ixed Income - Mortgage Backed Securities (MBS) Arbitrage strategies involve investing in mortgage backed securities and hedging the securities’ exposure to credit or interest rate risk. In recent years, new methods have evolved for managers to better handle this risks as well as techniques for a manager to better managed the implied prepayment option implied in mortgage backed securities. Recent changes in the packaging these types of securities has increased the opportunities in these markets.

The MBS arbitrageur seeks to buy cheap securities and at the same time sell a related security that is expensive. If the cheap security rises in value at the same time as the expensive security drops in value the position will benefit from both trades. For interest rates changes in general, the position would be immunized due to its offsetting positions. Therefore, profits are realized when the skewed relationship in price moves back to the anticipated level. Rather than try to guess in which direction the market will move, the managers neutralize interest rate changes and derive profits entirely from their ability to identify similar securities that are mispriced relative to one another. The most common position to take on is a spread position. When a certain spread is widening, the manager will go long the relatively undervalued security and short the relatively overvalued security.

After the position is taken, the position is monitored and liquidated when the instruments reach their expected values or expected relative values. Since price discrepancies in the fixed income market are relatively small, funds use significant leverage to make a significant amount of money from the trade.