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What is Arbitrage ?

CA AYUSH AGRAWAL , Last updated: 02 June 2010  

Many From Us are Unaware About The Actual Concept of Arbitrage.

Teacher Teaches The Arbitrage in One Words Only That " Risk-Less Profit"

But Arbitrage Also Carry Risk.

I Asked Many Student if IPCC/PCC That What You Know About Arbitrage. 

They Only Replied With One Practicle Example Only That is

Purchase in BSE & Sell in NSE.or VICe Varsa.

But That is Not Limit of Arbitrage.

I Tried My Best to Cover Arbitrage in Simple Terms.


What is an Arbitrage


In simple terms, Arbitrage is a system, or concept, that has been around for hundred of years, but there is still no any perfect definition of what it is. Your stock broker may give you one definition, while a commodities broker may tell you it’s something else. Hence, most investors have no clue what it’s about.

The basic idea of the arbitrage theory is that investors force a profit making opportunity to exist. In its most simple form, the definition should look something like, “Buy in a cheap market and immediately sell in a more expensive market.” It means “Buy Low, Sell High”.

A nice example would be the farmers markets found in two different villages. Mr. Parag Patel, an arbitrage junky, goes to the Cheap Village and sees that mangoes are selling for Rs 200 per lot. Through the grapevine, he’s heard that mangoes sell for Rs 250 in Expensive Village. Mr. Parag Patel takes all his cash and buys mangoes at Rs 200 per lot in Cheap Village, then walks to Expensive Village and immediately sells the oranges for Rs 250 per lot. This is basic arbitrage–Mr. Parag Patel has created a profit making opportunity of Rs 50 per lot. This theory has been used for a long time, at least conceptually.

There are four keys to arbitrage, outlined as follows…

Story: Mr. Parag Patel had to know that the mangoes were selling for Rs 200 in Cheap Village and Rs 250 in Expensive Village.

Profit Chance: Mr. Parag Patel had to see a profit making opportunity, that’s the key motivation to arbitrage.

Decision: Mr. Parag Patel had to use his judgment and determine the risk/reward factor.

Decision: Mr. Parag Patel had to make the decision whether to actually carry out his arbitrage scheme.

These four key factors seem obvious, but they are the result of many years of testing, discussion, consideration, and valuation. Summarily, there is still no set definition of arbitrage. Anyone will find several different definitions when checking dictionaries, encyclopedias, and financial glossaries. But to have a basic understanding of what the arbitrage theory represents, there are three important things to remember.

In short, Arbitrage means- Buy in a cheap market, sell in an expensive market.


Credit Card Arbitrage


Earning free money by credit cards by employing the debt to invest and improve the KING. it is the arbitration by the credit card. Here how the arbitration by the credit card functions. You are registered for one by the credit card with the good characteristics and employ all the funds on the chart to invest in a bond or to put the funds in high savings accounts of savings of an output. At the end of each month, you pay the minimum balance on your chart to appreciate your low rate and to avoid all the late penalties. You can make to as much a few thousands per year according to the amount of money which you borrow.

The arbitration by the credit card is employed by a good number of people throughout the world to make as high as a few thousands per year without carrying out too much work.

So that the arbitration of credit works you will need a capital stock transfer of 0% by the credit card. A chart of capital stock transfer which comes with the rate from introduction from 0% is ideal for this process. You will then employ a control of suitability or a transfer of wire to transfer your funds on your bank. It is where the things become complicated. You will have to appear outside how much risk you cost laid out to take with these funds. You can gain not less back of 30% with risky stocks but it is too risky. You can also spend all your money in a savings account of savings CD or in the short run high of output.

The best manner is usually some share in the interval. By diversification in multiple channels, you can receive a higher return on investment of your booklet. You should invest in stocks, the bonds, Cd, the money markets, and even the forex. But take care you to spend enough of money in your less risky channel to be able to handle difficult moments in your riskier channels.

The arbitration by the credit card assigns your credit a little. Your points of credit will be let fall slightly as you take more debt but they are not negative effects and put 'stay of T on your points of credit. In fact, they will disappear as soon as you pay in bottom of your debt.

