Arbitrage

What is Arbitrage?

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the opportunity to instantaneously buy something for a low price and sell it for a higher price.

In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets (relative value or convergence trades), as in merger arbitrage.

People who engage in arbitrage are called arbitrageurs — such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

Arbitrage has the effect of causing prices of the same or very similar assets in different markets to converge.

What Does Arbitrage Mean?

Arbitrage offers a risk-free return, and it is usually applied by arbitrageurs who seek to realize an immediate profit from an asset that trades in more than one exchanges. Given that the markets are imperfect, arbitrage capitalizes on the imperfect distribution of information and offers a net profit after the trading costs are subtracted. Hence, to implement arbitrage, the arbitrageur should be certain that the potential gain is higher than the costs involved in the process.

Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market at a higher price, thus considered to be risk-free profit for the trader. Arbitrage provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. With advancements in technology, it has become extremely difficult to profit from pricing errors in the market. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly, and the opportunity is often eliminated in a matter of seconds. Arbitrage is a necessary force in the financial marketplace.

Example

For example, if Company XYZ’s stock trades at $5.00 per share on the New York Stock Exchange (NYSE) and the equivalent of $5.05 on the London Stock Exchange (LSE), an arbitrageur would purchase the stock for $5 on the NYSE and sell it on the LSE for $5.05 — pocketing the difference of $0.05 per share.

Theoretically, the prices on both exchanges should be the same at all times, but arbitrage opportunities arise when they’re not. In theory, arbitrage is a riskless activity because traders are simply buying and selling the same amount of the same asset at the same time. For this reason, arbitrage is often referred to as “riskless profit.”

Arbitrageurs also try to exploit price differences created by mergers. In some cases, they purchase the shares of companies that are the targets of purchase offers, hoping to pocket the difference between the trading price and the eventual cash payment resulting from the merger. Even though this type of strategy is referred to as “arbitrage,” it’s a bit of a misnomer because there’s always a risk that a merger will not actually happen. Because it’s not risk-free, merger arbitrage is not “arbitrage” in its truest sense.

Why Arbitrage Matters

Only large institutional investors and hedge funds are capable of taking advantage of arbitrage opportunities. Because they’re able to trade large blocks of shares, they can pocket millions in arbitrage profits even if the spread between two security prices is small (and it usually is just pennies).

By contrast, individual investors typically don’t have the large sums of money needed to take advantage of arbitrage opportunities, and trading fees would eat up any profits an individual arbitrageur hoped to secure. Institutional investors aren’t burdened by these same limitations.

Of course, small investors and entrepreneurs take advantage of much smaller arbitrage opportunities every single day. For example, if you’ve ever purchased a bargain-priced item at a garage sale or flea market, and then sold that item for a higher price on eBay, then you’ve profited from a form of arbitrage.

The main creator of arbitrage opportunity used to be a lack of real-time communication about prices in other markets, but modern technology has reduced the number of arbitrage opportunities out there. The relatively few arbitrage opportunities that do exist are elusive and don’t last for long – when people realize that a security is cheaper in one market than another, their interest in exploiting the opportunity will drive up the price of the “cheap” security and drive down the price of the “expensive” security until there is no longer a price difference. In this manner, arbitrage does a good job of ensuring equilibrium in the markets.

Types of Arbitrage

Spatial arbitrage

Also known as geographical arbitrage, this is the simplest form of arbitrage. In spatial arbitrage, an arbitrageur looks for price differences between geographically separate markets. For example, there may be a bond dealer in Virginia offering a bond at 100-12/23 and a dealer in Washington bidding 100-15/23 for the same bond. For whatever reason, the two dealers have not spotted the difference in the prices, but the arbitrageur does. The arbitrageur immediately buys the bond from the Virginia dealer and sells it to the Washington dealer.

Merger arbitrage

Also called risk arbitrage, merger arbitrage generally consists of buying/holding the stock of a company that is the target of a takeover while shorting the stock of the acquiring company.

