Sunday, 26 October 2008

Swaps spreads and other lunch toppings

Why, sometimes I've believed as many as six impossible things before breakfast said Alice. This quotation came to mind in the discussion of the 30y dollar swap spread in the FT recently:
“Negative swap spreads have been considered by many to be a mathematical impossibility, just like negative probabilities or negative interest rates,” said Fidelio Tata, head of interest rate derivatives strategy at RBS Greenwich Capital Markets.
Oh dear me. A mathematical impossibility is 2 and 2 adding to 5, or the sudden discovery of a third square root of 4. A physical impossibility is something that we think is impossible according to our current understanding of science: accelerating from rest to go faster than the speed of light, say.

Negative swap spreads are neither of those. They simply represent an arbitrage. An arbitrage is when you can make free money without taking risk. Ignoring for a moment the risk de nos jours - counterparty risk - swap spreads allow one to lock in a positive P/L if one can fund at Libor flat. Free lunches do not often exist in finance, but they do happen in particular when there are no arbitrageurs left standing. No arbitrage relies not on the theoretical possibility of a free lunch, but on enough people actually wanting to dine for nothing that prices move to stop the feast. At the moment there is such a shortage of risk capital that one can indeed find free food. So `impossible' things are happening not just before breakfast but all through the day. Bon appetit.

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