TheInfoList

OR:

In
economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behaviour and intera ...
and
finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumption (economics) ...
, arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalise on the difference, the profit being the difference between the
market price A price is the (usually not negative) quantity of payment or Financial compensation, compensation given by one Party (law), party to another in return for Good (economics), goods or Service (economics), services. In some situations, the pr ...
s at which the unit is
trade Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Economists refer to a system or network that allows trade as a market (economics), market. An early form of trade, barter, s ...
d. When used by academics, an arbitrage is a transaction that involves no negative
cash flow A cash flow is a real or virtual movement of cash, money: *a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are exp ...
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 possibility 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. The term is mainly applied to trading in
financial instrument Financial instruments are monetary Contract, contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in ...
s, such as bonds,
stock In finance, stock (also capital stock) consists of all the Share (finance), shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which owners ...
s, derivatives,
commodities In economics, a commodity is an economic goods, good, usually a resource, that has full or substantial fungibility: that is, the Market (economics), market treats instances of the good as equivalent or nearly so with no regard to who Production ...
, and currencies. People who engage in arbitrage are called arbitrageurs (). Arbitrage has the effect of causing prices of the same or very similar assets in different markets to converge.

# Etymology

"Arbitrage" is a French word and denotes a decision by an arbitrator or arbitration tribunal (in modern French, "" usually means
referee A referee is an Official#Sports, official, in a variety of sports and competition, responsible for enforcing the Regulation of sport, rules of the sport, including sportsmanship decisions such as ejection (sports), ejection. The official taske ...
or
umpire An umpire is an Official#Sports, official in a variety of sports and competition, responsible for enforcing the Regulation of sport, rules of the sport, including sportsmanship decisions such as ejection (sports), ejection. The term derives f ...
). In the sense used here, it was first defined in 1704 by Mathieu de la Porte in his treatise "" as a consideration of different exchange rates to recognise the most profitable places of issuance and settlement for a bill of exchange (" in modern spelling".)

# Arbitrage-free

If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium, or an arbitrage-free market. An arbitrage equilibrium is a precondition for a general economic equilibrium. The "no arbitrage" assumption is used in quantitative finance to calculate a unique risk neutral price for derivatives.

# Arbitrage-free pricing approach for bonds

Arbitrage-free pricing for bonds is the method of valuing a coupon-bearing financial instrument by discounting its future cash flows by multiple discount rates. By doing so, a more accurate price can be obtained than if the price is calculated with a present-value pricing approach. Arbitrage-free pricing is used for bond valuation and to detect arbitrage opportunities for investors. For the purpose of valuing the price of a bond, its cash flows can each be thought of as packets of incremental cash flows with a large packet upon maturity, being the principal. Since the cash flows are dispersed throughout future periods, they must be discounted back to the present. In the present-value approach, the cash flows are discounted with one discount rate to find the price of the bond. In arbitrage-free pricing, multiple discount rates are used. The present-value approach assumes that the bond yield will stay the same until maturity. This is a simplified model because interest rates may fluctuate in the future, which in turn affects the yield on the bond. For this reason, the discount rate may differ for each cash flow. Each cash flow can be considered a zero-coupon instrument that pays one payment upon maturity. 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 flow The discounted cash flow (DCF) analysis is a method in finance of valuing a security (finance), security, project, company, or financial asset, asset using the concepts of the time value of money. Discounted cash flow analysis is widely used in ...
s. Arbitrage-free price refers to the price at which no price arbitrage is possible. The idea of using multiple discount rates obtained from zero-coupon bonds and discounting a similar bond's cash flow to find its price is derived from the yield curve, which 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 price mismatches, 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: #Investor shorts the bond at price at time t1. #Investor longs the zero-coupon bonds making up the related yield curve and strips and sells any coupon payments at t1. #As t>t1, the price spread between the prices will decrease. #At maturity, the prices will converge and be equal. Investor exits both the long and short positions, realising a profit. If the outcome from the valuation were the reverse 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. The prices of the bonds in t1 move closer together to finally become the same at tT.

# Conditions for arbitrage

Arbitrage may take place when: * the same asset does not trade at the same price on all markets (" the law of one price"). * two assets with identical cash flows do not trade at the same price. * an asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or the asset has significant costs of storage; so this condition holds true for something like grain but not for
securities A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
). 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 in 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'.As an arbitrage consists of at least two trades, the metaphor is of putting on a pair of pants, one leg (trade) at a time; the risk that one trade (leg) fails to execute is therefore called '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. "True" arbitrage requires that there is no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other. See rational pricing, particularly § arbitrage mechanics, for further discussion. Mathematically it is defined as follows: : $P\left(V_t \geq 0\right) = 1 \text P\left(V_t \neq 0\right) > 0 \,$ where $V_0 = 0$ and $V_t$ denotes the portfolio value at time ''t''.

# Price convergence

Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency
exchange rate In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of t ...
s, the price of
commodities In economics, a commodity is an economic goods, good, usually a resource, that has full or substantial fungibility: that is, the Market (economics), market treats instances of the good as equivalent or nearly so with no regard to who Production ...
, 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 Price discrimination is a microeconomics, microeconomic pricing strategies, pricing strategy where identical or largely similar goods or services are sold at different prices by the same provider in Market segmentation, different markets. Price ...
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 Purchasing power parity (PPP) is the measurement of prices in different countries that uses the prices of specific goods to compare the absolute purchasing power of the countries' currency, currencies. PPP is effectively the ratio of the price of ...
commodities In economics, a commodity is an economic goods, good, usually a resource, that has full or substantial fungibility: that is, the Market (economics), market treats instances of the good as equivalent or nearly so with no regard to who Production ...
, goods,
securities A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
, and currencies tend to change
exchange rate In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of t ...
s until the
purchasing power Purchasing power is the amount of goods and services that can be purchased with a unit of currency. For example, if one had taken one unit of currency to a store in the 1950s, it would have been possible to buy a greater number of items than would ...
is equal. In reality, most
asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that c ...
s exhibit some difference between countries. These,
transaction cost In economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behavi ...
s, 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).

# Risks

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 Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debt ...
. 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; this is called 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.

## Execution risk

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.g. basis block trades on LIFFE). Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk position. In the 1980s, risk arbitrage was common. In this form of
speculation In finance, speculation is the purchase of an asset (a commodity, good (economics), goods, or real estate) with the hope that it will become more valuable shortly. (It can also refer to short sales in which the speculator hopes for a decline i ...
, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected. 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 risk arbitrage in
leveraged buyout A leveraged buyout (LBO) is one company's acquisition of another company using a significant amount of borrowed money (Leverage (finance), leverage) to meet the cost of acquisition. The assets of the company being acquired are often used as col ...
s was associated with some of the famous financial scandals of the 1980s, such as those involving Michael Milken and Ivan Boesky.

## Mismatch

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.

## Counterparty risk

As arbitrages generally involve ''future'' movements of cash, they are subject to
counterparty risk A credit risk is risk of default (finance), default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal sum, principal and interest, disruptio ...
: the risk that a counterparty fails to fulfill their side of a transaction. 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. For example, if one purchases many risky bonds, then hedges them with CDSes, profiting from the difference between the bond spread and the CDS premium, in a financial crisis, the bonds may default ''and'' the CDS writer/seller may fail, due to the stress of the crisis, causing the arbitrageur to face steep losses.

## Liquidity risk

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 ''Margin Call'' is a 2011 American drama film written and directed by J. C. Chandor in his feature directorial debut. The principal story takes place over a 24-hour period at a large Wall Street Investment banking, investment bank during the in ...
), 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 synthesise 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.

## Gray market

Grey market arbitrage is the sale of goods purchased through informal channels to earn the difference in price.Lu, Y; Foropon, Cyril RH  VIAFID ORCID Logo  ; Wang, D; Xu, S ， Journal of Enterprise Information Management; Bradford ，2020 ， Arbitrage in gray markets and its impact on supply chain decisions ， vol.34 , no.1, pp.382-8. Excessive gray market arbitrage will lead to arbitrage behaviors in formal channels, which will reduce returns due to factors such as price confusion, and may even cause prices to plummet in severe cases.

# Types

## 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.

## Latency arbitrage

For very short amounts of time, the prices of two assets that are either
fungible In economics, fungibility is the property of a goods, good or a commodity whose individual units are essentially interchangeable, and each of whose parts is indistinguishable from any other part. Fungible tokens can be exchanged or replaced; f ...
or related by a strict pricing relationship may temporarily go out of sync as the market makers are slow to update the prices. This momentary mispricing creates the opportunity for an arbitrageur to capture the difference between the two prices. For example, the price of calls and puts on an underlying should be related by put-call parity. If these prices are misquoted relative to the put-call parity relationship, it provides an arbitrageur the opportunity to profit from the mispricing. Latency arbitrage is often mentioned especially in an
electronic trading In finance, an electronic trading platform also known as an online trading platform, is a computer software program that can be used to place orders for financial products over a network with a financial intermediary. Various financial products c ...
environment, where the use of fast server hardware allows an arbitrageur to capture realize opportunities that may exist for as little as nanoseconds. A study by the
Financial Conduct Authority The Financial Conduct Authority (FCA) is a financial regulation, financial regulatory body in the United Kingdom, but operates independently of the UK Government, and is financed by charging fees to members of the financial services industry. The ...

## 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 A casino is a facility for certain types of gambling. Casinos are often built near or combined with hotels, resorts, restaurants, retail shopping, cruise ships, and other tourist attractions. Some casinos are also known for hosting live entertai ...
has a statistical arbitrage in every game of chance that it offers, referred to as the house advantage, house edge,
vigorish Vigorish (also known as ''juice'', ''under-juice'', the ''cut'', the ''take'', the ''margin'', the ''house edge'' or simply the ''vig'') is the fee charged by a bookmaker (or ''bookie'') for accepting a gambler's wager. In American English, it can ...
, or house vigorish.

## Gray market

To accomplish arbitrage, the grey market buys items through marketing channels that sell them without the permission of the product trademark owner and sells them in the legitimate market. A Swiss watch sold by an approved dealer for £42,600 is an excellent example of a grey market product; customers can buy the identical watch for £27,227 on the Chrono24 website, which is an unlicensed 'grey market.'Autrey, R.L., Bova, F. and Soberman, D.A. (2015), “When gray is good: gray markets and marketcreating investments”, Production and Operations Management, Vol. 24 No. 4, pp. 547-559

# The fall of Long-Term Capital Management

Long-Term Capital Management (LTCM) lost 4.6 billion U.S. dollars in fixed income arbitrage in September 1998. LTCM had attempted to make money on the price difference between different bonds. For example, it would sell U.S. Treasury securities and buy Italian bond futures. The concept was that because Italian bond futures had a less liquid market, in the short term Italian bond futures would have a higher return than U.S. bonds, but in the long term, the prices would converge. Because the difference was small, a large amount of money had to be borrowed to make the buying and selling profitable. The downfall in this system began on August 17, 1998, when
Russia Russia (, , ), or the Russian Federation, is a List of transcontinental countries, transcontinental country spanning Eastern Europe and North Asia, Northern Asia. It is the List of countries and dependencies by area, largest country in the ...
defaulted on its
ruble The ruble (American English) or rouble (Commonwealth English) (; rus, рубль, p=rublʲ) is the currency unit of Belarus and Russia. Historically, it was the currency of the Russian Empire and of the Soviet Union. , currencies named ''rub ...
debt and domestic dollar debt. Because global markets were already nervous due to the
1997 Asian financial crisis The Asian financial crisis was a period of financial crisis that gripped much of East Asia and Southeast Asia beginning in July 1997 and raised fears of a worldwide economic meltdown due to financial contagion. However, the recovery in 1998–1 ...
, investors began selling non-U.S. treasury debt and buying U.S. treasuries, which were considered a safe investment. As a result, the price on US treasuries began to increase and the return began decreasing because there were many buyers, and the return (yield) on other bonds began to increase because there were many sellers (i.e. the price of those bonds fell). This caused the difference between the prices of U.S. treasuries and other bonds to increase, rather than to decrease as LTCM was expecting. Eventually this caused LTCM to fold, and their creditors had to arrange a bail-out. More controversially, officials of the
Federal Reserve The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
assisted in the negotiations that led to this bail-out, on the grounds that so many companies and deals were intertwined with LTCM that if LTCM actually failed, they would as well, causing a collapse in confidence in the economic system. Thus LTCM failed as a fixed income arbitrage fund, although it is unclear what sort of profit was realised by the banks that bailed LTCM out.

## Types of financial arbitrage

* Arbitrage betting * Covered interest arbitrage * Fixed income arbitrage * Political arbitrage * Options arbitrage * Risk arbitrage * Statistical arbitrage * Triangular arbitrage * Uncovered interest arbitrage * Volatility arbitrage

## Related concepts

* Airline booking ploys *
Algorithmic trading Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading attempts to leverage the speed and computational resources of ...
* Arbitrage pricing theory * Coherence (philosophical gambling strategy), analogous concept in
Bayesian probability Bayesian probability is an Probability interpretations, interpretation of the concept of probability, in which, instead of frequentist probability, frequency or propensity probability, propensity of some phenomenon, probability is interpreted as re ...
* Cointelation * Drop shipping * Efficient-market hypothesis * Immunization (finance) * Interest rate parity * Intermediation * No free lunch with vanishing risk * TANSTAAFL *
Value investing Value investing is an investment investor profile, paradigm that involves buying security (finance), securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philoso ...

# References

*Greider, William (1997). ''One World, Ready or Not''. Penguin Press. . *''Special Situation Investing: Hedging, Arbitrage, and Liquidation'', Brian J. Stark, Dow-Jones Publishers. New York, NY 1983. ;