Thursday, 20 November 2008

No arbitrage requires arbitrageurs

No arbitrage conditions are not natural laws. You can only rely on them if there are enough arbitrageurs around to keep the markets in line. At the moment, that isn't true in many settings. John Dizard points out an example from the Tips market:
seven-year Tips bonds are asset swapping at 130 basis points over Libor
As Dizard says, this is partly because the Tips are illiquid and hard to finance (and thus to leverage), and partly because there is not enough risk capital around:
The dealers can’t afford to make efficient markets, given their decapitalisation, downsizing, and outright disappearance. That means anomalies sit there for weeks and months, where they would have disappeared in minutes or seconds. The arbs, well, they thought they had risk-free books with perfectly offsetting positions. These turned out to be long-term, illiquid investments that first bled out negative carry, and then were sold off by merciless prime brokers.

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