Difference between revisions of "Arbitrage" - New World Encyclopedia

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[[Category:Economics]]
 
[[Category:Economics]]
  
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In [[economics]] and [[finance]], '''arbitrage''' is the practice of taking advantage of a price differential between two or more [[market]]s: a combination of matching deals are struck 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, a risk-free profit. A person who engages in arbitrage is called an '''arbitrageur'''. The term is mainly applied to trading in [[financial instruments]], such as [[Bond (finance)|bond]]s, [[stock]]s, [[derivative (finance)|derivatives]], [[Commodity|commodities]] and [[currency|currencies]].
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In [[economics]] and [[finance]], '''arbitrage''' is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. This usually takes place on different exchanges or marketplaces. This is also known as a "'''riskless profit'''".
  
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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 equilibrium|general economic equilibrium]].
 
  
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[[Statistical arbitrage]] is an imbalance in expected values. A casino has a statistical arbitrage in almost every game of chance that it offers.
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Alternatively, arbitrage is attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. The ideal version is riskless arbitrage.  
  
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== Conditions for arbitrage ==
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'''EXAMPLE''': Say a domestic stock also trades on a foreign exchange in another country, where it hasn't adjusted for the constantly changing exchange rate. A trader purchases the stock where it is undervalued and short sells the stock where it is overvalued, thus profiting from the difference.
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Arbitrage is possible when one of three conditions is met:
 
  
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#The same asset does not trade at the same price on all markets ("[[law of one price|the law of one price]]").
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==Arbitrage:Overview of conditions and types==
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#Two assets with identical cash flows do not trade at the same price.
 
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#An asset with a known price in the future does not today trade at its future price [[discount]]ed at the [[risk-free interest rate]] (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for [[security (finance)|securities]]).
 
  
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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.
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===Etymology===
  
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In the most simple example, any good sold in one market should sell for the same price in another. [[Trader]]s 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.
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"Arbitrage" is a French word and denotes a decision by an arbitrator or arbitration tribunal. (In modern French, "''arbitre''" usually means [[referee]] or [[umpire]]).  
  
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See [[rational pricing]], particularly [[rational pricing#Arbitrage mechanics|arbitrage mechanics]], for further discussion.
 
  
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== Examples ==
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In the sense used here it is first defined in 1704 by Mathieu de la Porte in his treatise "La science des négocians et teneurs de livres" as a consideration of different exchange rates to recognize the most profitable places of issuance and settlement for a bill of exchange ("[U]ne combinaison que l’on fait de plusieurs Changes, pour connoître quelle Place est plus avantageuse pour tirer et remettre"). See "Arbitrage" in [http://atilf.atilf.fr Trésor de la Langue Française].
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* Suppose that the [[exchange rate]]s (after taking out the fees for making the exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = £6 = $12.  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 arbitrage]]" is so simple that it almost never occurs. But more complicated foreign exchange arbitrages, such as the spot-forward arbitrage (see [[interest rate parity]]) are much more common.
 
  
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*One example of arbitrage involves the [[New York Stock Exchange]] and the [[Chicago Mercantile Exchange]]. When the price of a stock on the NYSE and its corresponding [[futures contract]] on the CME are out of sync, one can buy the less expensive one and sell the more expensive.  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 smartest mathematicians take advantage of series of small differentials that would not be profitable if taken individually.
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===Conditions of arbitrage===
  
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*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 [[People's Republic of China|China]], though some which require English are going to [[India]] and the [[Philippines]].
 
  
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*Sports arbitrage - numerous [[internet]] [[bookmakers]] offer odds on the outcome of the same event. Any given bookmaker will weight their odds so that no one [[customer]] 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 book]]. 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.
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"…….''I don't throw darts at a board. I bet on sure things. Read Sun-tzu, The Art of War. Every battle is won before it is ever fought''……."
  
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*[[Exchange-traded fund]] 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 fulfilling a useful function in the ETF marketplace by keeping ETF prices in line with their underlying value.
 
  
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* Some types of [[hedge fund]]s make use of a modified form of arbitrage to profit. Rather than exploiting price differences between identical assets, they will purchase and sell [[security (finance)|securities]], [[asset]]s and [[Derivative (finance)|derivatives]] with similar characteristics, and [[hedge (finance)|hedge]] 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 swap]]s to protect against [[country risk]] and other types of specific risk.
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Many might recognize these words spoken by Gordon Gekko in the movie Wall Street. In the movie, Gekko makes a fortune as a pioneer of arbitrage. Unfortunately, such risk-free trading is not available to everyone; however, there are several other forms of arbitrage that can be used to enhance the odds of executing a successful trade. Here we look at the concept of arbitrage, how market makers utilize "true arbitrage," and, finally, how retail investors can take advantage of arbitrage opportunities.
  
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==Price convergence==
 
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Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency [[exchange rate]]s, the price of [[commodities]], and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. The speed at which prices converge 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.
 
  
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Arbitrage moves different currencies toward [[purchasing power parity]]. As an example, assume that a car purchased in [[United States|America]] 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, and 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 for the exported cars. Both actions would increase demand for US Dollars, and supply of Canadian Dollars, and as a result, there would be an appreciation of the US Dollar. Eventually, if unchecked, this would make US cars more expensive for all buyers, and Canadian cars cheaper, until there is no longer an incentive to buy cars in the US and sell them in Canada.
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'''Arbitrage is possible when one of three conditions is met''':
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More generally, international arbitrage opportunities in [[commodity|commodities]], goods, [[security|securities]] and [[currency|currencies]], on a grand scale, tend to change [[exchange rate]]s until the [[purchasing power]] is equal.
 
