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Measuring Limits of Arbitrage in Fixed-Income Markets

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  • Jean-Sébastien Fontaine
  • Guillaume Nolin

Abstract

We use relative value to measure limits to arbitrage in fixed-income markets. Relative value captures apparent deviations from no-arbitrage relationships. It is simple, intuitive and can be computed model-free for any bond. A pseudo-trading strategy based on relative value generates higher returns than one based on the well-known noise measure. The relative value is therefore a better proxy for limits to arbitrage. We construct relative value indices for the US, UK, Japan, Germany, Italy, France, Switzerland and Canada. Limits to arbitrage increase with the scarcity of capital: we find that each index is correlated with local volatility and funding costs. Limits to arbitrage also exhibit strong commonality across countries, consistent with the international mobility of capital. The relative value indices are updated regularly and available publicly.

Suggested Citation

  • Jean-Sébastien Fontaine & Guillaume Nolin, 2017. "Measuring Limits of Arbitrage in Fixed-Income Markets," Staff Working Papers 17-44, Bank of Canada.
    • Handle: RePEc:bca:bocawp:17-44
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    References listed on IDEAS

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    Cited by:

    1. Jeffrey Gao & Jianjian Jin & Jacob Thompson, 2018. "The Impact of Government Debt Supply on Bond Market Liquidity: An Empirical Analysis of the Canadian Market," Staff Working Papers 18-35, Bank of Canada.
    2. Bulusu, Narayan, 2024. "Disentangling the supply and announcement effects of open market operations," Journal of Financial Markets, Elsevier, vol. 67(C).
    3. Corey Garriott & Sophie Lefebvre & Guillaume Nolin & Francisco Rivadeneyra & Adrian Walton, 2020. "Alternative futures for Government of Canada debt management," Journal of Financial Economic Policy, Emerald Group Publishing Limited, vol. 12(4), pages 659-685, January.
    4. Narayan Bulusu & Sermin Gungor, 2018. "Government of Canada Securities in the Cash, Repo and Securities Lending Markets," Discussion Papers 18-4, Bank of Canada.
    5. Jean-Sébastien Fontaine & Jabir Sandhu & Adrian Walton, 2019. "Relative Value of Government of Canada Bonds," Staff Analytical Notes 2019-23, Bank of Canada.
    6. Livingston, Miles & Wu, Yanbin & Zhou, Lei, 2019. "The decline in idiosyncratic values of US Treasury securities," Journal of Banking & Finance, Elsevier, vol. 107(C), pages 1-1.
    7. Jessica Lee & Jabir Sandhu & Adrian Walton, 2019. "Borrowing Costs for Government of Canada Treasury Bills," Staff Analytical Notes 2019-28, Bank of Canada.

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    More about this item

    Keywords

    Asset Pricing; Financial markets; International financial markets;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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