Arbitrage
Encyclopedia
In economics
and finance
, arbitrage (ˈɑrbɨtrɑːʒ) is the practice of taking advantage of a price difference between two or more market
s: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market price
s. When used by academics, an arbitrage is a transaction that involves no negative cash flow
at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit at zero cost.
In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage
, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets (relative value or convergence trade
s), as in merger arbitrage.
People who engage in arbitrage are called arbitrageurs (ˌɑrbɨtrɑːˈʒɜr)—such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments
, such as bonds
, stock
s, derivatives
, commodities
and currencies
.
. The assumption that there is no arbitrage is used in quantitative finance to calculate a unique risk neutral
price for derivatives
.
Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally only possible with securities and financial products which can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'.As an arbitrage consists of at least two trades, the metaphor is of putting on a pair of pants, one leg (trade) at a time. The risk that one trade (leg) fails to execute is thus 'leg risk'.
In the simplest example, any good sold in one market should sell for the same price in another. Traders
may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other.
See rational pricing
, particularly arbitrage mechanics, for further discussion.
Mathematically it is defined as follows:
and 
where
means a portfolio at time t.
s, the price of commodities, and the price of securities in different markets tend to converge. The speed at which they do so is a measure of market efficiency. Arbitrage tends to reduce price discrimination
by encouraging people to buy an item where the price is low and resell it where the price is high (as long as the buyers are not prohibited from reselling and the transaction costs of buying, holding and reselling are small relative to the difference in prices in the different markets).
Arbitrage moves different currencies toward purchasing power parity
. As an example, assume that a car purchased in the United States is cheaper than the same car in Canada. Canadians would buy their cars across the border to exploit the arbitrage condition. At the same time, Americans would buy US cars, transport them across the border, then sell them in Canada. Canadians would have to buy American Dollars to buy the cars; and Americans would have to sell the Canadian dollars they received in exchange. Both actions would increase demand for US Dollars and supply of Canadian Dollars. As a result, there would be an appreciation of the US currency. This would make US cars more expensive and Canadian cars less so until their prices were similar. On a larger scale, international arbitrage opportunities in commodities
, goods, securities
and currencies
tend to change exchange rate
s until the purchasing power
is equal.
In reality, most asset
s exhibit some difference between countries. These, transaction cost
s, taxes, and other costs provide an impediment to this kind of arbitrage. Similarly, arbitrage affects the difference in interest rates paid on government bonds issued by the various countries, given the expected depreciations in the currencies relative to each other (see interest rate parity
).
. Formally, arbitrage transactions have negative skew – prices can get a small amount closer (but often no closer than 0), while they can get very far apart. The day-to-day risks are generally small because the transactions involve small differences in price, so an execution failure will generally cause a small loss (unless the trade is very big or the price moves rapidly). The rare case risks are extremely high because these small price differences are converted to large profits via leverage
(borrowed money), and in the rare event of a large price move, this may yield a large loss.
The main day-to-day risk is that part of the transaction fails – execution risk. The main rare risks are counterparty risk and liquidity risk – that a counterparty to a large transaction or many transactions fails to pay, or that one is required to post margin
and does not have the money to do so.
In the academic literature, the idea that seemingly very low risk arbitrage trades might not be fully exploited because of these risk factors and other considerations is often referred to as limits to arbitrage
.
Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk position.
In the 1980s, risk arbitrage
was common. In this form of speculation
, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current price—if the merger goes through as predicted. Traditionally, arbitrage transactions in the securities markets involve high speed, high volume and low risk. At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act). When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing the risk is through the illegal use of inside information
, and in fact risk arbitrage with regard to leveraged buyout
s was associated with some of the famous financial scandals of the 1980s such as those involving Michael Milken
and Ivan Boesky
.
. In the extreme case this is merger arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses.
For example, if one purchases many risky bonds, then hedges them with CDSes
, profiting from the difference between the bond spread and the CDS premium, in a financial crisis the bonds may default and the CDS writer/seller may itself fail, due to the stress of the crisis, causing the arbitrageur to face steep losses.
(faces a margin call
), the trader may run out of capital (if they run out of cash and cannot borrow more) and go bankrupt even though the trades may be expected to ultimately make money. In effect, arbitrage traders synthesize a put option
on their ability to finance themselves.
Prices may diverge during a financial crisis, often termed a "flight to quality"; these are precisely the times when it is hardest for leveraged investors to raise capital (due to overall capital constraints), and thus they will lack capital precisely when they need it most.
, merger arbitrage generally consists of buying the stock of a company that is the target of a takeover
while shorting the stock of the acquiring company.
Usually the market price of the target company is less than the price offered by the acquiring company.
The spread between these two prices depends mainly on the probability and the timing of the takeover being completed as well as the prevailing level of interest rates.
The bet in a merger arbitrage is that such a spread will eventually be zero, if and when the takeover is completed. The risk is that the deal "breaks" and the spread massively widens.
Generally, managers seek relative value opportunities by being both long and short municipal bonds with a duration-neutral book. The relative value trades may be between different issuers, different bonds issued by the same entity, or capital structure trades referencing the same asset (in the case of revenue bonds). Managers aim to capture the inefficiencies arising from the heavy participation of non-economic investors (i.e., high income "buy and hold" investors seeking tax-exempt income) as well as the "crossover buying" arising from corporations' or individuals' changing income tax situations (i.e., insurers switching their munis for corporates after a large loss as they can capture a higher after-tax yield by offsetting the taxable corporate income with underwriting losses). There are additional inefficiencies arising from the highly fragmented nature of the municipal bond market which has two million outstanding issues and 50,000 issuers in contrast to the Treasury market which has 400 issues and a single issuer.
Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal bonds with the duration risk hedged by shorting
the appropriate ratio of taxable corporate bonds. These corporate equivalents are typically interest rate swaps referencing Libor or SIFMA
http://www.investinginbonds.com/story.asp?id=351 http://www.bondmarkets.com/story.asp?id=1157. The arbitrage manifests itself in the form of a relatively cheap longer maturity municipal bond, which is a municipal bond that yields significantly more than 65% of a corresponding taxable corporate bond. The steeper slope of the municipal yield curve
allows participants to collect more after-tax income from the municipal bond portfolio than is spent on the interest rate swap; the carry is greater than the hedge expense. Positive, tax-free carry from muni arb can reach into the double digits. The bet in this municipal bond arbitrage is that, over a longer period of time, two similar instruments—municipal bonds and interest rate swaps—will correlate with each other; they are both very high quality credits, have the same maturity and are denominated in U.S. dollars. Credit risk and duration risk are largely eliminated in this strategy. However, basis risk arises from use of an imperfect hedge, which results in significant, but range-bound principal volatility. The end goal is to limit this principal volatility, eliminating its relevance over time as the high, consistent, tax-free cash flow accumulates. Since the inefficiency is related to government tax policy, and hence is structural in nature, it has not been arbitraged away.