  
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In reality, of course, one must consider taxes and the costs of travelling back and forth between the US and Canada. Also, the features built into the cars sold in the US are not exactly the same as the features built into the cars for sale in Canada, due, among other things, to the different emissions and other auto regulations in the two countries. In addition, our example assumes that no duties have to be paid on importing or exporting cars from the USA to Canada.
 
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Similarly, most [[asset]]s exhibit (small) differences between countries, and [[transaction cost]]s, taxes, and other costs provide an impediment to this kind of arbitrage.
 
  
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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]]).
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*The same asset does not trade at the same price on all markets ("[[law of one price|the law of one price]]").  
  
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== Risks ==
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*Two assets with identical cash flows do not trade at the same price.
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Arbitrage transactions in modern securities markets involve fairly low risks. 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. There is also counter-party risk, that the other party to one of the deals fails to deliver as agreed; though unlikely, this hazard is serious because of the large quantities one must trade in order to make a profit on small price differences. These risks become magnified when [[Leverage (finance)|leverage]] or borrowed money is used.  
 
  
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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. In the extreme case this is risk arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses.
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*An asset with a known price in the future does not today trade at its future price [[discount]]ed at the [[risk-free interest rate]] (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for [[security (finance)|securities]]).
  
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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.
 
  
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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 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 [[Insider trading|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]].
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Thus, to summarize:  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.  
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( NOTE: In practical terms, this is generally only possible with securities and financial products which can be traded electronically. )
  
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==Types of arbitrage==
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====What is not "risk-less" arbitrage====
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=== Merger arbitrage ===
 
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Also called [[risk arbitrage]], merger arbitrage generally consists of buying the stock of a company that is the target of a [[takeover]] while [[Short (finance)|shorting]] the stock of the acquiring company.
 
  
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Usually the market price of the target company is less than the price offered by the acquiring company.
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In view of previous discussion, we present an example what is not an ”arbitrage” in the real sence of the world.
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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.
 
  
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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.
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'''EXAMPLE''': Say the keyword ‘dvd player’ costs $1 on Google’s auction market. On Nextag’s market it costs $2. Nextag does add value, by decreasing search costs for vertical merchants, say by $0.50 and Nextag also does have its own transaction costs, say $0.50.  
  
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=== Municipal bond arbitrage ===
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Overall, Nextag pockets a profit of $0.50 for their  [['''value add''']] — but if you assume the transaction was straight through processed and there were no credit or operational risks, this looks like a  risk-free profit.
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Also called ''municipal bond relative value arbitrage'', ''municipal arbitrage'', or just ''muni arb'', this hedge fund strategy involves one of two approaches.
 
  
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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.
 
