Arbitrage

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table2"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table3"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table4"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Arbitrage</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table5"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="98%" align="left" valign="top"> <p class="word_list"><a href="#arbitrage">arbitrage</a></p> <p class="word_list"><a href="#arbitrage free">arbitrage free</a></p> <p class="word_list"><strong style="font-weight: 400"> <a href="#arbitrageur">arbitrageur</a></strong><p class="word_list"> <strong style="font-weight: 400"><a href="#no arbitrage">no arbitrage condition</a></strong><p class="word_list"> <strong style="font-weight: 400"><a href="#statistical arbitrage"> statistical arbitrage</a></strong><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table6"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body"><strong style="font-weight: 400">An </strong><strong> <a name="arbitrage">arbitrage</a></strong><strong style="font-weight: 400"> is a certain type of transaction or portfolio. Actually, the term is used in two different ways, so it refers to either of two very different types of transactions or portfolios. This article explains both. People also speak of arbitrage as an activity—the activity of seeking out and implementing either of the two types of arbitrage opportunities. An </strong><strong> <a name="arbitrageur">arbitrageur</a></strong><strong style="font-weight: 400"> is an individual or institution who engages in one or the other form of arbitrage.</strong></p> <p class="body"><strong style="font-weight: 400">In finance theory, an arbitrage is a "free lunch"—a transaction or portfolio that makes a profit without <a href="../articles/risk.htm">risk</a>. Suppose a </strong> <a href="../articles/future.htm"> <strong style="font-weight: 400">futures</strong></a><strong style="font-weight: 400"> contract trades on two different exchanges. If, at one point in time, the contract is bid at <a href="../articles/currency_codes.htm">USD</a> 45.02 on one exchange and offered at USD 45.00 on the other, a trader could purchase the contract at one price and sell it at the other to make a risk-free profit of a USD 0.02. </strong></p> <p class="body"><strong style="font-weight: 400">Such arbitrage opportunities reflect minor pricing discrepancies between markets or related instruments. Per-transaction profits tend to be small, and they can be consumed entirely by </strong><a href="../articles/transaction_costs.htm"> <strong style="font-weight: 400">transaction costs</strong></a><strong style="font-weight: 400">. Accordingly, most arbitrage is performed by institutions that have very low transaction costs and can make up for small profit margins by doing a large volume of transactions. </strong></p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table7"> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p class="body">Formally, theoreticians define an arbitrage as <strong style="font-weight: 400"> a trading strategy that requires the investment of no <a href="../articles/capital_allocation.htm">capital</a>, cannot lose money, and has a positive probability of making money.</strong></p> <p class="body"><strong style="font-weight: 400">A market is said to have </strong> <strong><a name="no arbitrage">no arbitrage</a></strong><strong style="font-weight: 400">—or be </strong> <strong><a name="arbitrage free">arbitrage free</a>—</strong><strong style="font-weight: 400">if prices in that market offer no arbitrage opportunities. This is a theoretical condition that is usually assumed for markets in economic and financial models. The assumption underlies the financial engineering theory of <a href="../articles/arbitrage_free_pricing.htm">arbitrage-free pricing</a>.</strong></p> <p class="body"><strong style="font-weight: 400">Turning now to the second use of the term arbitrage, it is a usage that is shunned by theoretical purists. However, it has been in wide use for several decades, so it is fairly standard. According to this usage, an arbitrage is a <a href="../articles/leverage.htm">leveraged</a> speculative transaction or portfolio.</strong></p> <p class="body"><strong style="font-weight: 400">During the 1980s, <a href="../articles/junk_bond.htm">junk bond</a> financing funded an overheated mergers and acquisitions market. Arbitragers of this period were speculators who took leveraged <a href="../articles/common_stock.htm">equity</a> positions either in anticipation of a possible takeover or to put a firm in play. They also engaged in greenmail. <a href="../articles/junk_bond.htm">Ivan Boesky</a> was a famous arbitrager from this period who was ultimately convicted of insider trading.</strong></p> <p class="body">Today, the label arbitrage is often applied to the speculative trading strategies often associated with <a href="../articles/hedge_fund.htm">hedge funds</a>. These include</p> <p class="bullet" style="margin-top: 5; margin-bottom: 5"> <img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/market_neutral_strategy.htm">statistical arbitrage</a>,</p> <p class="bullet" style="margin-top: 5; margin-bottom: 5"> <img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/event_driven_strategy.htm">merger arbitrage</a>,</p> <p class="bullet" style="margin-top: 5; margin-bottom: 5"> <img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/market_neutral_strategy.htm">fixed income arbitrage</a>, and</p> <p class="bullet" style="margin-top: 5; margin-bottom: 5"> <img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/market_neutral_strategy.htm">convertible arbitrage</a>.</p> <p class="body">To distinguish between the two definitions of arbitrage, we might call them "true" arbitrage and "speculative" arbitrage. They are different, but in a sense they represent, two ends of a spectrum. In practice, true arbitrage is rare. There is always some risk—perhaps due to <a href="../articles/liquidity.htm">liquidity</a>, the timing of offsetting transactions, or perhaps some <a href="../articles/credit_risk.htm">credit exposure</a>. If these "true" arbitrages become increasingly complicated or sophisticated, the subtle risks multiply. From there, it is a slippery slope to "speculative" arbitrage.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table8"> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">The notion of true arbitrage is profoundly important in <a href="../articles/option_pricing_theory.htm">financial engineering</a> and theoretical finance. In theory, a market in equilibrium will offer no arbitrage opportunities. Much of the theory of asset valuation is based on the assumption that prices must be set in a consistent manner that affords no true arbitrage between them. This is called <a href="../articles/arbitrage_free_pricing.htm"> arbitrage-free pricing</a>.</p> <p class="body">In practice, people don't write about true arbitrage or speculative arbitrage. They just write about arbitrage. It is up to the reader to infer from context what type of arbitrage is being referred to. In a theoretical or financial engineering context, this is usually true arbitrage. In a trading or portfolio management context, it is usually speculative arbitrage. In a risk management context, it could be either—ask.</p> <p class="body">People from fields other than finance or economics sometimes confuse the two forms of arbitrage. I once helped a professor from an unrelated field who was writing a paper that mentioned arbitrage. He had read about the profound importance of arbitrage in finance theory but thought this was referring to the speculative arbitrage he had read about in books on hedge funds. Journalists are notorious for confusing the two. 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