Global Yield Curve Arbitrage with Term Structure Modeling

This study investigates the profitability of trading strategies based on yield curve arbitrage opportunities in international fixed-income markets. For constructing the yield curve, this paper adopts three- and four-factor Nelson-Siegel models, cubic B-splines, and kernel smoothing methods as candidate models, and evaluates the model fit by their ability of identifying the mispricing of the government bonds with a generic yield curve arbitrage strategy that longs all the over-priced bonds and shorts all the under-priced bonds. Next the paper continues with the most feasible yield curve models selected and constructs a modified yield curve arbitrage strategy with improved strategy specifications that maximize exposure to the arbitrage opportunities while limiting effect of other risk factors. The results show that there is no superior yield curve model globally when the pricing power of the yield curve is examined but the four-factor Nelson-Siegel models are preferred by more countries. A yield curve arbitrage strategy is profitable for all countries and is able to generate a positive risk premium. A more refined strategy specification is able to further enhance the performance by reducing volatilities and eliminating exposures to other risk factors.