Funding and Volatility Risks in Swap Spread Arbitrage
Summary
The document outlines a classic swap spread trade: buy a Treasury funded through general collateral repo, finance the haircut, and pay fixed in a maturity-matched swap. It frames the net return as exposure to the swap spread and funding components, then asks how short-term rate volatility, Treasury volatility, and changing haircuts may affect the position. It also asks how swap spreads have behaved when the cash yield curve steepens.
The brief accepted response suggests using term repo instead of overnight funding to reduce exposure to changes in the Treasury funding rate. It considers higher volatility as a possible cause of larger haircuts, but treats that effect as conditional rather than automatic, noting that margin requirements can change materially and quickly. The response does not provide research papers, quantify these risks, explain practical hedging of funding volatility, or answer the question about curve steepening and swap spread direction. Its guidance is therefore limited and partly speculative.
Key ideas
- The trade combines Treasury and repo funding with a maturity-matched pay-fixed swap.
- Term repo is suggested as a way to reduce exposure to overnight funding-rate volatility.
- Higher Treasury volatility could contribute to larger haircuts, though the response offers no quantitative rule.
- The exchange does not resolve how swap spreads typically respond to cash-curve steepening.
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Full text
# Swap Spread Arbitrage & Rates/STIRT Vol # Swap Spread Arbitrage & Rates/STIRT Vol Concerning the classic swap spread arbitrage trade where you (as far as I understand it): - Buy a treasury and borrow in GC repo, paying repo rate and funding the haircut in short term unsecured funding market. - Enter into a pay fixed swap with maturity matched to the treasury, borrowing initial margin @ OIS On net, you pay the swap spread, and earn LIBOR - GC repo rate - haircut/margin financing. Specifically, are there any papers that have done work on the effect of volatility in the short term rates markets on this trade? Given that LIBOR/GC repo rate are components in the trade’s return, are attempts ever made, in practice, to hedge the volatility in these components? A)Think an event like the repo spike in sept 2019. B)Or, hypothetically speaking, if you are doing this trade in the long dated treasury space (30y), could increasing UST vol, for example have an indirect effect on the trade by increasing haircuts? C)Moreover, is it plausible to suggest that a severe steepening in the cash curve would not be accompanied by a widening in swap spreads. What is the dynamic observed in practice? Post 2019, When the cash curve steepens, do swap spreads tend to widen or tighten? ## Answer by user42108 (score 0, accepted) https://quant.stackexchange.com/a/59976 "are attempts ever made, in practice, to hedge the volatility in these components?" You could try to fund the position via term repo rather than O/N which means no vol in your UST funding rate. if you are doing this trade in the long dated treasury space (30y), could increasing UST vol, for example have an indirect effect on the trade by increasing haircuts? My guess would be that the financing provider would build in some margin of error (excuse the pun) to the haircut so you'd need a significant pick-up in vol for the haircut to increase. But certainly possible and if you remember back to the GFC, there were meaningful changes in margin requirements (SI and CL spring to mind) at short notice which, at the time, were considered possible catalysts for position liquidations.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.