Note, however, that many municipal bonds are callable, and that this imposes substantial additional risks to the strategy.
is a bond
that an investor can return to the issuing company in exchange for a predetermined number of shares in the company.
A convertible bond can be thought of as a corporate bond
with a stock call option
attached to it.
The price of a convertible bond is sensitive to three major factors:
Given the complexity of the calculations involved and the convoluted structure that a convertible bond can have, an arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value.
Convertible arbitrage
consists of buying a convertible bond and hedging two of the three factors in order to gain exposure to the third factor at a very attractive price.
For instance an arbitrageur would first buy a convertible bond, then sell fixed income
securities or interest rate future
s (to hedge the interest rate exposure) and buy some credit protection
(to hedge the risk of credit deterioration).
Eventually what he'd be left with is something similar to a call option on the underlying stock, acquired at a very low price.
He could then make money either selling some of the more expensive options that are openly traded in the market or delta hedging his exposure to the underlying shares.
company wishing to raise more money may issue a depository receipt on the New York Stock Exchange
, as the amount of capital on the local exchanges is limited. These securities, known as ADRs (American Depositary Receipt
) or GDRs (Global Depositary Receipt ) depending on where they are issued, are typically considered "foreign" and therefore trade at a lower value when first released. Many ADR's are exchangeable into the original security (known as fungibility
) and actually have the same value. In this case there is a spread between the perceived value and real value, which can be extracted. Other ADR's that are not exchangeable often have much larger spreads. Since the ADR is trading at a value lower than what it is worth, one can purchase the ADR and expect to make money as its value converges on the original. However there is a chance that the original stock will fall in value too, so by shorting it one can hedge that risk.
(DLC) structure involves two companies incorporated in different countries contractually agreeing to operate their businesses as if they were a single enterprise, while retaining their separate legal identity and existing stock exchange listings. In integrated and efficient financial markets, stock prices of the twin pair should move in lockstep. In practice, DLC share prices exhibit large deviations from theoretical parity. Arbitrage positions in DLCs can be set up by obtaining a long position in the relatively underpriced part of the DLC and a short position in the relatively overpriced part. Such arbitrage strategies start paying off as soon as the relative prices of the two DLC stocks converge toward theoretical parity. However, since there is no identifiable date at which DLC prices will converge, arbitrage positions sometimes have to be kept open for considerable periods of time. In the meantime, the price gap might widen. In these situations, arbitrageurs may receive margin call
s, after which they would most likely be forced to liquidate part of the position at a highly unfavorable moment and suffer a loss. Arbitrage in DLCs may be profitable, but is also very risky, see. Background material is available at http://mathijsavandijk.com/dual-listed-companies/.
A good illustration of the risk of DLC arbitrage is the position in Royal Dutch Shell
—which had a DLC structure until 2005—by the hedge fund Long-Term Capital Management
(LTCM, see also the discussion below). Lowenstein (2000) describes that LTCM established an arbitrage position in Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent premium. In total $2.3 billion was invested, half of which long in Shell and the other half short in Royal Dutch (Lowenstein, p. 99). In the autumn of 1998 large defaults on Russian debt created significant losses for the hedge fund and LTCM had to unwind several positions. Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent and LTCM had to close the position and incur a loss. According to Lowenstein (p. 234), LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell
trade.
). Thus, if a publicly traded company specialises in the acquisition of privately held companies, from a per-share perspective there is a gain with every acquisition that falls within these guidelines. Exempli gratia, Berkshire-Hathaway. A hedge fund
that is an example of this type of arbitrage is Greenridge Capital
, which acts as an angel investor
retaining equity in private companies which are in the process of becoming publicly traded, buying in the private market and later selling in the public market. Private to public equities arbitrage is a term which can arguably be applied to investment banking
in general. Private markets to public markets differences may also help explain the overnight windfall gains enjoyed by principals of companies that just did an initial public offering
(IPO).
and the regulatory position. For example, if a bank, operating under the Basel I
accord, has to hold 8% capital against default risk, but the real risk of default is lower, it is profitable to securitise
the loan, removing the low risk loan from its portfolio. On the other hand, if the real risk is higher than the regulatory risk then it is profitable to make that loan and hold on to it, provided it is priced appropriately.
This process can increase the overall riskiness of institutions under a risk insensitive regulatory regime, as described by Alan Greenspan
in his October 1998 speech on The Role of Capital in Optimal Banking Supervision and Regulation.
Regulatory Arbitrage was used for the first time in 2005 when it was applied by Scott V. Simpson, a partner at law firm Skadden, Arps, to refer to a new defence tactic in hostile mergers and acquisitions where differing takeover regimes in deals involving multi-jurisdictions are exploited to the advantage of a target company under threat.
In economics, regulatory arbitrage (sometimes, tax arbitrage) may be used to refer to situations when a company can choose a nominal place of business with a regulatory, legal or tax regime with lower costs. For example, an insurance
company may choose to locate in Bermuda
due to preferential tax rates and policies for insurance companies. This can occur particularly where the business transaction has no obvious physical location: in the case of many financial products, it may be unclear "where" the transaction occurs.
Regulatory arbitrage can include restructuring a bank by outsourcing services such as IT. The outsourcing company takes over the installations, buying out the bank's assets and charges a periodic service fee back to the bank. This frees up cashflow usable for new lending by the bank. The bank will have higher IT costs, but counts on the multiplier effect of money creation
and the interest rate spread to make it a profitable exercise.
