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Earn Big Returns On Your Investment Using A
Well-Known, But Little-Understood No-Load Mutual Fund Strategy.
Arbitrage
When used in the context of academics, an arbitrage is a transaction involving no negative cash flow at any hypothetical or temporal state, and / or a positive cash flow in at least one of the states. A person who engages in the act of arbitrage is called an arbitrageur. This term is essentially applied with reference to trading of financial instruments, such as bonds, stocks, derivatives or other currencies. Entrepreneurs seek out arbitrage markets or insurance when they are looking to earn a profit. For instance, consumers usually benefit substantially from entities who locate lucrative arbitrage markets within the insurance industry. Insurance arbitrage markets are an immensely profitable trend that the Wall Street has been eyeing. Those insurance firms in a non-arbitrage environment are likely to have difficulty while competing against an arbitrage business model.
If the market prices do not accommodate a profitable arbitrage, in this situation the prices constitute arbitrage equilibrium or the market is said to become arbitrage free. Arbitrage equilibrium has now become a precondition for a general economic equilibrium and statistical arbitrage is an imbalance in expected values. For instance, a casino usually has a statistical arbitrage in every game of chance played, although it could lose money on any or every single game.
Conditions for Arbitrage
Arbitrage is possible when one of the following three conditions is met:
1. The law of one price: The same asset should not
trade at the same price in different markets.
2. Two assets with
identical cash flows should not trade at the same price.
3. An asset with a known price in the future
should not trade today at its future price discounted at the risk-free
interest rate that is, the asset should not have negligible costs of
storage. This condition for example holds for perishables but not for
securities.
A Few Examples:
o One of the examples of arbitrage involves the New York Stock Exchange or NYSE and the Chicago Mercantile Exchange or CME. When the price of a stock on the NYSE and the corresponding prices that feature on the CME are out of sync, one can buy the less expensive stock and sell the more expensive one to earn a profit. Since the differences between the prices are not likely to be very huge and do not usually last very long, this can only be accomplished profitably when a large number of computers are employed to examine a large number of prices and automatically exercise a trade when the prices are far enough out of balance, so as to generate a substantial profit. There is also the threat from the activity of other arbitrageurs which can make this risky. Those who make use of the fastest computers and the smartest mathematicians are therefore the ones who take advantage of series of small differentials that would not be profitable if considered individually.
o Assuming that the exchange rates after taking out the fees for making the exchange, in London are ?5 = $10 = ?1000 and similarly, the exchange rates in Tokyo are ?1000 = ?6 = $10. While converting $10 to ?6 in Tokyo and converting that ?6 into $12 in London, the profit of $2, would be termed arbitrage. In reality, this type of triangle arbitrage is so simple that it very seldom occurs. However, more complicated foreign exchange arbitrages, such as the spot-forward arbitrage are found to be much more common.
o Economists often use the term 'global labor arbitrage' to refer to the tendency of manufacturing and other labor intensive jobs to shift towards a country which has the lowest wages per unit output. At present there are several such countries that have reached the minimum requisite level of political and economic development to support industrialization in developed economies. Currently, many such jobs appear to be flowing towards China, while those which require personnel to be well versed in the English language are going to India.
o If one can buy an item at one price at a factory outlet and sell them for a higher price on an internet auction website such as eBay, you can capitalize upon the imbalance between those two markets for those items to generate sufficient profits as well as sell products at rates much lower than most other outlets.
o Exchange Traded Fund Arbitrage: Exchange Traded Funds or ETFs are those that allow authorized participants to exchange back and forth between shares in underlying securities held by the fund. This also applies to shares in the fund itself, rather than allowing the buying and selling of shares in the Exchange Traded Fund directly with the fund sponsor. ETFs usually trade in the open market, with prices that are set by market demand. An ETF may therefore trade at a premium or else a discount to the value of the underlying assets. When a premium that is significant enough appears, an arbitrageur will buy the underlying securities and subsequently convert them to shares in the ETF before selling them in the open market. When a discount does appear, an arbitrageur will do the reverse instead. In doing so, the arbitrageur makes a low risk profit, while still fulfilling a useful function in the ETF marketplace which they accomplish by keeping ETF prices in line with their actual underlying value.
o Sports Arbitrage: There are numerous internet
book-makers who offer odds on the outcome of the same event. Any bookmaker
will weight their odds at all times so that no single customer can cover
all the outcomes at a profit against their books. However, in order to
ensure their competitive edge, their margins are usually quite low.
Different bookmakers offer different odds on the same outcome of the same
given event and, by taking the best odds offered by each bookmaker, a
customer can under certain circumstances, cover all the different possible
outcomes of the event and ensure that they receive at least a small risk
free profit. This profit would typically be between 1 to 5% but can at
times be much higher than this. One of the problems with sports arbitrage
is that bookmakers may sometimes make mistakes and this can call for an
invocation of the 'palpable error' rule, which is one that most bookmakers
hide behind when they have committed an error by offering or posting
incorrect odds. As and when bookmakers become more and more proficient,
the odds involved in making an arbitrage usually last only for less than
an hour and generally only for not more than a few minutes.
Price Convergence
One of the effects arbitrage has is that of causing prices in different markets to converge. As a result of this, the currency exchange rates, the price of commodities as well as securities in different markets tend to converge to similar prices, across different markets, in each category. The speed at which prices converge is often used as a measure of market efficiency. Arbitrage usually reduces price discrimination and does this by encouraging people to buy an item in a market where the price is low, and resell it at a different market where the price is high. This is possible as long as the buyers are not prohibited from reselling and the transaction costs involved in buying, holding and reselling are small as compared to the difference in prices in the different markets in which it is being traded.
