Yield Curve Arbitrage In Chinese Treasury Bond Market

Fast growth of private equity funds encourages the demand for profitable hedging strategies,while developing Chinese bond market provides products and platform for fixed income hedgingstrategies. Though yield curve arbitrage strategy has been executed by a few financial institutions,there is still no relevant detailed and complete analysis in academic field. As a result, this paperaims to provide a framework covering construction of yield curve arbitrage strategy, analysis of riskfactor and evaluation of performance. Besides, we also check the mispricing of Chinese Treasurybond based on two-factor Vasicek model.We use all the Treasury bonds trading in both interbank and exchange market from July,2006to June,2012as sample.Based on two-factor Vasicek model, we calculate the theoretical bond price and by determininghedge ratio, trigger value and modeling transaction costs, we obtained eight series of excess returnwhich proved to be significantly positive on average with low volatility, fat-tailed and positivelyskewed distribution.We find that transaction cost is the key factor that can explain the excess return and that bothCAPM and Fama-French factor model do not fully capture the risks of our strategies, especially forexchange-based strategies even when liquidity factor is added. Besides, significant nonlinearityexists between strategy return and Fama-French factors. We also find that probability of failure instrategy is positively correlated with liquidity and negatively correlated with macro economy. Fromthe perspective of both traditional performance measure and efficiency test which considersnonlinearity and non-normality, our strategy does earn significantly positive return, but doesn’tdisplay superior performance.