Example:
Suppose the bank sells its IT installations for 40 million USD. With a reserve ratio of 10%, the bank can create 400 million USD in additional loans (there is a time lag, and the bank has to expect to recover the loaned money back into its books). The bank can often lend (and securitize the loan) to the IT services company to cover the acquisition cost of the IT installations. This can be at preferential rates, as the sole client using the IT installation is the bank. If the bank can generate 5% interest margin on the 400 million of new loans, the bank will increase interest revenues by 20 million. The IT services company is free to leverage their balance sheet as aggressively as they and their banker agree to. This is the reason behind the trend towards outsourcing in the financial sector. Without this money creation benefit, it is actually more expensive to outsource the IT operations as the outsourcing adds a layer of management and increases overhead.
Such services were previously offered in the United States by companies such as FuturePhone.com. These services would operate in rural telephone exchanges, primarily in small towns in the state of Iowa. In these areas, the local telephone carriers are allowed to charge a high "termination fee" to the caller's carrier in order to fund the cost of providing service to the small and sparsely populated areas that they serve. However, FuturePhone (as well as other similar services) ceased operations upon legal challenges from AT&T and other service providers.
is an imbalance in expected nominal values. A casino
has a statistical arbitrage in every game of chance that it offers—referred to as the house advantage, house edge, vigorish
or house vigorish.
(LTCM) lost 4.6 billion U.S. dollars in fixed income arbitrage
in September 1998. LTCM had attempted to make money on the price difference between different bonds
. For example, it would sell U.S. Treasury securities
and buy Italian bond futures. The concept was that because Italian bond futures had a less liquid market, in the short term Italian bond futures would have a higher return than U.S. bonds, but in the long term, the prices would converge. Because the difference was small, a large amount of money had to be borrowed to make the buying and selling profitable.
The downfall in this system began on August 17, 1998, when Russia
defaulted on its ruble
debt and domestic dollar debt. Because the markets were already nervous due to the Asian financial crisis, investors began selling non-U.S. treasury debt and buying U.S. treasuries, which were considered a safe investment. As a result the price on US treasuries began to increase and the return began decreasing because there were many buyers, and the return (yield) on other bonds began to increase because there were many sellers (i.e. the price of those bonds fell). This caused the difference between the prices of U.S. treasuries and other bonds to increase, rather than to decrease as LTCM was expecting. Eventually this caused LTCM to fold, and their creditors had to arrange a bail-out. More controversially, officials of the Federal Reserve assisted in the negotiations that led to this bail-out, on the grounds that so many companies and deals were intertwined with LTCM that if LTCM actually failed, they would as well, causing a collapse in confidence in the economic system. Thus LTCM failed as a fixed income arbitrage fund, although it is unclear what sort of profit was realized by the banks that bailed LTCM out.
or umpire.) In the sense used here it is first defined in 1704 by Mathieu de la Porte in his treatise "" as a consideration of different exchange rates to recognize the most profitable places of issuance and settlement for a bill of exchange ("".)
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
and finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, arbitrage (ˈɑrbɨtrɑːʒ) is the practice of taking advantage of a price difference between two or more market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
s: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market price
Market price
In economics, market price is the economic price for which a good or service is offered in the marketplace. It is of interest mainly in the study of microeconomics...
s. When used by academics, an arbitrage is a transaction that involves no negative cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit at zero cost.
In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage
Statistical arbitrage
In the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets (relative value or convergence trade
Convergence trade
Convergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future —and selling a similar asset forward for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal , and...
s), as in merger arbitrage.
People who engage in arbitrage are called arbitrageurs (ˌɑrbɨtrɑːˈʒɜr)—such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments
Financial instruments
A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....
, such as bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s, derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
, commodities
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
and currencies
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
.
Arbitrage-free
If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium or arbitrage-free market. An arbitrage equilibrium is a precondition for a general economic equilibriumGeneral equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
. The assumption that there is no arbitrage is used in quantitative finance to calculate a unique risk neutral
Risk neutral
In economics and finance, risk neutral behavior is between risk aversion and risk seeking. If offered either €50 or a 50% chance of each of €100 and nothing, a risk neutral person would have no preference between the two options...
price for derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
.
Conditions for arbitrage
Arbitrage is possible when one of three conditions is met:- The same asset does not trade at the same price on all markets ("the law of one priceLaw of one priceThe law of one price is an economic law stated as: "In an efficient market, all identical goods must have only one price."-Intuition:The intuition for this law is that all sellers will flock to the highest prevailing price, and all buyers to the lowest current market price. In an efficient market...
"). - Two assets with identical cash flows do not trade at the same price.
- An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rateRisk-free interest rateRisk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time....
(or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securitiesSecurity (finance)A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
).
Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally only possible with securities and financial products which can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'.As an arbitrage consists of at least two trades, the metaphor is of putting on a pair of pants, one leg (trade) at a time. The risk that one trade (leg) fails to execute is thus 'leg risk'.
In the simplest example, any good sold in one market should sell for the same price in another. Traders
Merchant
A merchant is a businessperson who trades in commodities that were produced by others, in order to earn a profit.Merchants can be one of two types:# A wholesale merchant operates in the chain between producer and retail merchant...
may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other.
See rational pricing
Rational pricing
Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away"...
, particularly arbitrage mechanics, for further discussion.
Mathematically it is defined as follows:
and where
means a portfolio at time t.Examples
- Suppose that the exchange rateExchange rateIn finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
s (after taking out the fees for making the exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = $12 = £6. Converting ¥1000 to $12 in Tokyo and converting that $12 into ¥1200 in London, for a profit of ¥200, would be arbitrage. In reality, this "triangle arbitrageTriangle arbitrageTriangular arbitrage is the act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three different currencies in the foreign exchange market...
" is so simple that it almost never occurs. But more complicated foreign exchange arbitrages, such as the spot-forward arbitrage (see interest rate parityInterest rate parityInterest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic...
) are much more common. - One example of arbitrage involves the New York Stock ExchangeNew York Stock ExchangeThe New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...
and the Security Futures Exchange OneChicago (OCX)OneChicago, LLCOneChicago is an all-electronic exchange owned jointly by IB Exchange Group , Chicago Board Options Exchange , and CME Group. It is a privately held company that is regulated by both the Securities and Exchange Commission and the Commodity Futures Trading Commission...
