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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. A person who engages in arbitrage is called an arbitrageur.
For example, if you can buy items at one price at a factory
outlet and sell them for a higher price on an internet auction
website such as eBay, you can exploit the imbalance between those
two markets for those items. The term "arbitrage", however, 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 prices is usually referred to as "the spread", so
arbitrage is often defined as "playing the spread" in the money
market.
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 all tend to converge to a fixed price. The speed at which
the prices converge is one measure of the efficiency of a 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. Sellers of goods and services often attempt to prohibit or
discourage arbitrage.
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).
In the 1980s a practice with the oxymoronic name of "risk
arbitrage" became 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.
The transaction involves a delay of weeks or months and 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 is obvious, 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.
Examples
Here's a theoretical example: 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 = $10.
Converting $10 to £6 in Tokyo and converting that £6 into $12 in
London, for a profit of $2, would be arbitrage.
One real-life example of arbitrage involves the stock market in New
York and the futures market in Chicago. When the price of a stock in
New York and its corresponding future in Chicago 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.
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.
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 earlier. In
comparison to the classical quick arbitrage transaction, such an
operation can produce disastrous losses.
Long-Term Capital Management (LTCM) lost $100 billion mis-managing
this concept in September 1998. LTCM had attempted to make money on
the difference between different bond instruments. For example, it
would buy U.S treasury bonds and sell 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, 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 rouble debt and domestic dollar debt. Since the
markets were already nervous due to the Asian 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 a
bailout had to be arranged to prevent a collapse in confidence in
the economic system.
An ironic footnote is that they were right long-term (the LT in
LTCM), and a few months after they folded their portfolio became
very profitable. However the long-term does not matter if you cannot
survive the short-term, and that they failed to do. |