sells a corporate bond, stock, currency or commodity on the same
reference entity in the derivative markets. This trade, according to Boyarchenko, Gupta, Steele
and Yen, 2016), “is generally considered to be an “arbitrage" trade in the sense that an investor
earns a non-zero return on a default-risk free portfolio.” In this sense, arbitrage can be used in a
credit derivative market whenever any bond, stock, currency or commodity is available for
purchase in one market at a given price and could be simultaneously sold in another existing
market at a higher price. For example, the security of company Y is trading at $50 on the
Johannesburg Stock Exchange (JSE) while at the same time, it is said to be traded for $53 on the
Nigerian Stock Exchange (NSE). Here, we can say that an arbitrage opportunity has been
created. A potential arbitrageur can buy the security on the JSE and simultaneously sell the same
security on the NSE, with the aim to make a $3 profit. Until an adjustment in price is made by
JSE, a trader can persistently exploit such arbitrage opportunity.

In credit derivatives markets, arbitrage strategies are commonly utilised by both hedge
funds and pension funds (Hodgkins, 2014). As posited by Goyal (2013), arbitrage strategy is “an
underlying mechanism of both hedge funds and mutual funds which is usually used to capture the
differences in price of the same equity share listed on two exchanges and/or on the derivative
segment”. This trade most time does not yield enough (Sill, 1997) especially when it is not
frequently done. This is why Sill (1997) suggested that a trader can only take advantage in a
credit derivative market through frequent trading.

Another way to generate a significant profit in a credit derivative market is to implement

an effective arbitrary strategy (Sill, 1997). Various arbitrage strategies have been identified in the
literature. An arbitrageur, who is willing to invest in the fixed income market can adopt a swap
spread arbitrage, mortgage arbitrage, yield curve arbitrage, capital structure arbitrage, volatility
arbitrage (Duarte, Longstaff and Yu, (2007). Other strategies include co-integration test (Engle
and Granger, 1987), statistical arbitrage (Hogan, Jarrow, Teo and Warachka, 2004) and many
more. All these strategies have their own unique features and come with diverse merits and
demerits. This explains why an arbitrageur should determine when a certain suitable is
appropriate.

CONSTRUCTING AN ARBITRAGE TRADE IN CREDIT DERIVATIVES MARKETS

It is understood that arbitrage trade offers traders the opportunity to make profit without
open currency exposure in credit derivatives markets. In a credit derivative market, arbitrage
trade is a free-trade strategy that involves the buying and selling of bonds, stocks, currency and
commodities to exploit pricing inefficiencies. To make a significant profit in a credit derivative
market, a trader must know how best to construct an arbitrage trade. In this section, this essay
identifies the following steps through which an arbitrageur can use to trade in credit derivatives
markets. (See figure 1 below).

Figure 1: Arbitrage Trade processes

Identify an
opportunity

Review the
Pocket the
transaction
profit
costs

Sell the Purchase

asset the asset

i. Identify an opportunity

It is necessary for a trader to find a discrepancy in a credit derivative market. The first
thing to do is to identify and find arbitrage opportunity. What this suggests is that an arbitrageur
needs to spot the value of an item that is relatively lower in a specific market than it is in other
markets. Arbitrage opportunities in credit derivatives markets usually arise during price quoting
in most news events. Also, traders can find arbitrage opportunity at financial institutions that
often utilise algorithms to scour the market. For example, if two different banks – United Bank
for Africa and Ecobank Nigeria have set different rates on USD and Euro, then we can say an
arbitrage opportunity has been created. See table 1

Table 1:

Banks Euro rates USD rates

United Bank for Africa 1 EUR 1.5 USD
Ecobank Nigeria 1 EUR 1.2 USD

From the above table, it can be said that arbitrage opportunity has been created given the
fact that the rate of USD in Ecobank Nigeria is lesser than it is in United Bank for Africa. It is
advised that a trader should buy USD from Ecobank Nigeria, which is selling for 1.2 USD with
the hope to sell to United Bank for United or other banks.

ii. Review the transaction costs

Identifying an arbitrage opportunity is a prerequisite to the second step which is to review

the transaction costs. Here, an arbitrageur needs to evaluate how much it will cost to make a sale.
An arbitrageur must ensure that the price of transaction must not match or exceed the price
difference. Where the price of transaction exceeds or matches the price difference, an arbitrageur
is likely not to benefit from the profit. For example, a 3 USD price difference in the rates of USD
has been identified by an arbitrageur. It must be assured that it does not cost 3 USD to sell the
USD to United Bank for Africa. If that is the case, it means an arbitrageur will have no profit to
gain.

iii. Purchase the asset

When an arbitrageur is sure of the discrepancy in the market, the next thing to do is to
buy the USD from Ecobank as it is a lower market price. An arbitrageur must act quickly as such
opportunity may not be available for long. Here, an arbitrageur agrees to purchase the identified
assets in form of currency and take on the risk. Until, an asset is purchased in a credit derivative
market, we can say that an arbitrage opportunity has been identified and taken.
 iv. Sell the asset

Credit derivatives markets do not create many opportunities for a very long time. It is
understood that the principle of arbitrage requires an arbitrageur to sell at immediate time. This is
because prices of bonds, stocks, currencies or commodities change often and arbitrage
opportunities are always around for a short time. In this sense, an arbitrageur must sell in USD
immediately to United Bank for Africa to maximise profit.

v. Pocket the profit

Having sold the purchased asset to United Bank for Africa at higher price, it is certain
that an arbitrageur has completed an arbitrage trade in credit derivatives markets. From the above
illustration, it can be said that an arbitrageur has gained of 3USD from each USD bought from
Ecobank Nigeria as a result of price differences.

CONCLUSION

From the foregoing, it can be seen that arbitrage is a fundamental concept in financial accounting
and it plays very crucial role in the determination of price discrepancies in the same asset across
market. In credit derivatives markets, arbitrage occurs and it is often used by arbitrageurs to
identify arbitrage opportunity and conduct arbitrage trade. From the above analysis, it can be
perceived that arbitrage trades in credit derivatives markets can be made in bond, currencies,
stocks or commodities. Arbitrage strategy can be used to identify the opportunity and execute or
implement the trades using a few strategies as identified in the study. These strategies include
swap spread arbitrage, mortgage arbitrage, yield curve arbitrage, capital structure arbitrage,
volatility arbitrage, co-integration test, statistical arbitrage and many more. Lastly, it is argued
that an arbitrageur must know how best to construct an arbitrage trade to make a significant
profit in a credit derivative market. It is in this light that this essay proposed a five steps process
that an arbitrageur can use to construct arbitrage trade in credit derivatives markets. It is
advisable that potential trader adopt the five steps process because it is advantageous in creating
a successful arbitrage trade in credit derivatives markets.
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