A colleague has identified a long-short bond arbitrage trading strategy with two corporate bonds that are...

A colleague has identified a long-short bond arbitrage trading strategy with two corporate bonds that are identical in every respect except that they are issued by two different companies. Explain to your colleague why the strategy is not "risk-free" as we would expect from an arbitrage trading strategy.

Expert Solution

This strategy is not risk free because of bonds being issued by different companies as these both company will be always having different type of company specific risk and company specific risk will mean that even at the time of significant boom in the economy, some companies are defaulting because they do not have adequate credit availability and Credit Management ability whereas other companies are performing exceptionally well,so it is about the individual specific performance of the company which cannot be completely related with the other company because their beta will be different and their volatility and standard deviation will be different and their credit worthiness will be different even though they are issuing the bonds with same rating, so it can be said that bonds of similar company should be used in arbitraging strategies because bonds of different companies will be carrying out different type of company specific risks which will not make it risk free arbitrage.

jeff jeffy answered 2 years ago

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