Harvard Case - Arbitrage in the Government Bond Market?
"Arbitrage in the Government Bond Market?" Harvard business case study is written by Michael E. Edleson, Peter Tufano. It deals with the challenges in the field of Finance. The case study is 9 page(s) long and it was first published on : Jan 8, 1993
At Fern Fort University, we recommend that the student, acting as the portfolio manager, does not pursue the arbitrage opportunity presented in the case. While the potential for profit seems attractive, the risks associated with this strategy outweigh the potential rewards. This recommendation is based on a comprehensive analysis of the situation, considering the complexities of the government bond market, the potential for unforeseen market fluctuations, and the inherent risks associated with arbitrage strategies.
2. Background
The case study revolves around a student working as a portfolio manager who identifies a potential arbitrage opportunity in the government bond market. The student observes a discrepancy in the prices of two identical bonds, one traded in the US and the other in the UK. This discrepancy, driven by the difference in interest rates between the two countries, presents a potential opportunity to profit by buying the cheaper bond in the UK and selling it in the US.
The main protagonist in the case is the student, who is tasked with evaluating the potential arbitrage opportunity and deciding whether to pursue it. The case study also highlights the role of the student's mentor, who provides guidance and advice on the risks and complexities involved in arbitrage strategies.
3. Analysis of the Case Study
The case study can be analyzed through the lens of financial analysis, particularly focusing on the risk assessment and return on investment (ROI) of the potential arbitrage opportunity.
Financial Analysis:
- Risk Assessment: The student must consider the various risks associated with the arbitrage strategy:
- Market risk: Unforeseen fluctuations in interest rates or currency exchange rates could significantly impact the profitability of the arbitrage.
- Liquidity risk: The student needs to ensure that there is sufficient liquidity in both markets to execute the trades efficiently and without significant price slippage.
- Transaction costs: The student needs to factor in transaction costs, such as brokerage fees, exchange fees, and potential taxes, which can erode the potential profits.
- Operational risk: The student must ensure that the trades are executed correctly and on time, minimizing the risk of errors or delays.
- Return on Investment (ROI): The student needs to calculate the potential ROI of the arbitrage strategy, considering the potential profits against the risks involved. This includes:
- Spread: The difference in prices between the two bonds, which represents the potential profit.
- Transaction costs: The costs associated with executing the trades, which will reduce the potential profit.
- Risk premium: The student needs to factor in a risk premium to account for the uncertainties and risks associated with the arbitrage strategy.
Other Considerations:
- Market Efficiency: The student needs to consider the efficiency of the government bond market. While the observed price discrepancy suggests potential inefficiencies, the market is generally considered to be highly efficient, making it difficult to consistently exploit such discrepancies.
- Regulatory Environment: The student needs to consider the regulatory environment in both the US and UK, as regulations can impact the feasibility of arbitrage strategies.
- Tax Implications: The student needs to consider the tax implications of the arbitrage strategy, as taxes can significantly impact the profitability of the investment.
4. Recommendations
Based on the analysis, we recommend that the student does not pursue the arbitrage opportunity. The potential risks associated with this strategy, including market risk, liquidity risk, transaction costs, and operational risk, outweigh the potential rewards. The student should prioritize a more conservative investment approach, focusing on diversification and risk management.
5. Basis of Recommendations
The recommendation is based on the following considerations:
- Risk Assessment: The potential risks associated with the arbitrage strategy are significant and difficult to quantify accurately. The student lacks the experience and resources to effectively manage these risks.
- Return on Investment (ROI): The potential ROI of the arbitrage strategy is uncertain and may not justify the risks involved. The student needs to consider the potential for losses, which could be substantial.
- Market Efficiency: The government bond market is generally considered to be highly efficient, making it difficult to consistently exploit arbitrage opportunities.
- Regulatory Environment: The regulatory environment surrounding arbitrage strategies can be complex and subject to change. The student needs to consider the potential impact of regulations on the feasibility of the strategy.
6. Conclusion
The student should not pursue the arbitrage opportunity presented in the case study. The potential risks associated with this strategy outweigh the potential rewards. The student should prioritize a more conservative investment approach, focusing on diversification and risk management.
7. Discussion
Other alternatives not selected include:
- Investing in a diversified portfolio of government bonds: This approach would provide exposure to the government bond market while mitigating the risks associated with arbitrage strategies.
- Investing in a diversified portfolio of other asset classes: This approach would further diversify the portfolio and reduce the overall risk.
The key assumptions of the recommendation include:
- The government bond market is highly efficient, making it difficult to consistently exploit arbitrage opportunities.
- The potential risks associated with the arbitrage strategy are significant and difficult to quantify accurately.
- The student lacks the experience and resources to effectively manage the risks associated with the arbitrage strategy.
8. Next Steps
The student should:
- Continue to monitor the government bond market for potential investment opportunities.
- Focus on diversifying their portfolio and managing risk.
- Seek guidance from their mentor on investment strategies and risk management.
- Develop a deeper understanding of the complexities of the government bond market and the risks associated with arbitrage strategies.
By taking these steps, the student can develop a more informed and responsible investment approach.
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Case Description
Documents a pricing anomaly in the large and liquid treasury bond market. The prices of callable treasury bonds seem to be inconsistent with the prices of noncallable treasuries and an arbitrage opportunity appears to exist. Permits instructors to introduce the treasury market, the concept of creating synthetic instruments, principles of arbitrage, and institutional frictions in the bond markets.
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