Resources for arbitrage Time Traveler!
What it is:
Traders may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other. 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 tend to converge. The speed  at which they do so is a measure of market efficiency. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell it where the price is high as long as the buyers are not prohibited from reselling and the transaction costs of buying, holding and reselling are small relative to the difference in prices in the different markets.
Arbitrage moves different currencies toward purchasing power parity. As an example, assume that a car purchased in the United States is cheaper than the same car in Canada. Canadians would buy their cars across the border to exploit the arbitrage condition. At the same time, Americans would buy US cars, transport them across the border, then sell them in Canada.
Canadians would have to buy American dollars to buy the cars and Americans would have to sell the Canadian dollars they received in exchange. Both actions would increase demand for US dollars and supply of Canadian dollars.
As a result, there would be an appreciation of the US currency. This would make US cars more expensive and Canadian cars less so until their prices were similar. On a larger scale, international arbitrage opportunities in commodities , goods, securities and currencies tend to change exchange rates until the purchasing power is equal.
In reality, most assets exhibit some difference between countries. These, transaction costs , taxes, and other costs provide an impediment to this kind of arbitrage. Similarly, arbitrage affects the difference in interest rates paid on government bonds issued by the various countries, given the expected depreciation in the currencies relative to each other see interest rate parity. Arbitrage transactions in modern securities markets involve fairly low day-to-day risks, but can face extremely high risk in rare situations,  particularly financial crises , and can lead to bankruptcy.
Formally, arbitrage transactions have negative skew — prices can get a small amount closer but often no closer than 0 , while they can get very far apart.
The day-to-day risks are generally small because the transactions involve small differences in price, so an execution failure will generally cause a small loss unless the trade is very big or the price moves rapidly. The rare case risks are extremely high because these small price differences are converted to large profits via leverage borrowed money , and in the rare event of a large price move, this may yield a large loss.
The main day-to-day risk is that part of the transaction fails — execution risk. The main rare risks are counterparty risk and liquidity risk — that a counterparty to a large transaction or many transactions fails to pay, or that one is required to post margin and does not have the money to do so. In the academic literature, the idea that seemingly very low risk arbitrage trades might not be fully exploited because of these risk factors and other considerations is often referred to as limits to arbitrage.
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. However, this is not necessarily the case. Many exchanges and inter-dealer brokers allow multi legged trades e.
Competition in the marketplace can also create risks during arbitrage transactions. This leaves the arbitrageur in an unhedged risk position.
In the s, risk arbitrage was 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.
Traditionally, arbitrage transactions in the securities markets involve high speed, high volume 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.
When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing this risk is through the illegal use of inside information , and in fact risk arbitrage with regard to leveraged buyouts was associated with some of the famous financial scandals of the s such as those involving Michael Milken and Ivan Boesky.
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; this is more narrowly referred to as a convergence trade.
In the extreme case this is merger arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses. As arbitrages generally involve future movements of cash, they are subject to counterparty risk: This is a serious problem if one has either a single trade or many related trades with a single counterparty, whose failure thus poses a threat, or in the event of a financial crisis when many counterparties fail.
This hazard is serious because of the large quantities one must trade in order to make a profit on small price differences. Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a short position. If the assets used are not identical so a price divergence makes the trade temporarily lose money , or the margin treatment is not identical, and the trader is accordingly required to post margin faces a margin call , the trader may run out of capital if they run out of cash and cannot borrow more and be forced to sell these assets at a loss even though the trades may be expected to ultimately make money.
In effect, arbitrage traders synthesize a put option on their ability to finance themselves. Prices may diverge during a financial crisis, often termed a " flight to quality "; these are precisely the times when it is hardest for leveraged investors to raise capital due to overall capital constraints , and thus they will lack capital precisely when they need it most.
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 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.
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. 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. There are additional inefficiencies arising from the highly fragmented nature of the municipal bond market which has two million outstanding issues and 50, issuers, in contrast to the Treasury market which has 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.
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. Note, however, that many municipal bonds are callable, and that this imposes substantial additional risks to the strategy.
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. 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. 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.
Some brokers in Germany do not offer access to the U. 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. 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. Lowenstein  describes that LTCM established an arbitrage position in Royal Dutch Shell in the summer of , when Royal Dutch traded at an 8 to 10 percent premium. In the autumn of , 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. 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. Julie's Suitor Rest of cast listed alphabetically: Supporting uncredited Ian Bonner Grand Jury Member uncredited Roger Brenner Business Associate uncredited Jennifer Butler Trader uncredited Julie Cavaliere Event Coordinator uncredited Marshall Factora Funeral Director uncredited James Farley Gala Guest uncredited Pete Fasanelli Bartender uncredited Max Gold Party Guest uncredited Darryl Reuben Hall Financial Trader uncredited Rachel Heller Rachel uncredited Vivian Kalinov Himself uncredited Marc Lombardo Plaza Partygoer uncredited Terence C.
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