In economics Economics is the social science that is concerned with the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek οἰκονομία from οἶκος (oikos, "house") + νόμος (nomos, "custom" or "law"), hence "rules of the house(hold)". Current and finance Finance is the science of funds management. The general areas of finance are business finance, personal finance, and public finance. Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money, and risk and how they are interrelated. It also deals with how money is spent and budgeted, arbitrage (IPA: /ˈɑrbɨtrɑːʒ/) is the practice of taking advantage of a price difference between two or more markets A market is any one of a variety of different systems, institutions, procedures, social relations and infrastructures whereby persons trade, and goods and services are exchanged, forming part of the economy. It is an arrangement that allows buyers and sellers to exchange things. Competition is essential in markets, and separates market from trade: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices 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. Market value and market price are equal only under conditions of market efficiency, equilibrium, and rational expectations. When used by academics, an arbitrage is a transaction that involves no negative cash flow Cash flow is a generic term used differently depending on the context. It may be defined by users for their own purposes. It can refer to actual past flows, or to projected future flows. It can refer to the total of all the flows involved or to only a subset of those flows. Subset terms include 'net cash flow', operating cash flow and free cash 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 As a trading strategy, statistical arbitrage is a heavily quantitative and computational approach to equity trading. It involves data mining and statistical methods, as well as automated trading systems, 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 Relative value is the attractiveness measured in terms of risk, liquidity, and return of one instrument relative to another, or for a given instrument, of one maturity relative to another. The term is used in economics, business or investment or convergence trades In finance, a convergence trade is buying one asset forward – i.e., for delivery in future and selling a similar asset forward (going short the asset) for a higher price, in the expectation that by the time the assets must be delivered, the prices will have become closer to equal (will have "converged"), and thus one profits by the), as in merger arbitrage Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.

A person who engages in arbitrage is called an arbitrageur (IPA: /ˌɑrbɨtrɑːˈʒɜr/)—such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments Alternatively, financial instruments can be categorized by "asset class" depending on whether they are equity based or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorised into short term (less than one year) or long term, such as bonds 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 and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals, stocks The stock or 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. Stock is distinct from the property and the assets of a business which may fluctuate in, derivatives A derivative, in non-financial-expert terms, is an agreement or contract that is not based on a real, or true, exchange, i.e.: There is nothing tangible like money, or a product, that is being exchanged. For example, a person goes to the grocery store, exchanges a currency for a commodity (say, an apple). The exchange is complete, both parties, commodities A commodity is a good for which there is demand, but which is supplied without qualitative differentiation across a market. It is fungible, i.e. equivalent no matter who produces it. Examples are petroleum, notebook paper, milk or copper. The price of copper is universal, and fluctuates daily based on global supply and demand. Stereo systems, on and currencies In economics, the term currency can refer to a particular currency, for example Pound Sterling, or to the coins and banknotes of a particular currency, which comprise the physical aspects of a nation's money supply. The other part of a nation's money supply consists of money deposited in banks , ownership of which can be transferred by means of.

Arbitrage-free

If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium or arbitrage-free In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash market. An arbitrage equilibrium is a precondition for a general economic equilibrium General equilibrium theory is a branch of theoretical neoclassical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many markets, by seeking to prove that equilibrium prices for goods exist and that all prices are at equilibrium, hence general equilibrium, in contrast to partial. The assumption that there is no arbitrage is used in quantitative finance Mathematical finance comprises the branches of applied mathematics concerned with the financial markets to calculate a unique risk neutral In economics, risk neutral behavior is in between risk aversion and risk seeking. If offered either €50 or a 50% chance of €100, a risk averse person will take the €50, a risk seeking person will take the 50% chance of €100, and a risk neutral person would have no preference between the two options price for derivatives A derivative, in non-financial-expert terms, is an agreement or contract that is not based on a real, or true, exchange, i.e.: There is nothing tangible like money, or a product, that is being exchanged. For example, a person goes to the grocery store, exchanges a currency for a commodity (say, an apple). The exchange is complete, both parties.

Conditions for arbitrage

Arbitrage is possible when one of three conditions is met:

1. The same asset does not trade at the same price on all markets ("the law of one price 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 the convergence on one price is instant").
2. Two assets with identical cash flows do not trade at the same price.
3. An asset with a known price in the future does not today trade at its future price discounted Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee. Essentially, the party that owes money in the present purchases the right to delay the payment until some future date. The discount, or charge, is simply the difference between the at the risk-free interest rate The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no default risk. However, the financial instrument can carry other types of risk, e.g. market risk , liquidity risk (the risk of being unable to sell the instrument for cash at short notice without significant costs), etc (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities A security is a fungible, negotiable instrument representing financial value. Securities are broadly categorized into debt securities and equity securities, e.g., common stocks; and derivative contracts, such as forwards, futures, options and swaps. The company or other entity issuing the security is called the issuer. A country's regulatory).

