Convergence trade
Encyclopedia
Convergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future (going long the asset)—and selling a similar asset forward (going short the asset) for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal (will have converged), and thus one profits by the amount of convergence.
Convergence trades are often referred to as arbitrage
(as in merger arbitrage), though in careful use arbitrage only refers to trading in the same or identical assets or cash flows, rather than in similar assets.
bonds (the most recently issued) generally trade at a premium over otherwise similar bonds, because they are more liquid—there is a liquidity premium
. Once a newer bond is issued, this liquidity premium will generally decrease or disappear.
For example, the 30-year US treasury bond generally trades at a premium relative to the 29½-year bond, even though these are otherwise quite similar. Once a few months pass (so the 30-year has aged to a 29½-year and the 29½-year has aged to a 29-year, say), and a new 30-year is issued, the old bonds are now both off-the run and the liquidity premium will in general decrease. Thus, if one sells the 30-year short, buys the 29½-year, and waits a few months, one profits from the change in the liquidity premium.
is a stricter notion, referring to trading in identical assets or cash flows, while relative value is a looser notion, referring to using valuation methods (value investing
) to take long-short positions in similar assets without necessarily assuming convergence, and is more associated with equities. For example, in relative value investing one may believe that the stock of one mining company is undervalued relative to some valuation, while another stock is overvalued (relative to this or another valuation), and thus one will expect the undervalued stock to outperform the overvalued stock, even if these are quite different companies.
(faces a margin call
), the trader may run out of capital (if they run out of cash and cannot borrow more) and go bankrupt even though the trades may be expected to ultimately make money. In effect, convergence traders synthesize a put option
on their ability to finance themselves.
Prices may diverge during a financial crisis
, often termed a "flight to quality"; these are precisely the times when it is hardest for leveraged investors to raise capital (due to overall capital constraints), and thus they will lack capital precisely when they need it most.
Further, if other market participants are aware of the positions, they can engineer such price divergences, driving the convergence trader into bankruptcy – compare short squeeze.
As with arbitrages, convergence trades have negative skew: they will usually make a small profit, but they will in rare cases lose a significant amount.
Convergence trades are often referred to as arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
(as in merger arbitrage), though in careful use arbitrage only refers to trading in the same or identical assets or cash flows, rather than in similar assets.
On the run/off the run
On the runOn the run (finance)
In finance, an on the run security or contract is the most recently issued, and hence most liquid, of a periodically issued security. On the run securities are generally more liquid and trade at a premium to other securities...
bonds (the most recently issued) generally trade at a premium over otherwise similar bonds, because they are more liquid—there is a liquidity premium
Liquidity premium
Liquidity premium is a term used to explain a difference between two types of financial securities , that have all the same qualities except liquidity. For example:...
. Once a newer bond is issued, this liquidity premium will generally decrease or disappear.
For example, the 30-year US treasury bond generally trades at a premium relative to the 29½-year bond, even though these are otherwise quite similar. Once a few months pass (so the 30-year has aged to a 29½-year and the 29½-year has aged to a 29-year, say), and a new 30-year is issued, the old bonds are now both off-the run and the liquidity premium will in general decrease. Thus, if one sells the 30-year short, buys the 29½-year, and waits a few months, one profits from the change in the liquidity premium.
Related concepts
Formally, convergence trades refer to trading in similar assets in the expectation that they will converge in value. ArbitrageArbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
is a stricter notion, referring to trading in identical assets or cash flows, while relative value is a looser notion, referring to using valuation methods (value investing
Value investing
Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
) to take long-short positions in similar assets without necessarily assuming convergence, and is more associated with equities. For example, in relative value investing one may believe that the stock of one mining company is undervalued relative to some valuation, while another stock is overvalued (relative to this or another valuation), and thus one will expect the undervalued stock to outperform the overvalued stock, even if these are quite different companies.
Risks
The risk of a convergence trade is that the expected convergence does not happen, or that it takes too long, possibly diverging before converging. Price divergence is particularly dangerous because convergence trades are necessarily synthetic, leveraged trades, as they involve a short position. Thus if prices diverge so that the trade temporarily loses money, and the trader is accordingly required to post marginMargin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
(faces a margin call
Margin Call
Margin Call is a 2011 American independent drama film, written and directed by J.C. Chandor. The film has an ensemble cast that includes Kevin Spacey, Demi Moore, Paul Bettany, Jeremy Irons, Zachary Quinto, Stanley Tucci, Simon Baker, and Penn Badgley...
), the trader may run out of capital (if they run out of cash and cannot borrow more) and go bankrupt even though the trades may be expected to ultimately make money. In effect, convergence traders synthesize a put option
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
on their ability to finance themselves.
Prices may diverge during a financial crisis
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...
, often termed a "flight to quality"; these are precisely the times when it is hardest for leveraged investors to raise capital (due to overall capital constraints), and thus they will lack capital precisely when they need it most.
Further, if other market participants are aware of the positions, they can engineer such price divergences, driving the convergence trader into bankruptcy – compare short squeeze.
As with arbitrages, convergence trades have negative skew: they will usually make a small profit, but they will in rare cases lose a significant amount.