  
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Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal bonds with the duration risk hedged by [[Short selling|shorting]] the appropriate ratio of taxable corporate bonds.  These corporate equivalents are typically [[interest rate swaps]] referencing Libor [http://en.wikipedia.org/wiki/Libor#LIBOR-based_derivatives] or BMA (short for Bond Market Association [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.
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However, the most significant risk of all: ''Paid traffic coming in doesn’t necessarily convert to paid traffic going out.''
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So, Nextag  can justify its higher cost-per-click fees, a comparison shopping site has to send its clients leads from people more likely to buy, which means the comparison shopping site---completely different from Google’s one--- has to qualify and filter the traffic it purchases.
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If a site attracts a user for $1 and sends that user to a merchat for $2, it makes money. But what happens if a site attracts a user for $1 and that user never clicks-out to a paying merchant?
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Besides, there’s more than a bit of risk involved here. A comparison-shopping sites aren’t “''buying from one market where there is a low price and selling in another where the price is higher''” - instead, '''''a comparison-shopping site buys from one market at a low price, attempt to add value to its purchase, and then tries to resell what it’s bought for a higher price''''' - a transaction that’s not always successful.
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Because of this, what a comparison-shopping site does can’t be called risk-free arbitrage in any sense of the word; in fact it sits on the boundary to call it "arbitrage" at all. There’s no such thing as easy money.
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===Types of Arbitrage===
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====Riskless or “True” Arbitrage====
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In finance theory, an arbitrage is a "free lunch"—a transaction or portfolio that makes a profit without risk. Suppose a futures contract trades on two different exchanges. If, at one point in time, the contract is bid at USD 45.02 on one exchange and offered at USD 45.00 on the other, a trader could purchase the contract at one price and sell it at the other to make a risk-free profit of a USD 0.02.
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Such arbitrage opportunities reflect minor pricing discrepancies between markets or related instruments. Per-transaction profits tend to be small, and they can be consumed entirely by transaction costs. Accordingly, most arbitrage is performed by institutions that have very low transaction costs and can make up for small profit margins by doing a large volume of transactions.
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Formally, theoreticians define an arbitrage as a trading strategy that requires the investment of no capital, cannot lose money, and has a positive probability of making money.
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A market is said to have no arbitrage, or to be arbitrage-free, if prices in that market offer no arbitrage opportunities. This is a theoretical condition that is usually assumed for markets in economic and financial models. The assumption underlies the financial engineering theory of arbitrage-free pricing. This is what we have seen in the “conditions of arbitrage” in the above section.
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Following are the basic types of  riskless or “true” arbitrage”:
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*'''Market Arbitrage'''
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Purchasing and selling the same security at the same time in different markets to take advantage of a price difference between the two separate markets. The example for this type of arbitrage is just at the beginning of this section ( two exchanges with different  contract prices--- $ 45.00 and $ 45.02. )
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An arbitrageur would short sell the higher priced stock and buy the lower priced one. The profit is the spread between the two assets.
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There is one basic condition ( or set of conditions ) that set the Market Makers quite apart from the  Retail Traders.  Even in the “True Arbitrage” environments have the  Market Makers ( big Wall Street, Bay Street etc. “movers” ) several advantages over retail traders. They have:
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*Far more trading capital.
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*Generally more skill.
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*Up-to-the-second news.
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*Faster computers.
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*More complex software.
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*Access to the dealing desk and more.
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Combined, these factors make it nearly impossible for a retail trader to take advantage of pure arbitrage opportunities. Market makers use complex software that is run on top-of-the-line computers to locate such opportunities constantly. Once found, the differential is typically negligible, and requires a vast amount of capital in order to profit—retail traders would likely get burned by commission costs. Needless to say, it is almost impossible for retail traders to compete in the risk-free genre of arbitrage.
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*'''Inward Arbitrage'''
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A form of arbitrage involving rearranging a bank's cash by borrowing from the inter-bank market, and re-depositing the borrowed money locally at a higher interest rate. The bank will make money on the spread between the interest rate on the local currency, and the interest rate on the borrowed currency.
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Inward arbitrage works because it allows the bank to borrow at a cheaper rate than it could in the local currency market. For example, assume an American bank goes to the Interbank market to borrow at the lower eurodollar rate, and then deposits those eurodollars at a bank within the US. The larger the spread, the more money that can be made.
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*'''Outward Arbitrage'''
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A form of arbitrage involving the rearrangement of a bank's cash by taking its local currency and depositing it into eurobanks. The interest rate will be higher in the inter-bank market, which will enable the bank to earn more on the interest it receives for the use of its cash.
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Outward arbitrage works because it allows the bank to lend for more abroad then it could in the local market. For example, assume an American bank goes to the inter-bank market to lend at the higher eurodollar rate. Money will be shifted from an American bank's branch within the U.S. to a branch located outside of the U.S. The bank will earn revenues on the spread between the two interest rates. The larger the spread, the more will be made.
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*'''Triangular Arbitrage'''
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The process of converting one currency to another, converting it again to a third currency and, finally, converting it back to the original currency within a short time span. This opportunity for riskless profit arises when the currency's exchange rates do not exactly match up. Triangular arbitrage opportunities do not happen very often and when they do, they only last for a matter of seconds. Traders that take advantage of this type of arbitrage opportunity usually have advanced computer equipment and/or programs to automate the process.
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'''EXAMPLE''': Suppose you have $1 million and you are provided with the following exchange rates:
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EUR/USD = 0. 8631, EUR/GBP = 1. 4600 and USD/GBP = 1. 6939.
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With these exchange rates there is an arbitrage opportunity:
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*1) Sell dollars for euros: $1 million x 0.8631 = 863,100 euros.
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*2) Sell euros for pounds: 863,100/1.4600 = 591,164.40 pounds.
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*3)  Sell pounds for dollars: 591,164.40 x 1.6939 =$1,001,373 dollars.
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From these transactions, you would receive an arbitrage profit of $1,373 (assuming no transaction costs or taxes) which is the positive difference between the “almost” simultaneous transactions 1), 2) , and 3) leading to $1,001,373  from which we subtract  the original outlay of  $1,000,000 with a yield of net profit of $1,373.
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*'''Sports arbitrage'''
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Numerous [[internet]] [[bookmakers]] offer odds on the outcome of the same event.  Any given bookmaker will weight their odds so that no one [[customer]] 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 book]].
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'''EXAMPLE''': During Wimbledon 2001, the ladies singles match between Lindsay Davenport and Kim Clijsters was priced differently by bookies Victor Chandler and Tote. Victor Chandler saw Davenport to win at odds of 2/5 while Tote saw Clijsters at 3/1.
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At 2/5 the total amount to invest in Davenport to return $100 was $71.42. At 3/1 the total amount to invest in Clijsters to return $100 was $25.
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This means that the total investment required to return $100 - whichever player wins - is just $96.42. A return of 3.58% within under 2 hours ( this is a very conservative example ).
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Although 3.58% may seem like a small return, we should remember that it was totally certain, risk free, took only 2 hours to achieve and there was never a possibility of ever losing the money or not getting the profit. It was a mathematical certainty.
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====Risk arbitrages====
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Risk arbitrage ( sometimes called  “statistical arbitrage” ) is.the second form of arbitrage that we will discuss. Unlike “true” or riskless arbitrage, risk arbitrage entails risk. Although considered "speculation," risk arbitrage has become one of the most popular ( and retail-trader friendly ) forms of arbitrage. As we noted above, just as  the disadvantages in pure arbitrage for retail traders ( as opposed to the big firms of Wall Street or Bay Street ), risk arbitrage is more accessible to most retail traders.
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'''EXAMPLE''': Let us say Company A is currently trading at $10/share. Company B, which wants to acquire Company A, decides to place a takeover bid on Company A for $15/share. This means that all of Company A's shares are now worth $15/share, but are trading at only $10/share.  
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Let's say the early trades ( typically not retail trades ) bid it up to $14/share. Now, there is still a $1/share difference—an opportunity for risk arbitrage. So, where's the risk? Well, the acquisition could fall through, in which case the shares would be worth only the original $10/share.
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It must be said that the usage of this term ( i.e. “arbitrage” ) is shunned by theoretical purists. However, it has been in wide use for several decades, so it is fairly standard. According to this usage, an arbitrage is a leveraged speculative transaction or portfolio.
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It is a bit like “'''leveling the field advantages'''.” Although this type of arbitrage requires taking on some risk, it is generally considered "playing the odds." Here we will examine some of the most common forms of arbitrage available to retail traders. These include:
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*'''Statistical arbitrage.'''
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It is an attempt to profit from pricing inefficiencies that are identified through the use of mathematical models. Statistical arbitrage attempts to profit from the likelihood that prices will trend toward a historical norm. Unlike pure arbitrage, statistical arbitrage is not riskless.
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Statistical arbitrage—or stat arb—is an equity trading strategy that employs time series methods to identify relative mispricings between stocks.
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*One technique is pairs trading:
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Pairs trading (also known as relative-value arbitrage) is far less common than the two forms discussed above. This form of arbitrage relies on a strong correlation between two related or unrelated securities. It is primarily used during sideways markets as a way to profit.
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Here's how it works. First, you must find "pairs." Typically, high-probability pairs are big stocks in the same industry with similar long-term trading histories. Look for a high percent correlation. Then, you wait for a divergence in the pairs between 5-7% divergence that lasts for an extended period of time (2-3 days). Finally, you can go long and/or short on the two securities based on the comparison of their pricing. Then, just wait until the prices come back together.
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'''EXAMPLE''': One example of securities that would be used in a pairs trade is GM and Ford. These two companies have a 94% correlation. You can simply plot these two securities and wait for a significant divergence; then chances are these two prices will eventually return to a higher correlation, offering opportunity in which profit can be attained.
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*'''Merger arbitrage.'''
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The example of risk arbitrage we saw in the above EXAMPLE that demonstrates takeover and merger arbitrage. It is probably the most common type of arbitrage. It typically involves locating an undervalued company that has been targeted by another company for a takeover bid. This bid would bring the company to its true, or intrinsic, value. If the merger goes through successfully, all those who took advantage of the opportunity will profit handsomely; however, if the merger falls through, the price may drop.  
 +
 
