11/5/2018 Convergence trade - Wikipedia

Convergence trade
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, though in careful use arbitrage only refers to trading in the same or
identical assets or cash flows, rather than in similar assets.

Contents
Examples
On the run/off the run
Cash and Carry
Reverse

Related concepts
Risks
References

Examples

On the run/off the run

On the run 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 had sold the 30-year short, bought the 29½-year, and waits a few months, one profits
from the change in the liquidity premium.

Cash and Carry

This is when a trader notices a difference in the price of a futures contract (for delivery in the future) and the underlying
asset (purchased immediately). For example, if gold is trading at $1000/oz, and there is a futures contract for $1200/oz,
the trader would long (buy) the gold and short (sell) the futures contract. They would make money as the prices converged
together, and the profit would be $200 dollars in this example, as the gold price equaled the futures price.[1][2]

Reverse

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A reverse version of this strategy also exists. This is when a trader believes that the futures contract is undervalued and the
underlying asset overvalued. Instead of shorting the futures contract the trader would long this, and short the underlying
asset.[3]

Related concepts
Formally, convergence trades refer to trading in similar assets in the expectation that they will converge in value.
Arbitrage 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.

Risks
The risk of a convergence trade is that the expected convergence does not
The market can stay
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
“ irrational longer than
you can stay solvent. ”
— John Maynard Keynes
if prices diverge so that the trade temporarily loses money, and the trader is
accordingly required to post margin (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.[4]

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.[4]

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 arbitrage, convergence trading has negative skew in return distributions it produces, resulting from the concave
payoff characteristic of most such high-probability low-return strategies. Operators engaging in such trades will usually
make consistent but relatively small profits, occasionally offset by significant losses, consuming previous profits earned
over a long period of time. The low probability of encountering a loss in such strategies can lead inexperienced traders to
underestimate the severity of such a loss, an assume excessive levels of leverage, potentially leading to bankruptcy as in
the LTCM case. See also the black swan risk.

References
1. "Cash and Carry Arbitrage" (http://www.uni.edu/thompsona/Futures%20Markets%20%20Cash%20and%20Carry%20
Arbitrage%20Note.pdf) (PDF). Uni.edu. Retrieved 29 July 2016.
2. "Cash and Carry Arbitrage Definition and Example" (http://www.investopedia.com/terms/c/cash-and-carry-arbitrage.as
p). Investopedia. Retrieved 29 July 2016.
3. "Reverse Cash and Carry Definition" (http://www.investopedia.com/terms/r/reverse-cash-and-carry-arbitrage.asp).
Investopedia. Retrieved 29 July 2016.

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4. "The Basis Monster that Ate Wall Street" (http://www.purearb.com/purearb/wp-content/uploads/2009/03/desco_marke

t_insights_vol_1_no_1_20090313.pdf) (PDF). DE Shaw & Co. March 2009. Retrieved 10 July 2015.

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