Arbitrage
has the effect of causing prices in different markets to converge. It's like a
free lunch. As a result of arbitrage, the currency exchange rates, the price of
commodities, and the price of securities in different markets tend to converge
to the same prices, in all markets, in each category. The speed at which prices
converge 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 transactions cost of buying, holding and reselling are small relative to the
difference in prices in the different markets.
Arbitrage
is an important factor of reaching purchasing power parity between different currencies.
For example if a car purchased in America is cheaper than the same car in Canada,
Canadians would buy their cars across the border to exploit the arbitrage condition.
However, in reality, one must consider taxes and the costs of travelling to the
U.S. and driving the new car back to Canada. Also, the features built into the
cars sold in the U.S. are not exactly the same as the features built into the
cars for sale in Canada. This is due to the different emissions and other auto
regulations in the two countries. When people arbitrage commodities, goods, securities
and currencies, on a large scale, the higher demand for US Dollars and the higher
supply of Canadian Dollars (Canadians would have to exchange their Dollars into
US Dollars) leads to an appreciation of the US Dollar and eventually make US cars
more expensive for all buyers, espcially for the Canadians. Similarly, arbitrage
affects the difference in interests rates paid on government bonds, issued by
the various countries, given the expected depreciations in the currencies, relative
to each other.
Then
there is of course road arbitrage, or lane arbitrage when drivers and shoppers
switch lanes to negotiate through the traffic or through the checkout counters,
in order to arrive at their destination sooner or get out of the store sooner
than by remaining in the same lane.
Risks
Arbitrage
transactions in modern securities markets involve fairly low risks. 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. There
is also counter-party risk, that the other party to one of the deals fails to
deliver as agreed; though unlikely, this hazard is serious because of the large
quantities one must trade in order to make a profit on small price differences.
These risks become magnified when leverage or borrowed money is used.
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. In the extreme case this is risk arbitrage, described below. In
comparison to the classical quick arbitrage transaction, such an operation can
produce disastrous losses.
In
the 1980s a practice with the oxymoronic name of risk arbitrage became 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 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 the
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 1980s such as those involving Michael Milken and Ivan Boesky.
Long-Term
Capital Management
Long-Term
Capital Management (LTCM) lost $100 billion mis-managing this concept in September
1998. LTCM had attempted to make money on the difference between different bond
instruments. For example, it would buy U.S treasury bonds and sell 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,
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 defaulted on its
ruble debt and domestic dollar debt. Since the markets were already nervous due
to the Asian crisis, investors began selling non-U.S. treasury debt and buying
U.S. treasuries, which were considered a safe investment. As a result the return
on U.S. treasuries began decreasing because there were many buyers, and the return
on other bonds began to increase because there were many sellers. This caused
the difference between the returns of U.S. treasuries and other bonds to increase,
rather than to decrease as LTCM was expecting. Eventually this caused LTCM to
fold, and a bailout had to be arranged to prevent a collapse in confidence in
the economic system.
An
ironic footnote is that they were right long-term (the LT in LTCM), and a few
months after they folded their portfolio became very profitable. However the long-term
does not matter if you cannot survive the short-term, and that they failed to
do.
See
also
Triangle
arbitrage
Covered interest arbitrage
Economics,
Banking & Finance
