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Risk and return in yield curve arbitrage : a survey of the USD and EUR interest rate swap markets

Ager-Wick, Brage; Luong, Ngan
Master thesis
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URI
https://hdl.handle.net/11250/2734282
Date
2020
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  • Master Thesis [4207]
Abstract
This thesis extends the research of Duarte, Longstaff and Yu (2007) by looking at the risk and

return characteristics of yield curve arbitrage. Like in Duarte et al., return indexes are created

by implementing a particular version of the strategy on historical data. We extend the analysis

to include both USD and EUR swap markets. The sample period is from 2006-2020, which is

more recent than in Duarte et al. (1988-2004). While the USD strategy produces risk-adjusted

excess returns of over five percent per year, the EUR strategy underperforms, which we argue

is a result of the term structure model not being well suited to describe the abnormal shape of

the EUR swap curve that manifests over much of the sample period. For both USD and EUR,

performance is much better over the first half of the sample (2006-2012) than over the second

half (2013-2020), which coincides with a fall in swap rate volatility. Still, risk factor exposure

is low for both strategies, though it is higher for USD than for EUR. We conclude that there is

potential for risk-adjusted excess returns in yield curve arbitrage, but that the strategy suffers

when there are structural changes in the shape and volatility of t he term structure.

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