. When the price of a stock on the NYSE and its corresponding futures contractFutures contractIn finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
on OCX are out of sync, one can buy the less expensive one and sell it to the more expensive market. Because the differences between the prices are likely to be small (and not to last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the most expertise take advantage of series of small differences that would not be profitable if taken individually. - Economists use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of political and economic development to support industrialization. At present, many such jobs appear to be flowing towards ChinaPeople's Republic of ChinaChina , officially the People's Republic of China , is the most populous country in the world, with over 1.3 billion citizens. Located in East Asia, the country covers approximately 9.6 million square kilometres...
, though some which require command of English are going to IndiaIndiaIndia , officially the Republic of India , is a country in South Asia. It is the seventh-largest country by geographical area, the second-most populous country with over 1.2 billion people, and the most populous democracy in the world...
and the PhilippinesPhilippinesThe Philippines , officially known as the Republic of the Philippines , is a country in Southeast Asia in the western Pacific Ocean. To its north across the Luzon Strait lies Taiwan. West across the South China Sea sits Vietnam...
. In popular terms, this is referred to as offshoringOffshoringOffshoring describes the relocation by a company of a business process from one country to another—typically an operational process, such as manufacturing, or supporting processes, such as accounting. Even state governments employ offshoring...
. (Note that "offshoring" is not synonymous with "outsourcing", which means "to subcontract from an outside supplier or source", such as when a business outsources its bookkeeping to an accounting firm. Unlike offshoring, outsourcing always involves subcontracting jobs to a different company, and that company can be in the same country as the outsourcing company.) - Sports arbitrageArbitrage bettingBetting arbitrage, miraclebets, surebets, sports arbitraging is a particular case of arbitrage arising on betting markets due to either bookmakers' different opinions on event outcomes or plain errors. By placing one bet per each outcome with different betting companies, the bettor can make a profit...
– numerous internetInternetThe Internet is a global system of interconnected computer networks that use the standard Internet protocol suite to serve billions of users worldwide...
bookmakers offer odds on the outcome of the same event. Any given bookmaker will weight their odds so that no one customerCustomerA customer is usually used to refer to a current or potential buyer or user of the products of an individual or organization, called the supplier, seller, or vendor. This is typically through purchasing or renting goods or services...
can cover all outcomes at a profit against their books. However, in order to remain competitive their margins are usually quite low. Different bookmakers may offer different odds on the same outcome of a given event; by taking the best odds offered by each bookmaker, a customer can under some circumstances cover all possible outcomes of the event and lock a small risk-free profit, known as a Dutch bookDutch bookIn gambling a Dutch book or lock is a set of odds and bets which guarantees a profit, regardless of the outcome of the gamble. It is associated with probabilities implied by the odds not being coherent....
. This profit would typically be between 1% and 5% but can be much higher. One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the 'palpable error' rule, which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds. As bookmakers become more proficient, the odds of making an 'arb' usually last for less than an hour and typically only a few minutes. Furthermore, huge bets on one side of the market also alert the bookies to correct the market. - Exchange-traded fundExchange-traded fundAn exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
arbitrage – Exchange Traded Funds allow authorized participants to exchange back and forth between shares in underlying securities held by the fund and shares in the fund itself, rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. ETFs trade in the open market, with prices set by market demand. An ETF may trade at a premium or discount to the value of the underlying assets. When a significant enough premium appears, an arbitrageur will buy the underlying securities, convert them to shares in the ETF, and sell them in the open market. When a discount appears, an arbitrageur will do the reverse. In this way, the arbitrageur makes a low-risk profit, while keeping ETF prices in line with their underlying value. - Some types of hedge fundHedge fundA hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s make use of a modified form of arbitrage to profit. Rather than exploiting price differences between identical assets, they will purchase and sell securitiesSecurity (finance)A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
, assetAssetIn financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s and derivativesDerivative (finance)A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
with similar characteristics, and hedgeHedge (finance)A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
any significant differences between the two assets. Any difference between the hedged positions represents any remaining risk (such as basis risk) plus profit; the belief is that there remains some difference which, even after hedging most risk, represents pure profit. For example, a fund may see that there is a substantial difference between U.S. dollar debt and local currency debt of a foreign country, and enter into a series of matching trades (including currency swaps) to arbitrage the difference, while simultaneously entering into credit default swapCredit default swapA credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
s to protect against country riskCountry riskCountry risk refers to the risk of investing in a country, dependent on changes in the business environment that may adversely affect operating profits or the value of assets in a specific country...
and other types of specific risk..
Price convergence
Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rateExchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
s, the price of commodities, and the price of securities in different markets tend to converge. The speed at which they do so is a measure of market efficiency. Arbitrage tends to reduce price discrimination
Price discrimination
Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices from the same provider...
by encouraging people to buy an item where the price is low and resell it where the price is high (as long as the buyers are not prohibited from reselling and the transaction costs of buying, holding and reselling are small relative to the difference in prices in the different markets).
Arbitrage moves different currencies toward purchasing power parity
Purchasing power parity
In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
. As an example, assume that a car purchased in the United States is cheaper than the same car in Canada. Canadians would buy their cars across the border to exploit the arbitrage condition. At the same time, Americans would buy US cars, transport them across the border, then sell them in Canada. Canadians would have to buy American Dollars to buy the cars; and Americans would have to sell the Canadian dollars they received in exchange. Both actions would increase demand for US Dollars and supply of Canadian Dollars. As a result, there would be an appreciation of the US currency. This would make US cars more expensive and Canadian cars less so until their prices were similar. On a larger scale, international arbitrage opportunities in commodities
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
, goods, securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
and currencies
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
tend to change exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
s until the purchasing power
Purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...
is equal.
In reality, most asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s exhibit some difference between countries. These, transaction cost
Transaction cost
In economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...
s, taxes, and other costs provide an impediment to this kind of arbitrage. Similarly, arbitrage affects the difference in interest rates paid on government bonds issued by the various countries, given the expected depreciations in the currencies relative to each other (see interest rate parity
Interest rate parity
Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic...
).
Risks
Arbitrage transactions in modern securities markets involve fairly low day-to-day risks, but can face extremely high risk in rare situations, particularly financial crises, and can lead to bankruptcyBankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
. Formally, arbitrage transactions have negative skew – prices can get a small amount closer (but often no closer than 0), while they can get very far apart. The day-to-day risks are generally small because the transactions involve small differences in price, so an execution failure will generally cause a small loss (unless the trade is very big or the price moves rapidly). The rare case risks are extremely high because these small price differences are converted to large profits via leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
(borrowed money), and in the rare event of a large price move, this may yield a large loss.