 +
The key to success in this type of arbitrage is speed; traders who utilize this method usually have access to streaming market news. The second something is announced, they try to get in on the action before anyone else.
 +
 
 +
Let's say you are a retail trader and, hence, you aren't among the first in, however. How do you know if it is still a good deal? Well, one way is to use [[Benjamin Graham]]'s risk-arbitrage formula to determine optimal risk/reward. His equations state the following:
 +
 
 +
   
 +
'''Annual Return  =  [C. (G-L ). (100%-C)] /YP,''' where:
 +
 
 +
 
 +
* C is the expected chance of success (%).
 +
 
 +
* P is the current price of the security.
 +
 
 +
* L is the expected loss in the event of a failure (usually original price).
 +
 
 +
* Y is the expected holding time in years (usually the time until the merger takes place).
 +
 
 +
* G is the expected gain in the event of a success (usually takeover price).
 +
 
 +
 
 +
Granted, this is highly empirical, but it will give you an idea of what to expect before you get into a merger arbitrage situation.
 +
 
 +
 
 +
*'''Fixed income trading.'''
 +
 
 +
 
 +
Fixed income arbitragers try to identify when historical patterns for spreads or term structure relationships have been violated and put on a long-short position in anticipation of the historical relationship being reestablished. They also look for situations where credit risk or liquidity risk is being over compensated and will then put on a long-short position that earns positive carry. Central bank intervention in the markets often creates abnormalities that can be exploited.
 +
 
 +
Fixed income arbitrage strategies are generally implemented to be duration neutral, but they are exposed to various other market risks. By their nature, particular strategies may be exposed to tilts in the term structure, spread risk and foreign exchange risk.
 +
 
 +
 
 +
*'''Convertible-bond arbitrage.'''
 +
 
  
−
=== Convertible bond arbitrage ===
 
 
A [[convertible bond]] is a [[bond (finance)|bond]] that an investor can return to the issuing company in exchange for a predetermined number of shares in the company.
 
A [[convertible bond]] is a [[bond (finance)|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.
+
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:
 +
 
  
−
The price of a convertible bond is sensitive to three major factors:
+
* 1) ''[[interest rate]]''. 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).
 +
 
 +
 
 +
* 2) ''stock price''. When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise.
 +
 
 +
 
 +
*  3) ''[[credit spread (bond)|credit spread]]''. If the creditworthiness of the issuer deteriorates (e.g. [[credit rating agency|rating]] 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).
  
−
*''[[interest rate]]''. 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 spread (bond)|credit spread]]''. If the creditworthiness of the issuer deteriorates (e.g. [[credit rating agency|rating]] 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.
 
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.
 
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 default swap|credit protection]] (to hedge the risk of credit deterioration).
 
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 default swap|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.
 
  
−
=== Depository receipts ===
+
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.
−
A [[depository receipt]] is a security that is offered as a "tracking stock" on another foreign market. For instance a [[China|Chinese]] 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. However, they 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. 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 you can hedge that risk.
+
 
 +
==Conclusion==
 +
 
 +
We shall conclude with a few words about the online marketing and advertising "arbitrage," that raises probably more diverse opinions than any other single word ( as it involves everybody who uses internet and thus computer. )
 +
 
 +
 
 +
The arbitrager is paid when searchers click out on yet another ad. The arbitrager  pockets the difference between what they paid per click and what they get paid per click.
 +
 
 +
An arbitrager has to know what they are being paid per click, understand the click-through rate on any given phrase, and combine that information with what they are paying for the traffic. If any of those numbers suddenly change, it's possible to lose a lot of money very quickly.
 +
 
 +
 
 +
Caught in the middle is an advertiser. Most advertisers find their ads on arbitrage sites by actually clicking on an ad and seeing one of these ad pages and then the realization that their ad dollars are funding these sites that quickly lead to emotional responses.
 +
 
 +
 
 +
*'''In Defense Of Arbitrage:'''
 +
 
  
−
===Regulatory arbitrage===
+
One of the advantages of arbitrage sites is that advertisers can receive traffic from ad positions they don't control on a search page. Usually an advertiser only controls a single ad position, and if the advertiser didn't attract the first click, then it becomes increasingly difficult to receive traffic from that consumer. Since an arbitrage site is displaying a page full of ads, if an advertiser appears in one of those they have a second chance to receive the click. In essence, advertisers can receive traffic from ad positions they don't control and which might be a bonus.
−
Regulatory arbitrage is where a regulated institution takes advantage of the difference between its real (or economic) [[risk]] 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 [[Securitization|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 [http://www.ny.frb.org/research/epr/98v04n3/9810gree.pdf The Role of Capital in Optimal Banking Supervision and Regulation].
 
