Speed and Conditional Noise as Information for Illiquidity and Fixed Income Arbitrage

Abstract

Previous studies suggest that trading conditions in the secondary market for nominal U.S. Treasury (UST) coupon securities embeds critical information about global financial market liquidity and the limits to arbitrage. We propose three new general measures based on deviations of observed nominal UST yields from their fitted values derived from standard estimates of the term structure. These metrics extend beyond unconditional fitting errors to include conditional mispricings net explicit estimates of premiums for liquidity and collateral value at the security-level. In addition, we consider not only the size of unconditional and conditional errors but also the speed at which arbitragers eliminate implied prospective gains. Based on daily CRSP data on individual UST securities from June 1961 through December 2013, broad inferences from these alternative measures contradict conclusions in previous studies that relate the size of UST fitting errors to overall global market liquidity. We also analyze market-neutral trading strategies that produce absolute returns that on average often exceed those on the S&P 500, with a small fraction of the variance, no covariance with stock returns, and very positive as opposed to negative skew.