What drives relative value strategies in financial markets?

Relative value strategies in financial markets primarily rely on identifying and exploiting pricing discrepancies between related securities. This approach focuses on the valuation relationship among securities, rather than their absolute prices. Investors employing relative value strategies seek to identify situations where two or more related instruments (like bonds, stocks, or derivatives) are mispriced relative to one another. For instance, if two similar bonds are trading at different yields, a relative value strategy might involve buying the undervalued bond while simultaneously selling the overvalued bond, anticipating that the prices will converge.

The essence of this strategy lies in the belief that the market may misprice these relationships due to temporary dislocations or inefficiencies, which can be corrected over time as investors recognize the discrepancies. Therefore, relative value strategies are fundamentally based on the analysis of relative prices and the relationships between securities, making them distinct from approaches focused on broader market trends, economic indicators, or short-term trading signals.

This approach underscores the importance of relative price movements and the interplay between related assets in crafting an investment strategy grounded in perceived value disparities.