  
−
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.
+
*'''A Blight Upon The Web:'''
  
−
===Telecom arbitrage===
 
−
Telecom arbitrage companies like [http://www.actiontelecom.co.uk Action Telecom UK] allow mobile phone users to make international calls for free through certain access numbers. 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. The end effect is telecom arbitrage. This is usually marketed as "free international calls." The profit margins are usually very small. However, with enough volume, enough money is made from the cost difference to turn a profit. This is very similar to [http://www.futurephone.com Future Phone] in the US.
 
  
−
===Online advertising arbitrage===
+
Some advertisers consider arbitrage an offense akin to spam—and not necessarily just search spam, but the vile kind that fills up your email inbox.  
−
Online ad services like [http://searchmarketing.yahoo.com Yahoo! Search Marketing] and [https://adwords.google.com Google Adwords] allow you to purchase online advertisements which cost you an agreed upon cost per click. These are known as PPC (Pay Per Click) ads. Some ad clicks will cost advertisers $0.01 while some can cost well over $10 depending on the keywords that were associated with the ad. Yahoo and [https://www.google.com/adsense Google] both have programs which allow web publishers (aka owners of websites) to place ads on their own websites to make money. Some webmasters will make a website associated with a high paying keyword(s) and place PPC ads on it. Then, they will purchase low cost ads on Yahoo and Google for their websites. The end effect is traffic arbitrage. Low cost traffic is redirected towards pages which contain high paying links. Enough money is made from clicks to cover the traffic cost and turn a profit.
 
  
−
This is not arbitrage as defined above. The owner of the website is simply betting that the income from the [[affiliate marketing]] organisation is more than the cost of bringing visitors to the site. The website owner must pay the [[search engine]] for each visitor to the website but payment from the affiliate only occurs if the visitor actually clicks onto one of the affiliate advertisements. A classic example might be where each visitor to the site costs the site owner 10 cents but an affiliate marketer will pay the website owner 10 dollars if that visitor clicks through to the target website. In this case if more than 1 in 100 visitors click through then the site makes a profit; and conversely if less than 1 in 100 click through then the site makes a loss. The same theory holds true if the affiliate is the same (or another) search engine.
 
  
−
==The debacle of Long-Term Capital Management==
+
The '''''first argument against arbitrage pleads for the user experience'''''. If a searcher is taken from a search result to a set of ads without any meaningful content, then they really didn't find any answers. The searcher now has to click on yet another ad to get to an advertiser's page. If the page full of ads wasn't in the middle between the search result and the advertiser’s page, the searcher would have found the information one click sooner and had a better experience.
−
{{main|Long-Term Capital Management}}
 
  
−
[[Long-Term Capital Management]] (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 [[Bond (finance)|bond]]s. For example, it would sell [[Treasury security|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 [[Russian ruble|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 return on U.S. treasuries began decreasing because there were many buyers, and the return on other bonds began to increase because there were many sellers.  This caused the difference between the returns 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.
+
One way of being profitable with arbitrage is to buy inexpensive words and send them to a page of similar, yet more expensive words. Thus, '''''the second argument against arbitrage resolves around ad relevancy'''''.  
  
−
== Etymology ==
 
−
"Arbitrage" is a French word and denotes a decision by an arbitrator or arbitration tribunal. (In modern French, "''arbitre''" usually means [[referee]] or [[umpire]]). In the sense used here it is first defined in 1704 by Mathieu de la Porte in his treatise "La science des négocians et teneurs de livres" as a consideration of different exchange rates to recognize the most profitable places of issuance and settlement for a bill of exchange ("[U]ne combinaison que l’on fait de plusieurs Changes, pour connoître quelle Place est plus avantageuse pour tirer et remettre"). See "Arbitrage" in [http://atilf.atilf.fr Trésor de la Langue Française].
 
  
 +
'''EXAMPLE''': If the search was "lawyer", one can assume it's a fairly ambiguous query. Because this is an ambiguous query, it's often not an overly expensive click compared to other legal terms. So, an arbitrager will buy the keyword "lawyer" and send it to a page about "personal injury lawyers," a click cost that is often four or more times more expensive than "lawyer."
  
 +
 +
Should an advertiser be charged for a "personal injury lawyer" click when the search was just for "lawyer?" Why should a company be able to buy an ad about one keyword and send traffic to ads about an entirely different keyword?
 +
 +
 +
'''''In short''''': Arbitrage is a word that is sure to evoke a response in any internet marketer ( and in every internet user ). However, the responses will vary as greatly as those found in a heated political debate.
 +
 +
There isn't necessarily a magic answer, but advertisers clearly want more control and a greater visibility into how their ad dollars are spent.
 +
 +
 +
When marketers have full visibility and control of ad dollars, they will have the ability to not just debate arbitrage—they will have the power to act on their feelings.
  
 
== References ==
 
== References ==
 +
*Burmeister E and Wall KD., The arbitrage pricing theory and macroeconomic factor measures, The Financial Review, 21:1-20, 1986
 +
*Chen, N.F, and Ingersoll, E., Exact pricing in linear factor models with finitely many assets: A note, Journal of Finance June 1983
 
*Greider, William (1997). ''One World, Ready or Not''. Penguin Press. ISBN 0-7139-9211-5.
 
*Greider, William (1997). ''One World, Ready or Not''. Penguin Press. ISBN 0-7139-9211-5.
 +
*Roll, Richard and Stephen Ross, An empirical investigation of the arbitrage pricing theory, Journal of Finance, Dec 1980,
 +
*Ross, Stephen, The arbitrage theory of capital asset pricing, Journal of Economic Theory, v13, issue 3, 1976
 +
  
 
== External links ==
 
== External links ==
−
 
  
 
*[http://economics.about.com/cs/finance/a/arbitrage.htm What is Arbitrage? (About.com)]
 
*[http://economics.about.com/cs/finance/a/arbitrage.htm What is Arbitrage? (About.com)]

Revision as of 15:51, 23 September 2007


In economics and finance, arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. This usually takes place on different exchanges or marketplaces. This is also known as a "riskless profit".