The arbitration of credit is probably the manner easiest to earn money with other people 'funds of S. You borrow the funds from your by the credit card and do not pay any interest on your debt during 6,12, or 15 month. What you want to do is to make sure that you it avalent wages your debt at the end of the period of introduction (the payment of the interest will cross in your benefit). Once you exhausted a chart, you should move with another chart or ask your service with the customers of transmitter 'of S to offer more same businesses to you. The arbitration is not each one. But if you are been willing to take a certain risk, you can earn much money without too much effort.


Risk Arbitrage



Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.

Two principal types of merger are possible:

In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash. Until the acquisition is completed, the stock of the target typically trades below the purchase price. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock.

In a stock for stock merger, the acquirer proposes to buy the target by exchanging its own stock for the stock of the target. An arbitrageur may then short sell the acquirer and buy the stock of the target. This process is called "setting a spread." After the merger is completed, the target's stock will be converted into stock of the acquirer based on the exchange ratio determined by the merger agreement. The arbitrageur delivers the converted stock into his short position to complete the arbitrage.

If that were all there was to it, then everyone would do it immediately, and any possible gain would disappear very quickly. But there is always a risk that the deal will not go through or the closing will be delayed. Obstacles may include either party's inability to satisfy conditions of the merger, a failure to obtain the requisite shareholder approval, failure to receive antitrust and other regulatory clearances, or some other event which may change the target's or the acquirer's willingness to consummate the transaction. Such possibilities put the risk in the term risk arbitrage.

Additional complications can arise in stock for stock mergers when the exchange ratio is not constant but changes with the price of the acquirer. These are called "collars" and arbitrageurs use options-based models to value deals with collars. In addition, the exchange ratio is commonly determined by taking the average of the acquirer's closing price over a period of time (typically 10 trading days prior to close), during which time the arbitrageur would actively hedge his position in order to ensure the correct hedge ratio.

In terms of hedge fund strategies, risk arbitrage shares some properties with other forms of arbitrage such as relative value, volatility arbitrage, convertible arbitrage, and statistical arbitrage, but it is also an example of an event driven strategy.

Imagine you are a gambler that "plays" the odds. That in a nutshell sums up the essence of this term. In a game of roulette, one option is to bet on red numbers or black numbers, which would amount to a fifty percent chance of an even payout; however, since there are two "green" numbers, this offsets the even percentage. Now, a player that would be betting against the red or black would be playing the substantial odds of "hitting" green.

Translated to investment: Hypothetically, if "Joe's" taco shop was publicly traded at $50.00 per share, and "Sam's" taco shop moved to take over Joe's taco shop at a proposed $65.00 per share, this means Joe's taco shop's shares are instantly worth $65.00 per share. The game comes into play because those same shares are currently trading at only $50.00 per share, should the buyout occur. If the early trades (restricted or non-retail trades) elevate the value up to $60.00 per share, there exists the $5.00 difference. This is the entrance of risk arbitrage. The risk may be easily illustrated that there is a chance that the acquisition may not be completed, and in this case the price per share will reduce to the original $50.00 per share.

There are many factors that are in play that prevent the individual retail trader having a chance at capitalizing on different types of arbitrage. Access to the market and the technology required to achieve "up-to-the-minute" details are usually considered some of the most prominent.

Regulatory Arbitrage


Regulatory arbitrage is 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.

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.

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. For example, an insurance company may choose to locate in Bermuda due to preferential tax rates and policies for insurance companies. 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 Sell the IT installations for 40 million USD. With a reserve ratio of 10%, the bank can create 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 their acquisition cost for 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. It is actually more expensive to outsource the IT operations as the outsourcing adds a layer of management and increases overhead.


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.


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.

Merger and Municipal bond arbitrage


Also called risk arbitrage, merger arbitrage generally consists of buying 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.

Also called municipal bond relative value arbitrage, municipal arbitrage, or just muni arb, this hedge fund strategy involves one of two approaches.

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(Security Industry and Financial Markets Association) (merged with and preceded by BMA (short for Bond Market Association]). 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 U.S. dollars. 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.


Arbitrage and it's Conditions


In economics and finance, arbitrage is the practice of taking advantage of a price differential 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. 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, a risk-free profit. A person who engages in arbitrage is called an arbitrageur 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.

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

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

Arbitrage is possible when one of three conditions is met:

1. The same asset does not trade at the same price on all markets ("the law of one price").
2. Two assets with identical cash flows do not trade at the same price.
3. 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 does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities).

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 only possible with securities and financial products which can be traded electronically.

In the most simple 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 be 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.


Ayush Agrawal

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