Arbitrage often moves different currencies toward parity in terms of purchasing power. For instance, if we assume that a car purchased in America is cheaper than the same car in Canada; Canadians would buy their cars across the border to maximize the use of the arbitrage condition. At the same time, Americans would buy the United States manufactured cars and transport them across the border to sell them in Canada so as to gain profits. Canadians would have to purchase American Dollars in order to buy the cars while the Americans would have to sell the Canadian dollars they received by selling the exported cars. Both actions would increase demand for United States Dollars, and supply of Canadian Dollars and as a result of this, there would be an appreciation of the US Dollar. Eventually, if this situation is left unchecked, it would make US made cars more expensive for all buyers and Canadian cars cheaper, until there would no longer be an incentive to buy cars in the US and sell them in Canada. In general, international arbitrage opportunities in terms of commodities, goods, securities and currencies, on a large scale, often change exchange rates till the purchasing power becomes equal.
In reality, however, there are many factors that hamper this type of arbitrage. In this example, one must consider taxes and the costs involved in traveling back and forth between the United States and Canada. So also, the features built into the cars sold in the United States are not usually the same as the features that are built into the cars for sale in Canada; the reason for this being, among other things, due to the different emissions and other auto regulations that are very different in the two countries. In addition to this, our example takes the assumption that no duties have to be paid on importing or exporting cars from the USA to Canada which is not the case in reality. Similarly, most assets have small differences between countries, and transaction costs, taxes, and other costs provide a formidable obstacle if one attempts to commit this kind of arbitrage.
Arbitrage also affects the difference in interest rates paid on government bonds, issued by the different countries, while taking into account the expected depreciations in the currencies, in relation to each other.
Risks
Arbitrage transactions in modern securities markets often involve fairly low risks. Usually it is impossible to close two or three transactions at the same time; therefore, there always is the possibility that when one part of the deal has been closed, a quick shift in prices makes it next to impossible to close the other part at a substantially profitable price. There is also the risk posed by the counter party, one in which the other party to one of the deals fails to deliver as agreed. Although unlikely, this hazard can have serious consequences because of the large quantities one is forced to trade in, in order to make a good profit on small price differences. These risks become even more magnified when leverage or borrowed money is used.
Another risk that can occur is in case the items being bought and sold are not similar and the arbitrage is conducted assuming that the prices of the items are inter linked or predictable. In the extreme case this is risk arbitrage, described below. While comparing with the classical quick arbitrage transaction, such an operation can end up in disastrous losses.
In the 1980s, risk arbitrage had gained a lot of popularity. In this form of speculation, an arbitrageur trades a security that is clearly undervalued or overvalued, when it is noticed that the wrong valuation is going to be set right by events. An apt example is that of the stock of a company that is undervalued in the stock market, but is about to be subject to of a takeover bid; the price of the takeover will be a clearer reflection of the value of the company, giving a large profit to those who bought its stocks at the current price-if the merger does go through as predicted. Over time, it has been seen that arbitrage transactions in the securities markets usually involve high speed and low risk. At some point in time a price difference does exist, and the difficulty lies in executing two or three balancing transactions while the difference persists, that is, before the other arbitrageurs realize and actively begin this kind of trade. When the transaction involves a longer delay of weeks or months, as mentioned above, it may result in considerable risk if borrowed money has been used to magnify the reward using leverage.
Convertible Bond Arbitrage
A convertible bond is one that an investor may return to the issuing company in return for a previously agreed upon number of shares in the same company. This type of a bond can be thought of as a corporate bond with a stock call option linked to it.
The price of a convertible bond depends on three major factors:
" Stock price: If the price of the stock that the bond
is convertible into increases, the price of the bond also tends to rise.
" Interest rate: If interest rates increase, the price of a bond
usually decreases.
" Credit
spread: Depending on whether the credit-worthiness of the issuer lowers or
if the credit score reduces i.e. if there is a rating downgrade and its
credit spread widens, the bond price tends to reduce.
Considering the complexity of the calculations associated with convertible bonds and the convoluted structure that these can have, an arbitrageur often has to rely on sophisticated quantitative models to identify bonds that are trading cheap as against their theoretical value.
Convertible arbitrage hence consists of buying a convertible bond and thereafter hedging at least two of the three aforementioned factors to gain exposure to the credit spread factor at an attractive price.
For example, an arbitrageur might first buy a convertible bond and later sell fixed income securities or interest rate futures, in a bid to hedge the interest rate exposure, and buy some credit protection in order to hedge the risk of credit deterioration. As a result, what he would be left with would be something similar to a call option on the base stock, which can be acquired at a very low price. He could then make money by either selling some of the more expensive options that are openly traded in the stock market or else by delta hedging his exposure to the underlying shares.
Regulatory Arbitrage
Regulatory arbitrage is one where a regulated institution makes the best of the difference between its real or economic risk and its regulatory position. For instance, if a bank, operating under the Basel I accord, has to hold 10% capital against default risk, but the real risk of default is much lower, it is profitable to securitize the loan, there by removing the low risk loan from its portfolio. On the other hand, if the real risk is greater than the regulatory risk then it might be more profitable to make that loan and hold on to it, provided it is priced realistically.
This process however can increase the overall risky nature of institutions under a regime that bears a callous attitude towards risk regulation. This is one of the aspects discussed by renowned economist Alan Greenspan in a speech he had delivered in October 1998 on the topic 'The Role of Capital in Optimal Banking Supervision and Regulation'.