Measuring Limits of Arbitrage in Fixed-Income Markets

Abstract

An emerging literature relies on an index of limits of arbitrage in fixed-income markets. We analyze the benefits of an index that is model-free, robust and intuitive. This new index strengthens the evidence that limits of arbitrage proxy for risks priced in the cross-section of returns. Trading simulations show that the new index improves identification of limits of arbitrage because it bypasses a noisy estimation step. Relative value indices in the US, the UK, Japan, Germany, Italy, France, Switzerland and Canada exhibit strong commonality and high correlations with local volatility and funding conditions. The indices are updated regularly and available publicly.

Keywords: Limits of Arbitrage, Fixed-Income, Sovereign Bonds

JEL Classification: G12