Relative value is a concept that refers to the value of an asset in relation to the value of other assets.
It is often used to compare the value of investments or to determine the fair value of an asset.
In trading, relative value is used to identify opportunities to buy or sell assets based on their relative values.
Similarly, if the relative value of a currency is lower than the relative value of another currency, it might be a good time to buy the undervalued currency and sell the overvalued one.
Key Takeaways – Relative Value
- Asset Comparison: Relative value in finance refers to the process of determining an asset’s worth by comparing it with the value of similar assets or benchmarks.
- Investment Strategy: It is a popular investment strategy where traders exploit price discrepancies between related financial instruments, aiming to profit from market corrections.
- Risk Management: Utilizing relative value strategies can aid in risk management, as it often involves hedging positions to neutralize market volatility and potential losses.
Relative Value Funds
Relative value hedge funds are investment funds that use relative value strategies to generate returns.
These strategies involve identifying mispricings in the market and taking positions to profit from the expected price changes.
They seek to identify discrepancies in the prices of these assets and to exploit these mispricings through a variety of techniques, such as arbitrage, statistical arbitrage, and capital structure arbitrage.
Relative value hedge funds are known for their low correlation with traditional asset classes, such as equities and fixed income, and for their ability to generate returns in both rising and falling markets.
Relative Value Strategies
Below we look at a variety of relative value strategies that are employed by traders and investment funds.
Equity market neutral is a relative value strategy that involves taking long and short positions in stocks with the goal of generating returns that are uncorrelated with the overall market.
The strategy seeks to profit from the mispricings between individual stocks, rather than from the direction of the overall market.
To implement an equity market-neutral strategy, an investment fund manager will first identify a group of stocks that are expected to perform well over a given time period.
The manager will then take a long position in the stocks that are expected to outperform and a short position in the stocks that are expected to underperform.
The long and short positions should be approximately equal in size for true equity market-neutral strategies, so that the overall market exposure of the portfolio is neutral.
The goal of an equity market-neutral strategy is to generate returns that are independent of the performance of the overall market.
This can be attractive to investors because it allows them to participate in the potential upside of individual stocks while mitigating the risk of market downturns.
However, it’s important to note that equity market-neutral strategies are not risk-free and can still be affected by a variety of factors, such as changes in the underlying stocks or shifts in market conditions.
Generally speaking, an equity market-neutral model is hard to make work if the fund doesn’t get its longs and shorts correct.
The credit long/short strategy is a relative value investment strategy that involves taking long positions in credit instruments that are expected to appreciate in value and short positions in credit instruments that are expected to decline in value.
The goal of this strategy is to generate returns that are uncorrelated with the overall market and to profit from mispricings in the credit markets.
For a credit long/short strategy, a trader/investor will typically identify a group of credit instruments, such as bonds, loans, or structured credit products, that are expected to perform well or poorly over a given time period.
The manager will then take a long position in the credit instruments that are expected to appreciate and a short position in the credit instruments that are expected to fall.
The long and short positions should be approximately equal in size, so that the overall market exposure of the portfolio is neutral.
The credit long/short strategy can be attractive to investors because it allows them to participate in the potential upside of credit instruments while mitigating the risk of market downturns.
Fixed income arbitrage
Fixed income arbitrage is a relative value investment strategy that involves taking advantage of mispricings between fixed income securities.
The goal of this strategy is to generate returns by identifying discrepancies in the prices of fixed income securities and exploiting these mispricings through a variety of techniques, such as yield curve arbitrage, spread trading, and statistical arbitrage.
The manager will then take positions in bonds with different maturities to profit from the expected changes in bond yields.
In spread trading, the manager will identify discrepancies in the spreads between different types of fixed income securities, such as Treasuries and corporate bonds, and take positions to profit from the expected changes in these spreads.
In statistical fixed income arbitrage, the manager will use statistical models and algorithms to identify mispricings in the fixed income markets and take positions to exploit these mispricings.
Fixed income arbitrage strategies can be attractive to investors because they can generate returns that tend to be uncorrelated with the overall market (when employed well) and are generally considered to be low risk due to this lack of correlation with traditional investment (e.g., stocks, bonds, credit).
Convertible arbitrage is a relative value investment strategy that involves taking advantage of mispricings between convertible securities, such as convertible bonds and convertible preferred shares, and their underlying stocks.
The goal of this strategy is to generate returns by identifying discrepancies in the prices of convertible securities and exploiting these mispricings through a variety of techniques.
One common technique used in convertible arbitrage is called “pair trading,” in which a hedge fund manager will take a long position in a convertible security and a short position in the underlying stock.
By doing this, the manager is betting that the price of the convertible security will rise relative to the price of the underlying stock.
If the bet pays off, the manager can profit from the difference in the prices of the two securities.
Another technique used in convertible arbitrage is called “capital structure arbitrage,” in which the manager will take a long position in a convertible security and a short position in a straight bond of the same issuer.
By doing this, the manager is betting that the price of the convertible security will rise relative to the price of the straight bond. If the bet pays off, the manager can profit from the difference in the prices of the two securities.
