Business, Legal & Accounting Glossary
Arbitrage is a financial transaction that involves a simultaneous purchase and sale of a given security or asset for the purpose of attaining the optimal profitability through yield differential. The synchronized buying and selling approach of arbitrage is best implemented when it takes place in different markets and exchanges. Thus, when arbitrage is employed, the purchase may be executed at one market, while the sale is done at another. An individual who engages in arbitrage is known as an arbitrageur, or merely an arb. An arbitrage investment strategy is sometimes referred to as a “risk-free profit” or “no beta profit” since an arbitrage position is completely hedged. That means that arbitrage guarantees the utmost performance of both sides of the transaction without risk or loss at the time the position is assumed. Arbitrage is an advance investment tactic based on arbitrage pricing theory. Emerging in the mid-seventies, arbitrage was devised as an alternative to CAPM (Capital Asset Pricing Model), which calculated the anticipated return by taking into account the rate of risk-free security and a risk premium.
Arbitrage is also used as a term that describes a leveraged speculative transaction or portfolio.
An investment strategy which attempts to profit by exploiting price differences between two or more different markets – the goal being risk-free profit at no cost. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.
Arbitrage is a type of transaction or portfolio. Actually, the term is used in two different ways, so it refers to either of two very different types of transactions or portfolios. People also speak of arbitrage as an activity—the activity of seeking out and implementing either of the two types of arbitrage transactions or portfolios. An arbitrageur is an individual or institution who engages in such arbitrage.
In finance theory, an arbitrage is a “free lunch” – a transaction or portfolio that makes a profit without risk. Suppose a futures contract trades on two different exchanges. If at one point in time, the contract is bid at USD 45.02 on one exchange and offered at USD 45.00 on the other, a trader could purchase the contract at one price and sell it at the other to make a risk-free profit of a USD 0.02.
Such arbitrage opportunities reflect minor pricing discrepancies between markets or related instruments. Per-transaction profits tend to be small, and they can be consumed entirely by transaction costs. Accordingly, most arbitrage is performed by institutions that have very low transaction costs and can make up for small profit margins by doing a large volume of transactions.
Formally, theoreticians define an arbitrage as a trading strategy that requires the investment of no capital, cannot lose money, and has a positive probability of making money.
Turning now to the second use of the term arbitrage, it is a usage that is shunned by theoretical purists. However, it has been in wide use for several decades, so it is fairly standard. According to this usage, an arbitrage is a leveraged speculative transaction or portfolio.
During the 1980s, junk bond financing funded an overheated mergers and acquisitions market. Arbitragers of this period were speculators who took leveraged equity positions either in anticipation of a possible takeover or to put a firm in play. They also engaged in greenmail. Ivan Boesky was a famous arbitrager from this period who was ultimately convicted of insider trading.
Today, the label arbitrage is often applied to the speculative trading strategies associated with hedge funds. These include
To distinguish between the two definitions of arbitrage, we might call them “true” arbitrage and “speculative” arbitrage. They are different, but in a sense, they represent two ends of a spectrum. In practice, true arbitrage is rare. There is always some risk—perhaps due to liquidity, the timing of offsetting transactions, or perhaps some credit exposure. If these “true” arbitrages become increasingly complicated or sophisticated, the subtle risks multiply. From there, it is a slippery slope to “speculative” arbitrage.
The notion of true arbitrage is profoundly important in financial engineering and theoretical finance. A market is said to have no arbitrage—or be arbitrage-free—if prices in that market offer no arbitrage opportunities. This is a theoretical condition that is usually assumed by economic and financial models. Much of the theory of asset valuation is based on the assumption that prices must be set in a consistent manner that affords no true arbitrage between them. This is called arbitrage-free pricing. A market in equilibrium must be arbitrage-free.
In practice, people don’t write about true arbitrage or speculative arbitrage. They just write about arbitrage. It is up to the reader to infer from context what type of arbitrage is being referred to. In a theoretical or financial engineering context, this is usually true arbitrage. In a trading or portfolio management context, it is usually speculative arbitrage. In a risk management context, it could be either—ask.
People from fields other than finance or economics sometimes confuse the two forms of arbitrage. I once helped a professor from an unrelated field who was writing a paper that mentioned arbitrage. He had read about the profound importance of arbitrage in finance theory but thought this was referring to the speculative arbitrage he had read about in books on hedge funds. Journalists are notorious for confusing the two. A former colleague, Kin Tam, once commented to me that journalists “write about [true] arbitrage as if it were something unconscionable.”
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This glossary post was last updated: 16th April, 2020 | 6 Views.