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. The term “arbitrage” is also used in the context of the Income Tax Regulations governing the investment of proceeds of municipal bonds; these regulations, aimed at the issuers or beneficiaries of tax-exempt municipal bonds, are different and, instead, attempt to remove the issuer’s ability to arbitrage between the low tax-exempt rate and a taxable investment rate.

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 or SIFMA. 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 the same currency. 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.

However, many municipal bonds are callable, and this adds substantial risks to the strategy.

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 can be thought of as a corporate bond with a stock call option attached to it.

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.

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.

Depository receipts

A depositary 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 depository receipt) depending on where they are issued, are typically considered “foreign” and therefore trade at a lower value when first released. Many ADR’s 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. Other ADR’s that are not exchangeable often have much larger spreads. 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 one can hedge that risk.

Cross-border arbitrage

Cross-border arbitrage exploits different prices of the same stock in different countries:

Example: Apple is trading on NASDAQ at US$108.84. The stock is also traded on the German electronic exchange, XETRA. If 1 euro costs US$1.11, a cross-border trader could enter a buy order on the XETRA at €98.03 per Apple share and a sell order at €98.07 per share.

Some brokers in Germany do not offer access to the U.S. exchanges. Hence if a German retail investor wants to buy Apple stock, he needs to buy it on the XETRA. The cross-border trader would sell the Apple shares on XETRA to the investor and buy the shares in the same second on NASDAQ. Afterwards, the cross-border trader would need to transfer the shares bought on NASDAQ to the German XETRA exchange, where he is obliged to deliver the stock.

In most cases, the quotation on the local exchanges is done electronically by high-frequency traders, taking into consideration the home price of the stock and the exchange rate. This kind of high-frequency trading benefits the public as it reduces the cost to the German investor and enables him to buy U.S. shares.

Dual-listed companies

A dual-listed company (DLC) structure involves two companies incorporated in different countries contractually agreeing to operate their businesses as if they were a single enterprise, while retaining their separate legal identity and existing stock exchange listings. In integrated and efficient financial markets, stock prices of the twin pair should move in lockstep. In practice, DLC share prices exhibit large deviations from theoretical parity. Arbitrage positions in DLCs can be set up by obtaining a long position in the relatively underpriced part of the DLC and a short position in the relatively overpriced part. Such arbitrage strategies start paying off as soon as the relative prices of the two DLC stocks converge toward theoretical parity. However, since there is no identifiable date at which DLC prices will converge, arbitrage positions sometimes have to be kept open for considerable periods of time. In the meantime, the price gap might widen. In these situations, arbitrageurs may receive margin calls, after which they would most likely be forced to liquidate part of the position at a highly unfavorable moment and suffer a loss. Arbitrage in DLCs may be profitable, but is also very risky.

A good illustration of the risk of DLC arbitrage is the position in Royal Dutch Shell — which had a DLC structure until 2005 — by the hedge fund Long-Term Capital Management (LTCM, see also the discussion below). Lowenstein (2000) describes that LTCM established an arbitrage position in Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent premium. In total, $2.3 billion was invested, half of which was long in Shell and the other half was short in Royal Dutch (Lowenstein, p. 99). In the autumn of 1998, large defaults on Russian debt created significant losses for the hedge fund and LTCM had to unwind several positions. Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent and LTCM had to close the position and incur a loss. According to Lowenstein (p. 234), LTCM lost $286 million in equity pairs trading and more than half of this loss is accounted for by the Royal Dutch Shell trade.

Private to public equities

The market prices for privately held companies are typically viewed from a return on investment perspective (such as 25%), whilst publicly held and or exchange listed companies trade on a Price to earnings ratio (P/E) (such as a P/E of 10, which equates to a 10% ROI). Thus, if a publicly traded company specialises in the acquisition of privately held companies, from a per-share perspective there is a gain with every acquisition that falls within these guidelines. E.g., Berkshire Hathaway and Halydean Corporation. Private to public equities arbitrage is a term which can arguably be applied to investment banking in general. Private markets to public markets differences may also help explain the overnight windfall gains enjoyed by principals of companies that just did an initial public offering (IPO).

