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

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.