The main day-to-day risk is that part of the transaction fails – execution risk. The main rare risks are counterparty risk and liquidity risk – that a counterparty to a large transaction or many transactions fails to pay, or that one is required to post margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
and does not have the money to do so.
In the academic literature, the idea that seemingly very low risk arbitrage trades might not be fully exploited because of these risk factors and other considerations is often referred to as limits to arbitrage
Limits to arbitrage
Limits to arbitrage is a theory that, due to restrictions that are placed on funds that would ordinarily be used by rational traders to arbitrage away pricing inefficiencies, prices may remain in a non-equilibrium state for protracted periods of time....
.
Execution risk
Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. However, this is not necessarily the case. Many exchanges and idbs allow multi legged trades (e.g. basis block trades on LIFFE).Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk position.
In the 1980s, risk arbitrage
Risk arbitrage
Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.Two principal types of merger are possible: a cash merger, and a stock merger. In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash...
was common. In this form of speculation
Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...
, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current price—if the merger goes through as predicted. Traditionally, arbitrage transactions in the securities markets involve high speed, high volume and low risk. At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act). When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing the risk is through the illegal use of inside information
Insider trading
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
, and in fact risk arbitrage with regard to leveraged buyout
Leveraged buyout
A leveraged buyout occurs when an investor, typically financial sponsor, acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage...
s was associated with some of the famous financial scandals of the 1980s such as those involving Michael Milken
Michael Milken
Michael Robert Milken is an American business magnate, financier, and philanthropist noted for his role in the development of the market for high-yield bonds during the 1970s and 1980s, for his 1990 guilty plea to felony charges for violating US securities laws, and for his funding of medical...
and Ivan Boesky
Ivan Boesky
Ivan Frederick Boesky is an American stock trader who is notable for his prominent role in a Wall Street insider trading scandal that occurred in the United States in the mid-1980s.-Life and career:...
.
Mismatch
Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable; this is more narrowly referred to as a convergence tradeConvergence trade
Convergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future —and selling a similar asset forward for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal , and...
. In the extreme case this is merger arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses.
Counterparty risk
As arbitrages generally involve future movements of cash, they are subject to counterparty risk: if a counterparty fails to fulfill their side of a transaction. This is a serious problem if one has either a single trade or many related trades with a single counterparty, whose failure thus poses a threat, or in the event of a financial crisis when many counterparties fail. This hazard is serious because of the large quantities one must trade in order to make a profit on small price differences.For example, if one purchases many risky bonds, then hedges them with CDSes
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
, profiting from the difference between the bond spread and the CDS premium, in a financial crisis the bonds may default and the CDS writer/seller may itself fail, due to the stress of the crisis, causing the arbitrageur to face steep losses.
Liquidity risk
Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a short position. If the assets used are not identical (so a price divergence makes the trade temporarily lose money), or the margin treatment is not identical, and the trader is accordingly required to post marginMargin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
(faces a margin call
Margin Call
Margin Call is a 2011 American independent drama film, written and directed by J.C. Chandor. The film has an ensemble cast that includes Kevin Spacey, Demi Moore, Paul Bettany, Jeremy Irons, Zachary Quinto, Stanley Tucci, Simon Baker, and Penn Badgley...
), the trader may run out of capital (if they run out of cash and cannot borrow more) and go bankrupt even though the trades may be expected to ultimately make money. In effect, arbitrage traders synthesize a put option
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
on their ability to finance themselves.
Prices may diverge during a financial crisis, often termed a "flight to quality"; these are precisely the times when it is hardest for leveraged investors to raise capital (due to overall capital constraints), and thus they will lack capital precisely when they need it most.
Merger arbitrage
Also called risk arbitrageRisk arbitrage
Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.Two principal types of merger are possible: a cash merger, and a stock merger. In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash...
, merger arbitrage generally consists of buying the stock of a company that is the target of a takeover
Takeover
In business, a takeover is the purchase of one company by another . In the UK, the term refers to the acquisition of a public company whose shares are listed on a stock exchange, in contrast to the acquisition of a private company.- Friendly takeovers :Before a bidder makes an offer for another...
while shorting the stock of the acquiring company.
Usually the market price of the target company is less than the price offered by the acquiring company.
The spread between these two prices depends mainly on the probability and the timing of the takeover being completed as well as the prevailing level of interest rates.
The bet in a merger arbitrage is that such a spread will eventually be zero, if and when the takeover is completed. The risk is that the deal "breaks" and the spread massively widens.
Municipal bond arbitrage
Also called municipal bond relative value arbitrage, municipal arbitrage, or just muni arb, this hedge fund strategy involves one of two approaches.Generally, managers seek relative value opportunities by being both long and short municipal bonds with a duration-neutral book. The relative value trades may be between different issuers, different bonds issued by the same entity, or capital structure trades referencing the same asset (in the case of revenue bonds). Managers aim to capture the inefficiencies arising from the heavy participation of non-economic investors (i.e., high income "buy and hold" investors seeking tax-exempt income) as well as the "crossover buying" arising from corporations' or individuals' changing income tax situations (i.e., insurers switching their munis for corporates after a large loss as they can capture a higher after-tax yield by offsetting the taxable corporate income with underwriting losses). There are additional inefficiencies arising from the highly fragmented nature of the municipal bond market which has two million outstanding issues and 50,000 issuers in contrast to the Treasury market which has 400 issues and a single issuer.
Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal bonds with the duration risk hedged by shorting
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
the appropriate ratio of taxable corporate bonds. These corporate equivalents are typically interest rate swaps referencing Libor or SIFMA
Securities Industry and Financial Markets Association
The Securities Industry and Financial Markets Association is a leading securities industry trade group representing securities firms, banks, and asset management companies in the U.S. and Hong Kong. SIFMA was formed on November 1, 2006, from the merger of The Bond Market Association and the...
http://www.investinginbonds.com/story.asp?id=351 http://www.bondmarkets.com/story.asp?id=1157. The arbitrage manifests itself in the form of a relatively cheap longer maturity municipal bond, which is a municipal bond that yields significantly more than 65% of a corresponding taxable corporate bond. The steeper slope of the municipal yield curve
Yield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
allows participants to collect more after-tax income from the municipal bond portfolio than is spent on the interest rate swap; the carry is greater than the hedge expense. Positive, tax-free carry from muni arb can reach into the double digits. The bet in this municipal bond arbitrage is that, over a longer period of time, two similar instruments—municipal bonds and interest rate swaps—will correlate with each other; they are both very high quality credits, have the same maturity and are denominated in U.S. dollars. Credit risk and duration risk are largely eliminated in this strategy. However, basis risk arises from use of an imperfect hedge, which results in significant, but range-bound principal volatility. The end goal is to limit this principal volatility, eliminating its relevance over time as the high, consistent, tax-free cash flow accumulates. Since the inefficiency is related to government tax policy, and hence is structural in nature, it has not been arbitraged away.
