DeIinition and Examples oI Arbitrage Trading

Arbitrage, or true arbitrage, involves buying and selling a security and taking advantage oI
prices diIIerences that may exists on diIIerent markets. While rare, this does happen Irom
time to time. For example, suppose you Iind on eBay that someone is selling a brand new
iPod Ior $150 while the local store is buying the same iPods Ior $170. In theory, you can buy
all the iPods available on eBay and sell them all to the local store, pocketing $20 per music
player. Taking advantage oI this price inequality is the essence oI true arbitrage.
In the old days when computers weren`t as sophisticated, humans can spot these price
inequalities in Iinancial markets and take advantage oI them. However, complex programs
nowadays are able to spot these so quickly that it is extremely diIIicult to truly take advantage
oI this type oI risk less arbitrage without developing complex trading programs yourselI.
Risk Arbitrage
The good news is that with some added risk, everyone can still proIit Irom what`s known as
risk arbitrage. The major difference between true and risk arbitrage is that you are
trading a different security in the latter. The risk comes in because while the
two securities in question might be related, they are diIIerent and the relationship can change
at any point in time.
Another less obvious diIIerence between the two types oI arbitrages is that while true (or pure
as it is sometimes called) arbitrage takes place instantly (you buy and immediately sell it),
risk arbitrage can take days (iI not weeks or even months). This added time lapse is never
good, because as time goes on, there are more risk Ior the dynamics oI the relationship to
change.
Examples oI Risk Arbitrage
1. erger and Acquisition Arbitrage The most common type oI risk abitrage is the price
inequalities that is created when a merger or acquistion is announced. Typically when
this happens, the acquiring company`s stock price usually drops in case the deal doesn`t
go through, while the stock price oI the company being acquired shoots up close to the
oIIered price (usually at a siginiIicant premium to the current traded price). It is
interesting to note (and the key to proIiting Irom it) that while the stock price oI the
acquired company rises, it will never reach the Iull oIIered price because there is always a
risk oI the deal not happening. ThereIore, we can take advantage oI this by buying stock
oI the acquired company and as the deal becomes more likely, the stock will rise.
2. nterest Rate Arbitrage When you are able to borrow at a short term lower interest
rate and invest with higher interest rates long term, you are practicing arbitrage. Most
people aren`t able to take advantage oI this because these types oI arbitrate most exists in
inter-country rates. For example, many people Ior years have been taking advantage oI
the low interest rates in Japan loans to invest in the stock market.
3. utures Contracts and Derivatives Arbitrage Another common type oI artibrage
exists with options and all other derivatives related to the underlying stock price. While
these should all be in sync with the actual stock price, they oIten do not due to the supply
and demand nature oI all these investments trading in the open market. ThereIore, there
are many opportunities Ior us to proIit iI we can spot the dynamics oI the relationships.
4. unds Arbitrage Since mutual Iunds and ETFs all buy and sell assetsand at the same
time have a value, there are opportunities Ior arbitrages. For example, let`s say that you
were able to Iind a mutual Iund and ETFwith the exact same portIolio. In theory, their
price relationship should stay constant at all times. However, as ETFs are traded on the
open market and mutual Iunds are not, there could be times that enough oI a price
inequality exists Ior you to proIit. OI course, it is pretty much impossible to Iind a mutual
Iund and ETF that has the exact same portIolio, but people are able to proIit when more
complex models are used as long as the relationship oI the two Iunds are correlated and
predictable.
As long as a pricing relationship exists and are correlated, it can be a Iorm oI risk arbitrage.
ThereIore, there are in theory unlimited number oI arbitrages to proIit Irom. The key is to be
absolute certian that you understand the sometimes complex correlation.
What Does Arbitrage Trading Mean Ior Us
While it oIten seems like a great opportunity to proIit without much risk, arbitrage is
considered a more advanced Iorm oI investing and should only be considered iI you
understand exactly what the risks are. More oIten than not, investors underestimate the risks
involved and is caught oII guard when results don`t happen the way it was intended.
To be able to consistently proIit Irom arbitrage, having a deep understanding oI the securities
and pricing relationships involved is key.

interest arbitrage

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