Alternatively, arbitrage is attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. The ideal version is riskless arbitrage.

EXAMPLE: Say a domestic stock also trades on a foreign exchange in another country, where it hasn't adjusted for the constantly changing exchange rate. A trader purchases the stock where it is undervalued and short sells the stock where it is overvalued, thus profiting from the difference.

Arbitrage:Overview of conditions and types

Etymology

"Arbitrage" is a French word and denotes a decision by an arbitrator or arbitration tribunal. (In modern French, "arbitre" usually means referee or umpire).


In the sense used here it is first defined in 1704 by Mathieu de la Porte in his treatise "La science des négocians et teneurs de livres" as a consideration of different exchange rates to recognize the most profitable places of issuance and settlement for a bill of exchange ("[U]ne combinaison que l’on fait de plusieurs Changes, pour connoître quelle Place est plus avantageuse pour tirer et remettre"). See "Arbitrage" in Trésor de la Langue Française.

Conditions of arbitrage

"…….I don't throw darts at a board. I bet on sure things. Read Sun-tzu, The Art of War. Every battle is won before it is ever fought……."


Many might recognize these words spoken by Gordon Gekko in the movie Wall Street. In the movie, Gekko makes a fortune as a pioneer of arbitrage. Unfortunately, such risk-free trading is not available to everyone; however, there are several other forms of arbitrage that can be used to enhance the odds of executing a successful trade. Here we look at the concept of arbitrage, how market makers utilize "true arbitrage," and, finally, how retail investors can take advantage of arbitrage opportunities.


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 price").
  • 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 rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities).


Thus, to summarize: 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. ( NOTE: In practical terms, this is generally only possible with securities and financial products which can be traded electronically. )

What is not "risk-less" arbitrage

In view of previous discussion, we present an example what is not an ”arbitrage” in the real sence of the world.

EXAMPLE: Say the keyword ‘dvd player’ costs $1 on Google’s auction market. On Nextag’s market it costs $2. Nextag does add value, by decreasing search costs for vertical merchants, say by $0.50 and Nextag also does have its own transaction costs, say $0.50.

Overall, Nextag pockets a profit of $0.50 for their '''value add''' — but if you assume the transaction was straight through processed and there were no credit or operational risks, this looks like a risk-free profit.


However, the most significant risk of all: Paid traffic coming in doesn’t necessarily convert to paid traffic going out.

So, Nextag can justify its higher cost-per-click fees, a comparison shopping site has to send its clients leads from people more likely to buy, which means the comparison shopping site---completely different from Google’s one--- has to qualify and filter the traffic it purchases.


If a site attracts a user for $1 and sends that user to a merchat for $2, it makes money. But what happens if a site attracts a user for $1 and that user never clicks-out to a paying merchant?


Besides, there’s more than a bit of risk involved here. A comparison-shopping sites aren’t “buying from one market where there is a low price and selling in another where the price is higher” - instead, a comparison-shopping site buys from one market at a low price, attempt to add value to its purchase, and then tries to resell what it’s bought for a higher price - a transaction that’s not always successful.

Because of this, what a comparison-shopping site does can’t be called risk-free arbitrage in any sense of the word; in fact it sits on the boundary to call it "arbitrage" at all. There’s no such thing as easy money.

Types of Arbitrage

Riskless or “True” Arbitrage

In finance theory, an arbitrage is a "free lunch"—a transaction or portfolio that makes a profit without risk. Suppose a futures contract trades on two different exchanges. If, at one point in time, the contract is bid at USD 45.02 on one exchange and offered at USD 45.00 on the other, a trader could purchase the contract at one price and sell it at the other to make a risk-free profit of a USD 0.02.


Such arbitrage opportunities reflect minor pricing discrepancies between markets or related instruments. Per-transaction profits tend to be small, and they can be consumed entirely by transaction costs. Accordingly, most arbitrage is performed by institutions that have very low transaction costs and can make up for small profit margins by doing a large volume of transactions.


Formally, theoreticians define an arbitrage as a trading strategy that requires the investment of no capital, cannot lose money, and has a positive probability of making money.


A market is said to have no arbitrage, or to be arbitrage-free, if prices in that market offer no arbitrage opportunities. This is a theoretical condition that is usually assumed for markets in economic and financial models. The assumption underlies the financial engineering theory of arbitrage-free pricing. This is what we have seen in the “conditions of arbitrage” in the above section.


Following are the basic types of riskless or “true” arbitrage”:


  • Market Arbitrage


Purchasing and selling the same security at the same time in different markets to take advantage of a price difference between the two separate markets. The example for this type of arbitrage is just at the beginning of this section ( two exchanges with different contract prices--- $ 45.00 and $ 45.02. )

An arbitrageur would short sell the higher priced stock and buy the lower priced one. The profit is the spread between the two assets.


There is one basic condition ( or set of conditions ) that set the Market Makers quite apart from the Retail Traders. Even in the “True Arbitrage” environments have the Market Makers ( big Wall Street, Bay Street etc. “movers” ) several advantages over retail traders. They have:


  • Far more trading capital.
  • Generally more skill.
  • Up-to-the-second news.
  • Faster computers.
  • More complex software.
  • Access to the dealing desk and more.


Combined, these factors make it nearly impossible for a retail trader to take advantage of pure arbitrage opportunities. Market makers use complex software that is run on top-of-the-line computers to locate such opportunities constantly. Once found, the differential is typically negligible, and requires a vast amount of capital in order to profit—retail traders would likely get burned by commission costs. Needless to say, it is almost impossible for retail traders to compete in the risk-free genre of arbitrage.


