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Encyclopedia > Arbitrage

If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium or arbitrage-free market. An arbitrage equilibrium is a precondition for a general economic equilibrium. The assumption that there is no arbitrage is used in quantitative finance to calculate a unique risk neutral price for derivatives. General Equilibrium (linear) supply and demand curves. ... Financial mathematics is the branch of applied mathematics concerned with the financial markets. ... In Economics, the term risk neutral is used to describe an individual who cares only about the expected outcome of an investment, and not the risk (variance of outcomes or the potential gains or losses). ... Derivatives traders at the Chicago Board of Trade. ...

Statistical arbitrage is an imbalance in expected values. A casino has a statistical arbitrage in almost every game of chance that it offers. Statistical arbitrage, or StatArb, as opposed to (deterministic) arbitrage, is related to the statistical mispricing of one or more assets based on the expected value of these assets. ...

## 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").
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 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).

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. The law of one price is an economic law stated as: In an efficient market all identical goods must have only one price. ... In finance, discounting is the process of finding the current value of an amount of cash at some future date, and along with compounding cash from the basis of time value of money calculations. ... The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no risk. ... For security (collateral), the legal right given to a creditor by a borrower, see security interest A security is a fungible, negotiable instrument representing financial value. ...

In the most simple example, any good sold in one market should sell for the same price in another. Traders may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other. The term Trader can refer to: In economics, a merchant, a retail business or one who attempts to generally buy wholesale and sell later at a profit In finance, someone who buys and sells financial instruments such as stocks, bonds and derivatives - see stock trader In marketing, Trader Classified Media...

See rational pricing, particularly arbitrage mechanics, for further discussion. Rational pricing is the assumption in financial economics that asset prices (and hence asset pricing models) 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... Rational pricing is the assumption in financial economics that asset prices (and hence asset pricing models) 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...

## Examples

• Suppose that the exchange rates (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.
• 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.
• 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 China, though some which require command of English are going to India and the Philippines.
• 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.
• 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.
• Some types of hedge funds make use of a modified form of arbitrage to profit. Rather than exploiting price differences between identical assets, they will purchase and sell securities, assets and derivatives with similar characteristics, and 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 swaps 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. The word commodity has a different meaning in business than in Marxian political economy. ... Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider. ...

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). It has been suggested that this article or section be merged with Spot-future parity. ...

## Risks

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 or borrowed money is used. In finance, leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified. ...

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.

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.

## 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. Risk arbitrage is an investment or trading strategy often associated with hedge funds. ... A takeover in business refers to one company (the acquirer, or bidder) purchasing another (the target). ... In finance, short selling or shorting is a way to profit from the decline in price of a security, such as stock or a bond. ...

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 [1] or BMA (short for Bond Market Association [2]). 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. It has been suggested that Short (finance) be merged into this article or section. ... In the field of derivatives trading, a popular form of swap is the interest rate swap, in which one party exchanges a stream of interest for another stream. ...

### 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, or convertible debenture, is a type of bond that can be converted into shares of stock in the issuing company, usually at some pre-announced ratio. ... For alternative meanings, see bond (a disambiguation page). ...

A convertible bond can be thought of as a corporate bond with a stock call option attached to it. A corporate bond is a bond issued by a corporation. ... This article does not cite any references or sources. ...

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. An interest rate is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. ... In finance, a credit spread is the difference in yield between different securities due to different credit quality. ... A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations. ...

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. This article does not cite any references or sources. ... Securities are tradeable interests representing financial value. ... An Interest Rate Future is a futures contract with an interest bearing instrument as the underlying asset. ... A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of (at least one) third party entity. ... Delta hedging is the process of setting or keeping the delta of a portfolio of financial instruments zero, or as close to zero as possible - where delta is the sensitivity of the value of a derivative to changes in the price of its underlying instrument; see Hedge (finance). ...

### 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. Depositary receipt is a financial instrument. ... The New York Stock Exchange (NYSE), nicknamed the Big Board, is a New York City-based stock exchange. ... An American Depositary Receipt (ADR) is how the stock of most foreign companies trades in United States stock markets. ... A Global Depository Receipt or Global Depositary Receipt (GDR) is a certificate issued by an international bank which can be subject of worldwide circulation on capital markets. ... Fungibility is a measure of how easily one good may be exchanged or substituted for another example of the same good at equal value. ...

### Regulatory arbitrage

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. Alan Greenspan (born March 6, 1926 in New York City) is an American economist and was Chairman of the Board of Governors of the Federal Reserve of the United States from 1987 to 2006. ...

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. Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. ...

### Telecom arbitrage

Telecom arbitrage companies like 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 Future Phone in the US.

## 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. Long Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether (the former vice-chairman and head of bond trading at Salomon Brothers). ... Long Term Capital Management (LTCM) was a hedge fund founded in 1994 by John Meriwether (the former vice-chairman and head of bond trading at Salomon Brothers). ... Fixed income arbitrage is an investment strategy generally associated with hedge funds, which consists of the discovery and exploitation of inefficiencies in the pricing of bonds, i. ... For alternative meanings, see bond (a disambiguation page). ... Treasury securities are government bonds issued by the United States Department of the Treasury through the Bureau of the Public Debt. ...

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 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. is the 229th day of the year (230th in leap years) in the Gregorian calendar. ... Year 1998 (MCMXCVIII) was a common year starting on Thursday (link will display full 1998 Gregorian calendar). ... ISO 4217 Code RUB User(s) Russia and self-proclaimed Abkhazia and South Ossetia Inflation 7% Source Rosstat, 2007 Subunit 1/100 kopek (ÐºÐ¾Ð¿ÐµÐ¹ÐºÐ°) Symbol Ñ€ÑƒÐ± kopek (ÐºÐ¾Ð¿ÐµÐ¹ÐºÐ°) Ðº Plural The language(s) of this currency is of the Slavic languages. ... The Asian financial crisis was a financial crisis that started in July 1997 in Thailand and affected currencies, stock markets, and other asset prices in several Asian countries, many considered East Asian Tigers. ... The Federal Reserve System is headquartered in the Eccles Building on Constitution Avenue in Washington, DC. The Federal Reserve System (also the Federal Reserve; informally The Fed) is the central banking system of the United States. ...

## 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. A referee is a person who has authority to make decisions about play in many sports. ... In sports, an umpire is an official appointed to rule on plays and procedure. ...

## References

• Greider, William (1997). One World, Ready or Not. Penguin Press. ISBN 0-7139-9211-5.

Results from FactBites:

 Arbitrage - definition of Arbitrage in Encyclopedia (1285 words) In economics, arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices. The term "arbitrage", is usually applied only to trading in money and investment instruments (such as stocks, bonds, and other securities), not to goods, and the difference in asset prices is usually referred to as "the spread", so arbitrage is often defined as "playing the spread" in the money market. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell where the price is high.
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