Asset-backed securities (fixed-income asset-backed)
In the context of asset-backed securities, relative value might involve buying securities that are believed to be undervalued and selling securities that are believed to be overvalued, based on a variety of factors such as credit quality, maturity, and the underlying assets.
One common relative value strategy in the asset-backed securities market is to take positions in securities with different credit ratings.
For example, a trader might buy securities with higher credit ratings and sell securities with lower credit ratings, based on the belief that the higher-rated securities are undervalued relative to the lower-rated ones.
Another relative value strategy is to take positions in securities with different maturities.
For example, a trader might buy securities with longer maturities and sell securities with shorter maturities, based on the belief that the longer-dated securities are undervalued relative to the shorter-dated ones.
Finally, a trader might also take positions in asset-backed securities based on the underlying assets, such as mortgages, auto loans, or credit card receivables.
For example, a trader might buy securities backed by mortgages with higher credit scores and sell securities backed by mortgages with lower credit scores, based on the belief that the higher-quality mortgages are undervalued relative to the lower-quality ones.
Relative value statistical arbitrage is a trading strategy that involves taking positions in assets that are expected to move in opposite directions based on statistical analysis.
It is based on the idea that certain assets or financial instruments may be mispriced relative to each other, and that there may be an opportunity to profit by taking advantage of these discrepancies.
There are several different approaches to relative value statistical arbitrage, but some common strategies include:
This involves taking a long position in one asset and a short position in another asset that are believed to be related. This might mean going long GM stock and short Ford stock, or vice versa.
As another example, a trader might take a long position in a stock and a short position in a related index, or a long position in one currency and a short position in another currency.
The goal is to profit from the difference in performance between the two assets.
This strategy involves taking positions in assets that are believed to be temporarily mispriced, with the expectation that they will eventually revert back to their long-term averages.
Traders using this approach may use statistical analysis to identify assets that are over or undervalued, and take positions accordingly.
This involves taking a long position in one asset and a short position in another asset that are closely related, with the goal of profiting from the difference in their prices.
For example, a trader might take a long position in crude oil and a short position in heating oil, in order to profit from the difference in their prices.
There are many different factors that can affect the success of a relative value statistical arbitrage strategy, including market conditions, liquidity, and the accuracy of the statistical analysis used.
It is important for traders to carefully consider these factors and to use risk management techniques in order to minimize loss potential.
Volatility arbitrage is a type of statistical arbitrage that seeks to profit from discrepancies in the implied volatility of financial instruments.
These discrepancies can occur due to differences in the way that different markets or exchanges price the same security or due to changes in the overall level of market volatility.
Volatility arbitrage strategies aim to exploit these discrepancies by buying or selling options or other securities that are under- or overpriced relative to their expected volatility (i.e., implied volatility).
There are several different types of volatility arbitrage strategies that traders may use.
One common approach is to buy options that are underpriced relative to the underlying security and sell options that are overpriced.
This can be done using a variety of option spreads, such as bull call spreads, bear put spreads, or straddles.
Another approach is to buy or sell futures contracts on volatility indices, such as the VIX, which is a measure of expected market volatility.
Traders may also use options on volatility indices as part of their volatility arbitrage strategies.
Nonetheless, volatility arbitrage can be a complex and risky trading strategy, as it involves predicting changes in market volatility, which can be difficult to do with accuracy.
In addition, volatility arbitrage strategies often require a significant amount of capital and may be subject to liquidity risks.
As with any trading strategy, it is important to carefully evaluate the potential risks and rewards before implementing a volatility arbitrage strategy.
Regulatory arbitrage refers to the practice of taking advantage of differences in regulations between different markets or countries to generate profits.
This can involve exploiting differences in tax laws, financial reporting standards, or other regulatory requirements.
In trading, regulatory arbitrage strategies may involve executing trades that take advantage of these differences in order to generate profits.
One example of regulatory arbitrage in trading might be buying securities in a market with lower capital gains taxes and selling them in a market with higher capital gains taxes.
This can generate profits by allowing the trader to capture the price difference between the two markets while also benefiting from the lower tax rate.
Other regulatory arbitrage strategies might involve taking advantage of differences in financial reporting standards.
For example, if a company’s financial statements are more favorable under one set of accounting standards compared to another, a trader might buy the company’s securities in a market that uses the more favorable standards and sell them in a market that uses less favorable standards.
This can create an opportunity to profit from the difference in valuation between the two markets.
However, regulatory arbitrage strategies can be complex and may involve a high level of risk and require deep expertise in whatever securities and events are being traded.
They also may be subject to regulatory scrutiny, as authorities may view such strategies as attempts to evade or circumvent regulations.
As a result, it is important for traders to be familiar with the relevant regulations and to be aware of any potential risks or legal issues that may arise from such strategies.
Relative value risk arbitrage involves identifying discrepancies in the prices of securities that are related to one another and trading on those discrepancies to generate profits.
One common example of relative value risk arbitrage is the convergence trade, in which an investor buys the target company’s stock in a merger or acquisition deal and simultaneously sells the stock of the acquiring company.
The goal is to profit from the difference in the price of the two stocks as they converge toward the deal price.
