Arbitrage is the practice of taking advantage of imbalances among markets. One who engages in this practice is called an arbitrageur. It is a nearly risk-free investment strategy, usually with relatively modest returns. A successful arbitrageur must possess a great deal of savvy. If many people know about the imbalance and attempt to exploit it, the effect is to diminish the imbalance and the potential profit, a phenomenon known as convergence.
Arbitrage is possible when one of three conditions exist.
- The same asset (stocks, bonds, currency, commodities, derivatives, etc.) does not trade at the same price on all markets. It is possible to buy the stock at a lower price in one market and immediately sell it for a profit in the more expensive market.
- Two assets of equal cash flow trade at different prices.
- An asset with a known price in the future trades below that price today. A futures contract is a type of derivative that is a promise to sell stock at a set price on a set future date. If a futures contract for a stock is worth more than the stock itself, it is possible to buy the stock and immediately sell the futures contract, pocketing the difference.
A common arbitrage strategy occurs during mergers. This strategy, called merger arbitrage or risk arbitrage, involves purchasing stock in the company that is the target of a takeover and simultaneously shorting the stock of the acquiring company.
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The target company’s stock usually trades at a lower value, and after the merger, it is guaranteed to converge to the higher price of the acquiring company’s stock. This tactic does include more of an element of risk, as it is always possible for the merger to fall through.
Arbitrage on depository receipts is one more example of a relatively simple arbitrage strategy. A depository receipt is a primary way that stocks of foreign companies are traded in the United States.
Each American Depositary Receipt, or ADR, represents one or more shares of a foreign company. When an ADR is first issued, it will sometimes trade at a lower price than its true value because of investors’ reluctance to get involved in foreign markets. However, the real value of the stock represented by the receipt may be higher, and the ADR is fully exchangeable.
This perception gap can be exploited by purchasing the ADR soon after it is released, and making money as the price of the receipt inevitably converges on the true price of the stock it represents. There is always a chance that the original stock may fall in value in the meantime, but this risk can be hedged by shorting that stock. Then, if the stock does fall in value, losses are recouped and the only trade-off is that the profit is not as high as it could have been if the stock rises.
Arbitrage strategies can be very complicated and sophisticated, to a much greater degree than the examples listed. The price differential necessary for a successful trader does not last long because of the market’s tendency to self-correct. The only real way to make a profit is to act very quickly and trade a lot of assets at once. Often, the transaction will be leveraged to boost profits.
Leveraging is the tactic of using borrowed money to magnify the outcome of a deal. If the deal is profitable, then the profit will be proportionately greater, but the potential loss in the event of failure increases as well. Since arbitrage is relatively risk-free, this type of deal is frequently leveraged.
Another common tactic is to use computers to analyze many stocks at once and initiate deals as soon as a gap opens up. Since the very act of arbitrage helps reduce the market imbalance, those who get there first are the ones who profit.
Arbitrage is associated with financial scandals involving insider trading. The whole game is to know what most don’t. Information is crucial to success, and the temptation to illegally use it can be great given the quantity of money involved. Some of the great financial scandals of the 1980s involved arbitrage. Insiders would illegally use information about pending mergers and acquisitions to make staggering profits through the strategy of merger arbitrage discussed above.
The infamous Ivan Boesky, who made hundreds of millions of dollars in this way, was particularly arrogant, sometimes concluding deals mere days before the takeover was announced. After serving a light prison sentence, he gave a speech at UC Berkeley extolling greed as a human virtue. This was the inspiration for a similar speech given by Michael Douglas’ character in the 1987 movie Wall Street, a film that fictionalized and dramatized arbitrage-related insider-trading scandals.
Risky Investments – Part of the Hedge Fund Strategy
Hedge funds are known for making risky investments, such as investing in volatile international markets or in failing companies.
Hedge funds might invest in “distressed securities,” which is taking advantage of the low stock price of companies that are reorganizing or whose market shares have been unfairly driven below their actual value. Betting that the company will get back on its feet, the hedge fund pours in the money to make it happen, gaining a tidy profit if the company rebounds as expected.
A more extreme variant of this is the “activist fund,” in which the hedge fund actually gains majority control of a bankrupt or near-bankrupt company. Typically, this is with the intention of directly dictating managerial and structural changes that will help the company become profitable again. Needless to say, these sorts of investments are very high-risk. If the company fails to perform as expected, almost the entire investment is lost.