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'.^{[note 1]}

In the simplest example, any good sold in one market should sell for the same price in another. Traders A merchant class characterizes many pre-modern societies. Its status can range from high to low, as in Chinese culture, owing to the presumed distastefulness of profiting from "mere" trade rather than from labor or the labor of others as in agriculture and craftsmanship 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 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". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments, particularly arbitrage mechanics 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". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments, for further discussion.

Mathematically it is defined as follows:

and

where V_t means a portfolio at time t.

Examples

• Suppose that the exchange rates In finance, the exchange rates between two currencies specifies how much one currency is worth in terms of the other. It is the value of a foreign nation’s currency in terms of the home nation’s currency. For example an exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY 91 is worth the same as USD 1 (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 arbitrage Triangular arbitrage refers to taking advantage of a state of imbalance between three foreign exchange markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices" is so simple that it almost never occurs. But more complicated foreign exchange arbitrages, such as the spot-forward arbitrage (see interest rate parity Interest rate parity, or sometimes incorrectly known as International Fisher effect, is an economic concept, expressed as a basic algebraic identity that relates interest rates and exchange rates. The identity is theoretical, and usually follows from assumptions imposed in economic models. There is evidence to support as well as to refute the) are much more common.
• One example of arbitrage involves the 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 the world's largest stock exchange by market capitalization of its listed companies at US$12.25 trillion as of May 2010. Average daily trading value was approximately US$153 billion in 2008 and the Chicago Mercantile Exchange The Chicago Mercantile Exchange (often called "the Chicago Merc," or "the Merc") is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization. The exchange demutualized in November 2000, went. When the price of a stock on the NYSE and its corresponding futures contract In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality at a specified future date at a price agreed today . The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They on the CME 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 Industrialisation is the process of social and economic change that transforms a human group from a pre-industrial society into an industrial one. It is a part of a wider modernisation process, where social change and economic development are closely related with technological innovation, particularly with the development of large-scale energy and. At present, many such jobs appear to be flowing towards China b. ^ Simple characterizations of the political structure since the 1980s are no longer possible, though some which require command of English are going to India India, 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 1.18 billion people, and the most populous democracy in the world. Mainland India is bounded by the Indian Ocean on the south, the Arabian Sea on the west, and the Bay of Bengal on the and the Philippines The Philippines , officially known as the Republic of the Philippines (Filipino: Republika ng Pilipinas), 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. The Sulu Sea to the southwest lies between the country and the island of Borneo, and. In popular terms, this is referred to as offshoring Offshoring 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 arbitrage Betting 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. As long as different Bookmakers are used for – numerous internet The Internet is a global system of interconnected computer networks that use the standard Internet Protocol Suite to serve billions of users worldwide. It is a network of networks that consists of millions of private, public, academic, business, and government networks of local to global scope that are linked by a broad array of electronic and bookmakers Most bookmakers in the United States bet merely on college and professional sports, though in the United Kingdom and Ireland they offer a wider range of bets, including each-way betting on golf, football and tennis, and especially horse racing and greyhound racing. They also specialize in novelty events such as betting that there will be a white offer odds on the outcome of the same event. Any given bookmaker will weight their odds so that no one customer A customer, also called client, buyer, or purchaser, 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. However, in certain contexts, the term customer also includes by extension 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 In 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 fund An exchange-traded fund (also known as Exchange-Traded Product (ETP)) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Most ETFs track an index, such as the S& 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.
• Some types of hedge funds A hedge fund is an investment fund open to a limited range of investors that undertakes a wider range of investment and trading activities than traditional long-only investment funds, and that, in general, pays a performance fee to its investment manager. Every hedge fund has its own investment strategy that determines the type of investments and make use of a modified form of arbitrage to profit. Rather than exploiting price differences between identical assets, they will purchase and sell securities A security is a fungible, negotiable instrument representing financial value. Securities are broadly categorized into debt securities and equity securities, e.g., common stocks; and derivative contracts, such as forwards, futures, options and swaps. The company or other entity issuing the security is called the issuer. A country's regulatory, assets 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. Simplistically stated, assets represent ownership of value that can be converted into cash . The balance sheet of a firm and derivatives A derivative, in non-financial-expert terms, is an agreement or contract that is not based on a real, or true, exchange, i.e.: There is nothing tangible like money, or a product, that is being exchanged. For example, a person goes to the grocery store, exchanges a currency for a commodity (say, an apple). The exchange is complete, both parties with similar characteristics, and hedge In finance, a hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk. There are many specific financial vehicles to accomplish this, including insurance policies, forward contracts, swaps, options, 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 swaps A credit default swap is a swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default to protect against country risk 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 rates, 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.

