How Can Arbitrage Work For Me?

Arbitrage is the exploitation of price differences between different financial markets in order to make a profit, with a minimal amount of risk. Luckily, arbitrage investing is an arena wherein you can profit quickly.

This example will clarify arbitrage investing for you: Suppose there were 2 farmer’s markets in your city. One of them (Market A) sold a particular type of apple for $2.00 / lb. The other market (Market B) sold identical apples for $3 / lb. You could simply buy apples at Market A and then stroll over to Market B and sell them. How could you lose?

That’s arbitrage. Now, those conditions probably wouldn’t last long. In the financial world, those types of situations tend to correct themselves very quickly. For the best results, you must be vigilant to discover these types of situations and then act quickly. Someone that takes part in arbitrage is an arbitrageur. Let’s see what it takes to become an arbitrageur.

Positive Conditions For An Arbitrage Investment

Experts say that one of three conditions must exist for arbitrage to be possible:

Same asset, different prices. An asset trades at different prices on at least two different financial markets.
Two assets, same cash flows. Two different assets trade at different prices, but have the same cash flows.
One asset, future price is known to be higher. The future price of an asset is known, but the asset is not trading at that price now when discounted at the risk-free interest rate. The risk-free interest rate is the rate an investor could get elsewhere on his money and be 100% risk-free.

Technically, arbitrage is not buying a product in one market and selling in another at a later time. To truly avoid risk, the transactions have to occur simultaneously. The greater the amount of time that passes between each leg, the greater the risk incurred. This type of risk is called “execution risk.”

Types Of Arbitrage

There are many types of arbitrage. You may wish to get started with one of these types:

Merger Arbitrage. This is also commonly referred to as risk arbitrage. The basic idea is to purchase the stock of a company that is the target of a takeover and simultaneously short the stock of the company that is executing the takeover.
If the takeover actually happens, the stock of the company being taken over tends to rise considerably and the price of the acquirer tends to fall. Then you would make money on both investments.
Convertible Bond Arbitrage. Convertible bonds are bonds that can be exchanged for a predetermined number of shares of stock in a company. There are 3 factors that affect the current price of any convertible bond: interest rate, stock price, and credit spread.
If this type of arbitrage appeals to you, some detailed research on the calculations necessary to find bonds that 3 are currently cheap compared to their theoretical values will help you. The different strategies for making a good profit with these transactions are also very complicated, so you might wish to start with less complex types of arbitrage.
Depository Receipts Arbitrage. Depository receipts are similar to stock shares of foreign companies. For example, Sony is a Japanese company, and the shares of Sony that you purchase on NYSE are actually depository receipts, not stock shares.
When these shares are first released, they tend to be valued lower than the underlying stock. Over time, this gap tends to close.
Also, the depository receipts of some companies can be exchanged for the actual stock. This exchange is not possible however, for all companies, so be on the lookout for those you can exchange for a profit.
Dual-listed Companies. These are different businesses that agree to operate as one company but to also keep their stock listings separate. Frequently, one stock will be overpriced and the other will be underpriced. Over time, the stock prices tend to converge.
By purchasing the underpriced stock and shorting the overpriced stock, you can attempt to take advantage of both.

More Complex Arbitrage

Many other types of profitable arbitrage investing exist, but they are either very complex or beyond the scope of this article. You might want to pass these by at first when looking for arbitrage investing opportunities, at least until you become more skilled and confident with arbitrage investing. These types of arbitrage fall into this more complicated category:

Municipal Bond Arbitrage
Regulatory Arbitrage
Statistical Arbitrage

Now that you know the 3 conditions that lead to arbitrage opportunities and the various types of arbitrage, you can get busy and become an arbitrageur. Simple arbitrage opportunities do exist for the average investor that has the time and expertise to find them. The more complex arbitrage possibilities should probably be left to the pros. As with any investment, do your homework and be sure you know what you’re doing before putting any of your money at risk.


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