Note, however, that many municipal bonds are callable, and that this imposes substantial additional risks to the strategy.
Convertible bond arbitrage
A convertible bondConvertible bond
In finance, a convertible note is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features...
is a bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
that an investor can return to the issuing company in exchange for a predetermined number of shares in the company.
A convertible bond can be thought of as a corporate bond
Corporate bond
A corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date...
with a stock call option
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
attached to it.
The price of a convertible bond is sensitive to three major factors:
- interest rateInterest rateAn interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
. When rates move higher, the bond part of a convertible bond tends to move lower, but the call option part of a convertible bond moves higher (and the aggregate tends to move lower). - stock price. When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise.
- credit spreadCredit spread (bond)The financial term, credit spread is the yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk...
. If the creditworthiness of the issuer deteriorates (e.g. ratingCredit rating agencyA Credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves...
downgrade) and its credit spread widens, the bond price tends to move lower, but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility).
Given the complexity of the calculations involved and the convoluted structure that a convertible bond can have, an arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value.
Convertible arbitrage
Convertible arbitrage
Convertible arbitrage is a market-neutral investment strategy often employed by hedge funds. It involves the simultaneous purchase of convertible securities and the short sale of the same issuer's common stock....
consists of buying a convertible bond and hedging two of the three factors in order to gain exposure to the third factor at a very attractive price.
For instance an arbitrageur would first buy a convertible bond, then sell fixed income
Fixed income
Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable....
securities or interest rate future
Interest rate future
An interest rate futures is a financial derivative with an interest-bearing instrument as the underlying asset.Examples include Treasury-bill futures, Treasury-bond futures and Eurodollar futures....
s (to hedge the interest rate exposure) and buy some credit protection
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
(to hedge the risk of credit deterioration).
Eventually what he'd be left with is something similar to a call option on the underlying stock, acquired at a very low price.
He could then make money either selling some of the more expensive options that are openly traded in the market or delta hedging his exposure to the underlying shares.
Depository receipts
A depository receipt is a security that is offered as a "tracking stock" on another foreign market. For instance a ChineseChina
Chinese civilization may refer to:* China for more general discussion of the country.* Chinese culture* Greater China, the transnational community of ethnic Chinese.* History of China* Sinosphere, the area historically affected by Chinese culture...
company wishing to raise more money may issue a depository receipt on the New York Stock Exchange
New York Stock Exchange
The New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...
, as the amount of capital on the local exchanges is limited. These securities, known as ADRs (American Depositary Receipt
American Depositary Receipt
An American depositary receipt is a negotiable security that represents the underlying securities of a non-U.S. company that trades in the US financial markets...
) or GDRs (Global Depositary Receipt ) depending on where they are issued, are typically considered "foreign" and therefore trade at a lower value when first released. Many ADR's are exchangeable into the original security (known as fungibility
Fungibility
Fungibility is the property of a good or a commodity whose individual units are capable of mutual substitution, such as crude oil, wheat, precious metals or currencies...
) and actually have the same value. In this case there is a spread between the perceived value and real value, which can be extracted. Other ADR's that are not exchangeable often have much larger spreads. Since the ADR is trading at a value lower than what it is worth, one can purchase the ADR and expect to make money as its value converges on the original. However there is a chance that the original stock will fall in value too, so by shorting it one can hedge that risk.
Dual-listed companies
A dual-listed companyDual-listed company
A dual-listed company or DLC is a corporate structure in which two corporations function as a single operating business through a legal equalization agreement, but retain separate legal identities and stock exchange listings...
(DLC) structure involves two companies incorporated in different countries contractually agreeing to operate their businesses as if they were a single enterprise, while retaining their separate legal identity and existing stock exchange listings. In integrated and efficient financial markets, stock prices of the twin pair should move in lockstep. In practice, DLC share prices exhibit large deviations from theoretical parity. Arbitrage positions in DLCs can be set up by obtaining a long position in the relatively underpriced part of the DLC and a short position in the relatively overpriced part. Such arbitrage strategies start paying off as soon as the relative prices of the two DLC stocks converge toward theoretical parity. However, since there is no identifiable date at which DLC prices will converge, arbitrage positions sometimes have to be kept open for considerable periods of time. In the meantime, the price gap might widen. In these situations, arbitrageurs may receive margin call
Margin Call
Margin Call is a 2011 American independent drama film, written and directed by J.C. Chandor. The film has an ensemble cast that includes Kevin Spacey, Demi Moore, Paul Bettany, Jeremy Irons, Zachary Quinto, Stanley Tucci, Simon Baker, and Penn Badgley...
s, after which they would most likely be forced to liquidate part of the position at a highly unfavorable moment and suffer a loss. Arbitrage in DLCs may be profitable, but is also very risky, see. Background material is available at http://mathijsavandijk.com/dual-listed-companies/.
A good illustration of the risk of DLC arbitrage is the position in Royal Dutch Shell
Royal Dutch Shell
Royal Dutch Shell plc , commonly known as Shell, is a global oil and gas company headquartered in The Hague, Netherlands and with its registered office in London, United Kingdom. It is the fifth-largest company in the world according to a composite measure by Forbes magazine and one of the six...
—which had a DLC structure until 2005—by the hedge fund Long-Term Capital Management
Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
(LTCM, see also the discussion below). Lowenstein (2000) describes that LTCM established an arbitrage position in Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent premium. In total $2.3 billion was invested, half of which long in Shell and the other half short in Royal Dutch (Lowenstein, p. 99). In the autumn of 1998 large defaults on Russian debt created significant losses for the hedge fund and LTCM had to unwind several positions. Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent and LTCM had to close the position and incur a loss. According to Lowenstein (p. 234), LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell
Royal Dutch Shell
Royal Dutch Shell plc , commonly known as Shell, is a global oil and gas company headquartered in The Hague, Netherlands and with its registered office in London, United Kingdom. It is the fifth-largest company in the world according to a composite measure by Forbes magazine and one of the six...
trade.
