Convergence trade

Convergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future (going long the asset)—and selling a similar asset forward (going short the asset) for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal (will have converged), and thus one profits by the amount of convergence.

Convergence trades are often referred to as arbitrage (as in merger arbitrage), though in careful use arbitrage only refers to trading in the same or identical assets or cash flows, rather than in similar assets.

Examples

On the run/off the run

On the run bonds (the most recently issued) generally trade at a premium over otherwise similar bonds, because they are more liquid—there is a liquidity premium. Once a newer bond is issued, this liquidity premium will generally decrease or disappear.

For example, the 30-year US treasury bond generally trades at a premium relative to the 29½-year bond, even though these are otherwise quite similar. Once a few months pass (so the 30-year has aged to a 29½-year and the 29½-year has aged to a 29-year, say), and a new 30-year is issued, the old bonds are now both off-the run and the liquidity premium will in general decrease. Thus, if one had sold the 30-year short, bought the 29½-year, and waits a few months, one profits from the change in the liquidity premium.