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, 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. More generally, international arbitrage opportunities in commodities, goods, securities and currencies, on a grand scale, tend to change exchange rates until the purchasing power is equal.

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. Similarly, most assets exhibit (small) differences between countries, transaction costs, 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).

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 bankruptcy. 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.^[1]

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.

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 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 buyouts was associated with some of the famous financial scandals of the 1980s such as those involving Michael Milken and Ivan Boesky.

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 trade. 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.

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, 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 margin (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.^[2]

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.^[2]

Types of arbitrage

Merger arbitrage

Also called risk arbitrage, 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.

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 the appropriate ratio of taxable corporate bonds. These corporate equivalents are typically interest rate swaps referencing Libor or SIFMA [2] [3]. 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.

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:

• 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. 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.

Depository receipts

A depository receipt is a security that is offered as a "tracking stock" on another foreign market. For instance a 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.

Dual-listed companies

A dual-listed company (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 calls, 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 ^[3]. Background material is available at [4].

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) ^[4] 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.

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 multiple (such as a P/E of 10, which equates to a 10% ROI). 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.

Regulatory arbitrage

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 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.

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.^[5] 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.^[6]

Statistical arbitrage

Statistical arbitrage 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.

The debacle of 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 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 on other bonds began to increase because there were many sellers. 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, "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 ("L'arbitrage est une combinaison que l’on fait de plusieurs changes, pour connoitre [connaître, in modern spelling] quelle place est plus avantageuse pour tirer et remettre".)^[7]

See also

Types of financial arbitrage

• Arbitrage betting
• Covered interest arbitrage
• Fixed income arbitrage
• Political arbitrage
• Risk arbitrage
• Statistical arbitrage
• Triangular arbitrage
• Uncovered interest arbitrage
• Volatility arbitrage

Related concepts

• Algorithmic trading
• Arbitrage pricing theory
• Coherence (philosophical gambling strategy), analogous concept in Bayesian probability
• Efficient market hypothesis
• Immunization (finance)
• Interest rate parity
• Intermediation
• TANSTAAFL
• Value investing

Notes

1. ^ 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'.

References

1. ^ See e.g. Shleifer, Andrei, and Robert Vishny, 1997, The limits of arbitrage, Journal of Finance 52, 35-55. Xiong, Wei, 2001, Convergence trading with wealth effects, Journal of Financial Economics 62, 247-292. Kondor, Peter, 2009. Risk in Dynamic Arbitrage: Price Effects of Convergence Trading Journal of Finance 64(2),638-658,
2. ^ ^{a b} The Basis Monster That Ate Wall Street, D. E. Shaw & Co.
3. ^ de Jong, A., L. Rosenthal and M.A. van Dijk, 2008, The Risk and Return of Arbitrage in Dual-Listed Companies, June 2008.[1]
4. ^ Lowenstein, R., 2000, When genius failed: The rise and fall of Long-Term Capital Management, Random House.
5. ^ Ned Potter (2006-10-13). "Free International Calls! Just Dial ... Iowa". http://abcnews.go.com/Technology/story?id=2560255. Retrieved 2008-12-23.
6. ^ Mike Masnick (2007-02-07). "Phone Call Arbitrage Is All Fun And Games (And Profit) Until AT&T Hits You With A $2 Million Lawsuit". http://techdirt.com/articles/20070207/123022.shtml. Retrieved 2008-12-23.
7. ^ See "Arbitrage" in Trésor de la Langue Française.

• Greider, William (1997). One World, Ready or Not. Penguin Press. ISBN 0-7139-9211-5.
• Special Situation Investing: Hedging, Arbitrage, and Liquidation, Brian J. Stark, Dow-Jones Publishers. New York, NY 1983. ISBN 0870943847; ISBN 9780870943843

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.
• News
• Financial Articles about arbitrage,derivatives,bonds,stocks

Categories: Financial markets

See Also:

What Links Here:

• Home

Recently Viewed Pages:

• Mary Kay: Images
• Society: Issues: Business: Allegedly Unethical Firms: Directory
• Video Computer Store: Blogs
• Wealth: Encyclopedia
• Get-rich-quick Scheme: News
• Home
• Shopping
• Get-rich-quick Scheme: Encyclopedia
• Gambling: Encyclopedia
• Society: Issues: Fraud: Internet: Make Money Fast: Chain Letters: Directory

Most Popular Pages:

• Society: Issues: Business: Allegedly Unethical Firms: Directory
• Retirese: Toc
• Mary Kay: Images
• Tyco: Images
• Besmirching: News
• Livent
• Sitemap
• Video Computer Store: Blogs
• Toc
• Affinity Fraud: Images

Related 'Arbitrage' Searches: