What Is Arbitrage? - Definition & Example


Exploiting arbitrage opportunities: From trading stocks to sports. “Arbitrage is the simultaneous purchase and sale of an asset to profit from a difference in the price.

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Arbitrage Defined

Arbitrage is a American thriller drama film directed by Nicholas Jarecki and starring Richard Gere, Susan Sarandon, Tim Roth and Brit Marling. Filming began in April in New York City. It opened in U.S. theaters in September

After being driven home by Grant, Miller drags his injured body into bed at 4: The next day, he is questioned by police detective Bryer Tim Roth. Bryer is keen on arresting Robert for manslaughter and begins to put the pieces together. Brooke discovers the financial irregularities, realizes that she could be implicated and confronts her father. Jimmy is arrested and placed before a grand jury but still refuses to admit to helping Miller.

Miller once again contemplates turning himself in. Even though Jimmy is about to go to prison, Miller tells Jimmy that investors are depending on him and that waiting for the sale to close before coming forward would serve the greater good. Eventually, the sale is closed, but Robert finds a way to avoid being charged. He proves that Bryer had fabricated evidence.

The case against Jimmy is dismissed, and the detective is ordered not to go near him. Robert's wife tries to blackmail him with a separation agreement getting rid of his wealth. When Robert refuses to sign, his wife says that she will tell the police that he got into bed at 4: In the final scene, Robert addresses a banquet honoring him for his successful business, with his wife at his side and his daughter introducing him to the audience but their false embrace on the stage signifies that he has lost the respect and admiration of his daughter.

As Robert approaches the podium to deliver his speech the screen cuts to black, leaving his decision ambiguous. Arbitrage was a worldwide box-office success and is the highest grossing "day-and-date" independently produced film of all time. The film also outperformed financially in several areas: It was the top film in Israel two weeks running and No.

The discount rates used should be the rates of multiple zero-coupon bonds with maturity dates the same as each cash flow and similar risk as the instrument being valued. By using multiple discount rates, the arbitrage-free price is the sum of the discounted cash flows.

Arbitrage-free price refers to the price at which no price arbitrage is possible. The ideas of using multiple discount rates obtained from zero-coupon bonds and discount a similar bonds cash flow to find its price is derived from the yield curve. The yield curve is a curve of the yields of the same bond with different maturities. This curve can be used to view trends in market expectations of how interest rates will move in the future.

In arbitrage-free pricing of a bond, a yield curve of similar zero-coupon bonds with different maturities is created. If the curve were to be created with Treasury securities of different maturities, they would be stripped of their coupon payments through bootstrapping. This is to transform the bonds into zero-coupon bonds. The yield of these zero-coupon bonds would then be plotted on a diagram with time on the x -axis and yield on the y -axis. Since the yield curve displays market expectations on how yields and interest rates may move, the arbitrage-free pricing approach is more realistic than using only one discount rate.

Investors can use this approach to value bonds and find mismatches in prices, resulting in an arbitrage opportunity. If a bond valued with the arbitrage-free pricing approach turns out to be priced higher in the market, an investor could have such an opportunity:. If the outcome from the valuation were the reversed case, the opposite positions would be taken in the bonds.

This arbitrage opportunity comes from the assumption that the prices of bonds with the same properties will converge upon maturity. This can be explained through market efficiency, which states that arbitrage opportunities will eventually be discovered and corrected accordingly. The prices of the bonds in t 1 move closer together to finally become the same at t T. Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time.

The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally possible only with securities and financial products that can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade and subsequently having to trade it soon after at a worse price is called 'execution risk' or more specifically 'leg risk'.

In the simplest example, any good sold in one market should sell for the same price in another. 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 [3] 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, [3] 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.