Arbitrage profit concept

CFA Level II Fixed Income
#1

Hi folks,

Need some help with the concept of arbitrage profit.

Schweser defines an arbitrage profit as a “transaction involves no initial cash outlay but a positive riskless profit (cash flow) at some point in the future”

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Then, they give the following set of bonds and ask how we could have an arbitrage gain:
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Their answer is: selling 10 FFPQ bonds and simultaneously purchasing 1 DALO and 1 NKDS bond.
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My questions are:

  1. If we short 10 FFPQ, doesn’t that mean we have sold the bond? How would we have cash flow of -$1,000 in Year 1 and -$11,000 in Year 2?
  2. In this example, the arbitrage profit is made upfront, not in the future. So is Schweser’s definition of “positive riskless profit (cash flow) at some point in the future” wrong?

Thanks so much folks!

#2

  1. If we short 10 FFPQ, doesn’t that mean we have sold the bond? How would we have cash flow of -$1,000 in Year 1 and -$11,000 in Year 2?

         If we are short at the start we have a cash inflow of $11,701.20
    But then we will have outflows of $1,000 and $11,000 as we vecuase we are short we will need to pay the coupons and par to the long side of the trade.

  2. In this example, the arbitrage profit is made upfront, not in the future. So is Schweser’s definition of “positive riskless profit (cash flow) at some point in the future” wrong?

       We could construct the trade,a ssuming we can buy or short  fractions of par, so we had zero cash flow now and positive income at year 1 and year 2
   If we have positive cash flow now we will have positive in the future we could just invest it in the risk free rate until the end of the trade.
#3

Thanks @MikeyF !

  1. Why would we need to pay coupons and par value to the long side? Isn’t it the bond issuer who needs to pay it?

  2. Thanks, that make sense

#4
  1. Why would we need to pay coupons and par value to the long side? Isn’t it the bond issuer who needs to pay it?
    How do you short a bond?
    You borrow it form someone, i.e pension fund, and sell it.
    You have to make good to the lender all the cash flows they would have got.
    Same with shares. You short a share you need to pay the equivalent of the dividends that would have been paid had the lender held on it the shares.
#5

Thanks very much @MikeyF , that really helps