Friday, November 21, 2014

On the Varieties of Capital Arbitrage

An oldie (June 19, 2012) but goodie from Deus Ex Macchiato:
There are only a few basic types of capital arbitrage trade. My first attempt at a taxonomy is:
  • The leveller. Here risk within the same category is treated unfairly, with some risk cheap or equitable, and some risk expensive. The leveller turns expensive risk into something cheaper. A typical example is the collateral swap. Say a counterparty has collateral which is good, but which doesn’t count for regulatory purposes. For a fee, that is swapped for something which does count. If the capital saving is sufficient, then the fee is worth paying even if the risk has not changed (or even has got worse).
  • The tranformer. Here something can be looked at in two different ways, with two different capital treatments. You turn the expensive one into the cheap one. A good example is doing a swap structured as a loan to avoid CVA capital.
  • The deconstructor. Here the parts of something are cheaper than the thing. Buy the thing and split it into parts. (The inverse trade, the constructor, is sometimes seen too.) CDO tranches fall into this category. The capital on the underlying assets in the CDO is often much smaller than that of all the tranches. If you own enough of the tranches, it can make sense to buy the rest and split the CDO apart.
  • The natural home. This is an arb between rules, where one set is expensive and the other is cheap (or non-existent). Most trades between banks and insurers fall into this category, as do banks offloading expensive risk, like CVA, onto hedge funds....

Sadly he hasn't posted since May 2014.