  • Inward Arbitrage


A form of arbitrage involving rearranging a bank's cash by borrowing from the inter-bank market, and re-depositing the borrowed money locally at a higher interest rate. The bank will make money on the spread between the interest rate on the local currency, and the interest rate on the borrowed currency.

Inward arbitrage works because it allows the bank to borrow at a cheaper rate than it could in the local currency market. For example, assume an American bank goes to the Interbank market to borrow at the lower eurodollar rate, and then deposits those eurodollars at a bank within the US. The larger the spread, the more money that can be made.


  • Outward Arbitrage


A form of arbitrage involving the rearrangement of a bank's cash by taking its local currency and depositing it into eurobanks. The interest rate will be higher in the inter-bank market, which will enable the bank to earn more on the interest it receives for the use of its cash.

Outward arbitrage works because it allows the bank to lend for more abroad then it could in the local market. For example, assume an American bank goes to the inter-bank market to lend at the higher eurodollar rate. Money will be shifted from an American bank's branch within the U.S. to a branch located outside of the U.S. The bank will earn revenues on the spread between the two interest rates. The larger the spread, the more will be made.


  • Triangular Arbitrage


The process of converting one currency to another, converting it again to a third currency and, finally, converting it back to the original currency within a short time span. This opportunity for riskless profit arises when the currency's exchange rates do not exactly match up. Triangular arbitrage opportunities do not happen very often and when they do, they only last for a matter of seconds. Traders that take advantage of this type of arbitrage opportunity usually have advanced computer equipment and/or programs to automate the process.

EXAMPLE: Suppose you have $1 million and you are provided with the following exchange rates:

EUR/USD = 0. 8631, EUR/GBP = 1. 4600 and USD/GBP = 1. 6939.


With these exchange rates there is an arbitrage opportunity:


  • 1) Sell dollars for euros: $1 million x 0.8631 = 863,100 euros.
  • 2) Sell euros for pounds: 863,100/1.4600 = 591,164.40 pounds.
  • 3) Sell pounds for dollars: 591,164.40 x 1.6939 =$1,001,373 dollars.


From these transactions, you would receive an arbitrage profit of $1,373 (assuming no transaction costs or taxes) which is the positive difference between the “almost” simultaneous transactions 1), 2) , and 3) leading to $1,001,373 from which we subtract the original outlay of $1,000,000 with a yield of net profit of $1,373.


  • Sports arbitrage


Numerous internet bookmakers offer odds on the outcome of the same event. Any given bookmaker will weight their odds so that no one customer 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 book.

EXAMPLE: During Wimbledon 2001, the ladies singles match between Lindsay Davenport and Kim Clijsters was priced differently by bookies Victor Chandler and Tote. Victor Chandler saw Davenport to win at odds of 2/5 while Tote saw Clijsters at 3/1.


At 2/5 the total amount to invest in Davenport to return $100 was $71.42. At 3/1 the total amount to invest in Clijsters to return $100 was $25.


This means that the total investment required to return $100 - whichever player wins - is just $96.42. A return of 3.58% within under 2 hours ( this is a very conservative example ).


Although 3.58% may seem like a small return, we should remember that it was totally certain, risk free, took only 2 hours to achieve and there was never a possibility of ever losing the money or not getting the profit. It was a mathematical certainty.


Risk arbitrages

Risk arbitrage ( sometimes called “statistical arbitrage” ) is.the second form of arbitrage that we will discuss. Unlike “true” or riskless arbitrage, risk arbitrage entails risk. Although considered "speculation," risk arbitrage has become one of the most popular ( and retail-trader friendly ) forms of arbitrage. As we noted above, just as the disadvantages in pure arbitrage for retail traders ( as opposed to the big firms of Wall Street or Bay Street ), risk arbitrage is more accessible to most retail traders.

EXAMPLE: Let us say Company A is currently trading at $10/share. Company B, which wants to acquire Company A, decides to place a takeover bid on Company A for $15/share. This means that all of Company A's shares are now worth $15/share, but are trading at only $10/share.

Let's say the early trades ( typically not retail trades ) bid it up to $14/share. Now, there is still a $1/share difference—an opportunity for risk arbitrage. So, where's the risk? Well, the acquisition could fall through, in which case the shares would be worth only the original $10/share.


It must be said that the usage of this term ( i.e. “arbitrage” ) is shunned by theoretical purists. However, it has been in wide use for several decades, so it is fairly standard. According to this usage, an arbitrage is a leveraged speculative transaction or portfolio.


It is a bit like “leveling the field advantages.” Although this type of arbitrage requires taking on some risk, it is generally considered "playing the odds." Here we will examine some of the most common forms of arbitrage available to retail traders. These include:


  • Statistical arbitrage.


It is an attempt to profit from pricing inefficiencies that are identified through the use of mathematical models. Statistical arbitrage attempts to profit from the likelihood that prices will trend toward a historical norm. Unlike pure arbitrage, statistical arbitrage is not riskless. Statistical arbitrage—or stat arb—is an equity trading strategy that employs time series methods to identify relative mispricings between stocks.


  • One technique is pairs trading:

Pairs trading (also known as relative-value arbitrage) is far less common than the two forms discussed above. This form of arbitrage relies on a strong correlation between two related or unrelated securities. It is primarily used during sideways markets as a way to profit.

Here's how it works. First, you must find "pairs." Typically, high-probability pairs are big stocks in the same industry with similar long-term trading histories. Look for a high percent correlation. Then, you wait for a divergence in the pairs between 5-7% divergence that lasts for an extended period of time (2-3 days). Finally, you can go long and/or short on the two securities based on the comparison of their pricing. Then, just wait until the prices come back together.