Other relative value risk arbitrage strategies include:
- pairs trading, as discussed in preceding sections in other relative value strategy contexts, where an investor buys and sells two correlated securities in an attempt to profit from their price relationship, and
- index arbitrage, where an investor takes advantage of discrepancies between the prices of the component stocks of an index and the value of the index itself.
There are several risks associated with relative value risk arbitrage, including:
- event risk (e.g., the merger or acquisition deal falling through)
- liquidity risk (the difficulty of buying or selling large quantities of a security), and
- market risk (changes in the overall market that affect the value of the securities being traded)
As such, relative value risk arbitrage strategies can be complex and require a high level of sophistication to execute successfully.
Relative Value Trading – a basic introduction
Relative Value vs. Absolute Value
In finance, relative value refers to the comparison of the value of one security to another, while absolute value refers to the intrinsic value of a security on its own.
For example, consider two stocks, A and B.
An investor who is considering a relative value trade might look at the price of stock A and compare it to the price of stock B, and then decide whether to buy or sell one of the stocks based on the relationship between the two prices.
In contrast, an investor who is focused on absolute value might try to determine the intrinsic value of stock A and then decide whether to buy or sell the stock based on whether the market price is higher or lower than the intrinsic value.
Relative value analysis is often used in trading strategies such as risk arbitrage, where the goal is to take advantage of discrepancies in the prices of related securities.
Absolute value analysis, on the other hand, is more commonly used in fundamental analysis, where the goal is to determine the intrinsic value of a security and make buy or sell decisions based on that value.
FAQs – Relative Value
What is an example of a relative value strategy?
A relative value strategy is an investment approach that involves identifying opportunities to profit from mispricings between different financial instruments.
This can be done by taking long positions in undervalued assets and short positions in overvalued assets, or by using other strategies such as arbitrage or pairing trades.
One example of a relative value strategy is a pairs trade.
A pairs trade involves taking a long position in one security and a short position in a related security, with the goal of profiting from the difference in their returns.
For example, an investor might take a long position in the stock of Company A and a short position in the stock of Company B, if they believe that Company A is undervalued relative to Company B.
If the stock of Company A rises in value while the stock of Company B falls, the investor would profit from the difference in their returns.
Another example of a relative value strategy is a convergence trade, which involves buying a financial instrument that is expected to increase in value and selling a related instrument that is expected to decrease in value.
For example, an investor might buy a bond and sell a futures contract on that bond, if they believe that the bond is undervalued relative to the futures contract.
If the bond’s price increases and the futures contract’s price decreases, the investor would profit from the difference in their returns.
What is absolute and relative value?
In finance, trading, and investing, absolute value and relative value are two important concepts that are often used to make investment decisions.
Absolute value refers to the intrinsic or fundamental value of an asset, such as a stock or bond.
This value is based on the underlying financial performance of the asset, as well as economic and market conditions.
Investors who focus on absolute value aim to buy assets that are undervalued based on their intrinsic value, with the expectation that the price will eventually rise to reflect the asset’s true worth.
Relative value, on the other hand, refers to the value of an asset in relation to other assets.
For example, an investor may compare the relative value of two stocks by looking at their price-to-earnings ratios, or by comparing the yield on a bond to the yield on other bonds with similar risk and maturity.
Investors who focus on relative value aim to buy assets that are relatively undervalued compared to other assets, with the expectation that the price will rise as the asset’s relative value increases.
Both absolute and relative value can be useful in making investment decisions, and many investors use a combination of both approaches.
Why is relative valuation important?
Relative valuation is a method of valuing a company or asset by comparing it to similar companies or assets.
It is used to determine the fair value of an asset by comparing it to similar assets or companies.
This is important in finance because it allows investors to compare the value of different investments and to make more informed decisions about where to allocate their capital.
By using relative valuation, investors can compare the potential returns and risks of different investments and choose the ones that offer the most attractive combination of these factors.
It is a key tool for investors to use when analyzing and comparing different investment opportunities.
What is equity relative value?
Equity relative value is a method of valuing a company’s stock by comparing it to the stocks of similar companies.
It is a type of relative valuation that is based on the idea that the value of a company’s stock should be related to the value of other stocks in the same industry or sector.
When performing equity relative value analysis, an investor will compare the financial metrics of a company to those of other companies in the same industry or sector in order to determine if the stock is overvalued, undervalued, or fairly valued.
By comparing the relative values of different stocks, investors can identify opportunities to buy undervalued stocks or sell overvalued stocks in order to maximize their returns.
Conclusion – Relative Value
Relative value is an important concept in finance and investing, as it allows investors to compare the relative worth of different assets.
Relative value analysis involves comparing the prices of related securities and looking for discrepancies that can be exploited for profit.
It is often used in trading strategies such as risk arbitrage or pairs trading, where the goal is to take advantage of price discrepancies between related assets.
Absolute value analysis, on the other hand, focuses on determining the intrinsic or fundamental value of a security and using this information to make buy/sell decisions.
Both absolute and relative value can be useful tools in making investment decisions.
Which approach a trader or investor uses depends on their individual goals and objectives.
By understanding both approaches and applying them appropriately, traders and investors can maximize their returns and reduce risk.