Private to public equities
The market prices for privately held companies are typically viewed from a return on investment perspective (such as 25%), whilst publicly held and or exchange listed companies trade on a Price to earnings ratio (P/E) (such as a P/E of 10, which equates to a 10% ROIReturn on investment
Return on investment is one way of considering profits in relation to capital invested. Return on assets , return on net assets , return on capital and return on invested capital are similar measures with variations on how “investment” is defined.Marketing not only influences net profits but also...
). Thus, if a publicly traded company specialises in the acquisition of privately held companies, from a per-share perspective there is a gain with every acquisition that falls within these guidelines. Exempli gratia, Berkshire-Hathaway. A hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
that is an example of this type of arbitrage is Greenridge Capital
Greenridge Capital
Greenridge Capital is an exclusive, private investment group, or hedge fund, founded in 2006 by a small group of Christian philanthropists. The company is incorporated in Minnesota, USA, and has contractor offices in 6 other states, including reps from Costa Rica, Puerto Rico, Germany, Sweden, and...
, which acts as an angel investor
Angel investor
An angel investor or angel is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity...
retaining equity in private companies which are in the process of becoming publicly traded, buying in the private market and later selling in the public market. Private to public equities arbitrage is a term which can arguably be applied to investment banking
Investment banking
An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities...
in general. Private markets to public markets differences may also help explain the overnight windfall gains enjoyed by principals of companies that just did an initial public offering
Initial public offering
An initial public offering or stock market launch, is the first sale of stock by a private company to the public. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises...
(IPO).
Regulatory arbitrage
Regulatory arbitrage is where a regulated institution takes advantage of the difference between its real (or economic) riskRisk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
and the regulatory position. For example, if a bank, operating under the Basel I
Basel I
Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten countries...
accord, has to hold 8% capital against default risk, but the real risk of default is lower, it is profitable to securitise
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
the loan, removing the low risk loan from its portfolio. On the other hand, if the real risk is higher than the regulatory risk then it is profitable to make that loan and hold on to it, provided it is priced appropriately.
This process can increase the overall riskiness of institutions under a risk insensitive regulatory regime, as described by Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
in his October 1998 speech on The Role of Capital in Optimal Banking Supervision and Regulation.
Regulatory Arbitrage was used for the first time in 2005 when it was applied by Scott V. Simpson, a partner at law firm Skadden, Arps, to refer to a new defence tactic in hostile mergers and acquisitions where differing takeover regimes in deals involving multi-jurisdictions are exploited to the advantage of a target company under threat.
In economics, regulatory arbitrage (sometimes, tax arbitrage) may be used to refer to situations when a company can choose a nominal place of business with a regulatory, legal or tax regime with lower costs. For example, an insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
company may choose to locate in Bermuda
Bermuda
Bermuda is a British overseas territory in the North Atlantic Ocean. Located off the east coast of the United States, its nearest landmass is Cape Hatteras, North Carolina, about to the west-northwest. It is about south of Halifax, Nova Scotia, Canada, and northeast of Miami, Florida...
due to preferential tax rates and policies for insurance companies. This can occur particularly where the business transaction has no obvious physical location: in the case of many financial products, it may be unclear "where" the transaction occurs.
Regulatory arbitrage can include restructuring a bank by outsourcing services such as IT. The outsourcing company takes over the installations, buying out the bank's assets and charges a periodic service fee back to the bank. This frees up cashflow usable for new lending by the bank. The bank will have higher IT costs, but counts on the multiplier effect of money creation
Money creation
In economics, money creation is the process by which the money supply of a country or a monetary region is increased due to some reason. There are two principal stages of money creation. First, the central bank introduces new money into the economy by purchasing financial assets or lending money...
and the interest rate spread to make it a profitable exercise.
Example:
Suppose the bank sells its IT installations for 40 million USD. With a reserve ratio of 10%, the bank can create 400 million USD in additional loans (there is a time lag, and the bank has to expect to recover the loaned money back into its books). The bank can often lend (and securitize the loan) to the IT services company to cover the acquisition cost of the IT installations. This can be at preferential rates, as the sole client using the IT installation is the bank. If the bank can generate 5% interest margin on the 400 million of new loans, the bank will increase interest revenues by 20 million. The IT services company is free to leverage their balance sheet as aggressively as they and their banker agree to. This is the reason behind the trend towards outsourcing in the financial sector. Without this money creation benefit, it is actually more expensive to outsource the IT operations as the outsourcing adds a layer of management and increases overhead.
Telecom arbitrage
Telecom arbitrage companies allow phone users to make international calls for free through certain access numbers. Such services are offered in the United Kingdom; the telecommunication arbitrage companies get paid an interconnect charge by the UK mobile networks and then buy international routes at a lower cost. The calls are seen as free by the UK contract mobile phone customers since they are using up their allocated monthly minutes rather than paying for additional calls.Such services were previously offered in the United States by companies such as FuturePhone.com. These services would operate in rural telephone exchanges, primarily in small towns in the state of Iowa. In these areas, the local telephone carriers are allowed to charge a high "termination fee" to the caller's carrier in order to fund the cost of providing service to the small and sparsely populated areas that they serve. However, FuturePhone (as well as other similar services) ceased operations upon legal challenges from AT&T and other service providers.
Statistical arbitrage
Statistical arbitrageStatistical arbitrage
In the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
is an imbalance in expected nominal values. A casino
Casino
In modern English, a casino is a facility which houses and accommodates certain types of gambling activities. Casinos are most commonly built near or combined with hotels, restaurants, retail shopping, cruise ships or other tourist attractions...
has a statistical arbitrage in every game of chance that it offers—referred to as the house advantage, house edge, vigorish
Vigorish
Vigorish, or simply the vig, also known as juice or the take, is the amount charged by a bookmaker, or bookie, for his services. In the United States it also means the interest on a shark's loan. The term is Yiddish slang originating from the Russian word for winnings, выигрыш vyigrysh...
or house vigorish.
