Do Arbitrage Opportunities Exist in the UK Gilt Market?

Abstract

The UK Government introduced a Strip facility for UK Gilts on 8th December 1997. The Strip facility enables investors to exchange a coupon bearing Gilt (conventional) for a series of individual cash flows, each of which can then be traded separately. Investors can also reconstitute the Gilt by exchanging the series of Stripped cash flows for the original conventional Gilt. Arbitrage opportunities exist if the portfolio of Stripped components trades at significantly different values to the corresponding conventional Gilt. If the Stripped components have a lower value than the conventional Gilt, the investor should short sell the conventional and buy the Stripped components which they then reconstitute to close the short position. If the cash flows arising from this are greater than the transaction costs (including the bid-ask spread), an arbitrage profit is made. If the Gilt market is efficient arbitrageurs will limit the divergence in prices. This paper examines for arbitrage opportunities at different maturities and coupon rates and thus questions whether the Gilt market is efficient.