EXAMPLE: One example of securities that would be used in a pairs trade is GM and Ford. These two companies have a 94% correlation. You can simply plot these two securities and wait for a significant divergence; then chances are these two prices will eventually return to a higher correlation, offering opportunity in which profit can be attained.


  • Merger arbitrage.


The example of risk arbitrage we saw in the above EXAMPLE that demonstrates takeover and merger arbitrage. It is probably the most common type of arbitrage. It typically involves locating an undervalued company that has been targeted by another company for a takeover bid. This bid would bring the company to its true, or intrinsic, value. If the merger goes through successfully, all those who took advantage of the opportunity will profit handsomely; however, if the merger falls through, the price may drop.

The key to success in this type of arbitrage is speed; traders who utilize this method usually have access to streaming market news. The second something is announced, they try to get in on the action before anyone else.

Let's say you are a retail trader and, hence, you aren't among the first in, however. How do you know if it is still a good deal? Well, one way is to use Benjamin Graham's risk-arbitrage formula to determine optimal risk/reward. His equations state the following:


Annual Return = [C. (G-L ). (100%-C)] /YP, where:


  • C is the expected chance of success (%).
  • P is the current price of the security.
  • L is the expected loss in the event of a failure (usually original price).
  • Y is the expected holding time in years (usually the time until the merger takes place).
  • G is the expected gain in the event of a success (usually takeover price).


Granted, this is highly empirical, but it will give you an idea of what to expect before you get into a merger arbitrage situation.


  • Fixed income trading.


Fixed income arbitragers try to identify when historical patterns for spreads or term structure relationships have been violated and put on a long-short position in anticipation of the historical relationship being reestablished. They also look for situations where credit risk or liquidity risk is being over compensated and will then put on a long-short position that earns positive carry. Central bank intervention in the markets often creates abnormalities that can be exploited.

Fixed income arbitrage strategies are generally implemented to be duration neutral, but they are exposed to various other market risks. By their nature, particular strategies may be exposed to tilts in the term structure, spread risk and foreign exchange risk.


  • Convertible-bond arbitrage.


A convertible bond 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:


  • 1) interest rate. 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).


  • 2) stock price. When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise.


  • 3) credit spread. If the creditworthiness of the issuer deteriorates (e.g. rating 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 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 futures (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.

Conclusion

We shall conclude with a few words about the online marketing and advertising "arbitrage," that raises probably more diverse opinions than any other single word ( as it involves everybody who uses internet and thus computer. )


The arbitrager is paid when searchers click out on yet another ad. The arbitrager pockets the difference between what they paid per click and what they get paid per click.

An arbitrager has to know what they are being paid per click, understand the click-through rate on any given phrase, and combine that information with what they are paying for the traffic. If any of those numbers suddenly change, it's possible to lose a lot of money very quickly.


Caught in the middle is an advertiser. Most advertisers find their ads on arbitrage sites by actually clicking on an ad and seeing one of these ad pages and then the realization that their ad dollars are funding these sites that quickly lead to emotional responses.


  • In Defense Of Arbitrage:


One of the advantages of arbitrage sites is that advertisers can receive traffic from ad positions they don't control on a search page. Usually an advertiser only controls a single ad position, and if the advertiser didn't attract the first click, then it becomes increasingly difficult to receive traffic from that consumer. Since an arbitrage site is displaying a page full of ads, if an advertiser appears in one of those they have a second chance to receive the click. In essence, advertisers can receive traffic from ad positions they don't control and which might be a bonus.


  • A Blight Upon The Web:


Some advertisers consider arbitrage an offense akin to spam—and not necessarily just search spam, but the vile kind that fills up your email inbox.


The first argument against arbitrage pleads for the user experience. If a searcher is taken from a search result to a set of ads without any meaningful content, then they really didn't find any answers. The searcher now has to click on yet another ad to get to an advertiser's page. If the page full of ads wasn't in the middle between the search result and the advertiser’s page, the searcher would have found the information one click sooner and had a better experience.


One way of being profitable with arbitrage is to buy inexpensive words and send them to a page of similar, yet more expensive words. Thus, the second argument against arbitrage resolves around ad relevancy.


EXAMPLE: If the search was "lawyer", one can assume it's a fairly ambiguous query. Because this is an ambiguous query, it's often not an overly expensive click compared to other legal terms. So, an arbitrager will buy the keyword "lawyer" and send it to a page about "personal injury lawyers," a click cost that is often four or more times more expensive than "lawyer."


Should an advertiser be charged for a "personal injury lawyer" click when the search was just for "lawyer?" Why should a company be able to buy an ad about one keyword and send traffic to ads about an entirely different keyword?


In short: Arbitrage is a word that is sure to evoke a response in any internet marketer ( and in every internet user ). However, the responses will vary as greatly as those found in a heated political debate.

There isn't necessarily a magic answer, but advertisers clearly want more control and a greater visibility into how their ad dollars are spent.


When marketers have full visibility and control of ad dollars, they will have the ability to not just debate arbitrage—they will have the power to act on their feelings.

References
ISBN links support NWE through referral fees

  • Burmeister E and Wall KD., The arbitrage pricing theory and macroeconomic factor measures, The Financial Review, 21:1-20, 1986
  • Chen, N.F, and Ingersoll, E., Exact pricing in linear factor models with finitely many assets: A note, Journal of Finance June 1983
  • Greider, William (1997). One World, Ready or Not. Penguin Press. ISBN 0-7139-9211-5.
  • Roll, Richard and Stephen Ross, An empirical investigation of the arbitrage pricing theory, Journal of Finance, Dec 1980,
  • Ross, Stephen, The arbitrage theory of capital asset pricing, Journal of Economic Theory, v13, issue 3, 1976


External links


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