The debacle of Long-Term Capital Management
Long-Term Capital ManagementLong-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
(LTCM) lost 4.6 billion U.S. dollars in fixed income arbitrage
Fixed income arbitrage
Fixed-income arbitrage is an investment strategy generally associated with hedge funds, which consists of the discovery and exploitation of inefficiencies in the pricing of bonds, i.e...
in September 1998. LTCM had attempted to make money on the price difference between different bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
. For example, it would sell U.S. Treasury securities
Treasury security
A United States Treasury security is government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt. Treasury securities are the debt financing instruments of the United States federal government, and they are often referred to simply as Treasuries...
and buy Italian bond futures. The concept was that because Italian bond futures had a less liquid market, in the short term Italian bond futures would have a higher return than U.S. bonds, but in the long term, the prices would converge. Because the difference was small, a large amount of money had to be borrowed to make the buying and selling profitable.
The downfall in this system began on August 17, 1998, when Russia
Russia
Russia or , officially known as both Russia and the Russian Federation , is a country in northern Eurasia. It is a federal semi-presidential republic, comprising 83 federal subjects...
defaulted on its ruble
Russian ruble
The ruble or rouble is the currency of the Russian Federation and the two partially recognized republics of Abkhazia and South Ossetia. Formerly, the ruble was also the currency of the Russian Empire and the Soviet Union prior to their breakups. Belarus and Transnistria also use currencies with...
debt and domestic dollar debt. Because the markets were already nervous due to the Asian financial crisis, investors began selling non-U.S. treasury debt and buying U.S. treasuries, which were considered a safe investment. As a result the price on US treasuries began to increase and the return began decreasing because there were many buyers, and the return (yield) on other bonds began to increase because there were many sellers (i.e. the price of those bonds fell). This caused the difference between the prices of U.S. treasuries and other bonds to increase, rather than to decrease as LTCM was expecting. Eventually this caused LTCM to fold, and their creditors had to arrange a bail-out. More controversially, officials of the Federal Reserve assisted in the negotiations that led to this bail-out, on the grounds that so many companies and deals were intertwined with LTCM that if LTCM actually failed, they would as well, causing a collapse in confidence in the economic system. Thus LTCM failed as a fixed income arbitrage fund, although it is unclear what sort of profit was realized by the banks that bailed LTCM out.
Etymology
"Arbitrage" is a French word and denotes a decision by an arbitrator or arbitration tribunal. (In modern French, "" usually means refereeReferee
A referee is the person of authority, in a variety of sports, who is responsible for presiding over the game from a neutral point of view and making on the fly decisions that enforce the rules of the sport...
or umpire.) In the sense used here it is first defined in 1704 by Mathieu de la Porte in his treatise "" as a consideration of different exchange rates to recognize the most profitable places of issuance and settlement for a bill of exchange ("".)
Types of financial arbitrage
- Arbitrage bettingArbitrage bettingBetting arbitrage, miraclebets, surebets, sports arbitraging is a particular case of arbitrage arising on betting markets due to either bookmakers' different opinions on event outcomes or plain errors. By placing one bet per each outcome with different betting companies, the bettor can make a profit...
- Covered interest arbitrageCovered interest arbitrageCovered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency...
- Fixed income arbitrageFixed income arbitrageFixed-income arbitrage is an investment strategy generally associated with hedge funds, which consists of the discovery and exploitation of inefficiencies in the pricing of bonds, i.e...
- Political arbitragePolitical arbitragePolitical arbitrage is a trading strategy which involves using knowledge or estimates of future political activity to forecast and discount security values. For example, the major factor in the values of some foreign government bonds is the risk of default, which is a political decision taken by...
- Risk arbitrageRisk arbitrageRisk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.Two principal types of merger are possible: a cash merger, and a stock merger. In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash...
- Statistical arbitrageStatistical arbitrageIn the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
- Triangular arbitrage
- Uncovered interest arbitrageUncovered interest arbitrageUncovered interest arbitrage is a form of arbitrage where funds are transferred abroad to take advantage of higher interest in foreign monetary centers. It involves the conversion of the domestic currency to the foreign currency to make investment; and subsequent re-conversion of the fund from the...
- Volatility arbitrageVolatility arbitrageIn finance, volatility arbitrage is a type of statistical arbitrage that is implemented by trading a delta neutral portfolio of an option and its underlier. The objective is to take advantage of differences between the implied volatility of the option, and a forecast of future realized volatility...
Related concepts
- Algorithmic tradingAlgorithmic tradingIn electronic financial markets, algorithmic trading or automated trading, also known as algo trading, black-box trading or robo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the...
- Arbitrage pricing theoryArbitrage pricing theoryIn finance, arbitrage pricing theory is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a...
- Coherence (philosophical gambling strategy)Coherence (philosophical gambling strategy)In a thought experiment proposed by the Italian probabilist Bruno de Finetti in order to justify Bayesian probability, an array of wagers is coherent precisely if it does not expose the wagerer to certain loss regardless of the outcomes of events on which he is wagering, even if his opponent makes...
, analogous concept in Bayesian probabilityBayesian probabilityBayesian probability is one of the different interpretations of the concept of probability and belongs to the category of evidential probabilities. The Bayesian interpretation of probability can be seen as an extension of logic that enables reasoning with propositions, whose truth or falsity is... - Efficient market hypothesisEfficient market hypothesisIn finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...
- Immunization (finance)Immunization (finance)In finance, interest rate immunization is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the opposite amount...
- Interest rate parityInterest rate parityInterest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic...
- IntermediationIntermediationIntermediation involves the "matching" of lenders with savings to borrowers who need money by an agent or third party, such as a bank.If this matching is successful, the lender obtains a positive rate of return, the borrower receives a return for risk taking and entrepreneurship and the banker...
- No free lunch with vanishing risk
- TANSTAAFLTANSTAAFL"There ain't no such thing as a free lunch" is a popular adage communicating the idea that it is impossible to get something for nothing. The acronyms TANSTAAFL and TINSTAAFL are also used...
- Value investingValue investingValue investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
External links
- What is Arbitrage? (About.com)
- ArbitrageView.com – Arbitrage opportunities in pending merger deals in the U.S. market
- Information on arbitrage in dual-listed companies on the website of Mathijs A. van Dijk.
- What is Regulatory Arbitrage. Regulatory Arbitrage after the Basel ii framework and the 8th Company Law Directive of the European Union.
- Institute for Arbitrage.