Regulatory arbitrage

Regulatory arbitrage is an avoidance strategy of regulation that is exercised as a result of a regulatory inconsistency. In other words, where a regulated institution takes advantage of the difference between its real (or economic) risk and the regulatory position. For example, if a bank, operating under the Basel I accord, has to hold 8% capital against default risk, but the real risk of default is lower, it is profitable to securitise the loan, removing the low risk loan from its portfolio. On the other hand, if the real risk is higher than the regulatory risk then it is profitable to make that loan and hold on to it, provided it is priced appropriately. Regulatory arbitrage can result in parts of entire businesses being unregulated as a result of the 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.

The term “Regulatory Arbitrage” was used for the first time in 2005 when it was applied by Scott V. Simpson, a partner at law firm Skadden, Arps, to refer to a new defence tactic in hostile mergers and acquisitions where differing takeover regimes in deals involving multi-jurisdictions are exploited to the advantage of a target company under threat.

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. 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.

Regulatory arbitrage can include restructuring a bank by outsourcing services such as IT. The outsourcing company takes over the installations, buying out the bank’s assets and charges a periodic service fee back to the bank. This frees up cashflow usable for new lending by the bank. The bank will have higher IT costs, but counts on the multiplier effect of money creation and the interest rate spread to make it a profitable exercise.

Example: Suppose the bank sells its IT installations for US$40 million. With a reserve ratio of 10%, the bank can create US$400 million in additional loans (there is a time lag, and the bank has to expect to recover the loaned money back into its books). The bank can often lend (and securitize the loan) to the IT services company to cover the acquisition cost of the IT installations. This can be at preferential rates, as the sole client using the IT installation is the bank. If the bank can generate 5% interest margin on the 400 million of new loans, the bank will increase interest revenues by 20 million. The IT services company is free to leverage their balance sheet as aggressively as they and their banker agree to. This is the reason behind the trend towards outsourcing in the financial sector. Without this money creation benefit, it is actually more expensive to outsource the IT operations as the outsourcing adds a layer of management and increases overhead.

According to PBS Frontline’s 2012 four-part documentary, “Money, Power, and Wall Street,” regulatory arbitrage, along with asymmetric bank lobbying in Washington and abroad, allowed investment banks in the pre- and post-2008 period to continue to skirt laws and engage in the risky proprietary trading of opaque derivatives, swaps, and other credit-based instruments invented to circumvent legal restrictions at the expense of clients, government, and publics.

Due to the Affordable Care Act’s expansion of Medicaid coverage, one form of Regulatory Arbitrage can now be found when businesses engage in “Medicaid Migration”, a maneuver by which qualifying employees who would typically be enrolled in company health plans elect to enroll in Medicaid instead. These programs that have similar characteristics as insurance products to the employee, but have radically different cost structures, resulting in significant expense reductions for employers.

Telecom arbitrage

Telecom arbitrage companies allow phone users to make international calls for free through certain access numbers. Such services are offered in the United Kingdom; 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.

Such services were previously offered in the United States by companies such as FuturePhone.com. These services would operate in rural telephone exchanges, primarily in small towns in the state of Iowa. In these areas, the local telephone carriers are allowed to charge a high “termination fee” to the caller’s carrier in order to fund the cost of providing service to the small and sparsely populated areas that they serve. However, FuturePhone (as well as other similar services) ceased operations upon legal challenges from AT&T and other service providers.

Statistical arbitrage

Statistical arbitrage is an imbalance in expected nominal values. A casino has a statistical arbitrage in every game of chance that it offers — referred to as the house advantage, house edge, vigorish or house vigorish.

Summary

  • Arbitrage means a strategy that takes advantage of price inefficiencies to realize a profit from buying and selling an asset at the same time.
  • Arbitrage happens when a security is purchased in one market and simultaneously sold in another at a higher price.
  • This results in a profit from the temporary price difference.
  • Arbitrage is considered a risk-free profit for the investor or trader.
  • A trader tries to exploit arbitrage opportunities like buying a stock on a foreign exchange where the price hasn’t yet adjusted for the fluctuating exchange rate.

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