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Arbitrage 

Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

Buying a specified item – whether FOREIGN EXCHANGE, stocks bonds, gold or silver bullion, bills of exchange, and less frequently grains and other commodities – or its equivalent in one market and simultaneously selling it for its equivalent in the same market, or in other markets, for the differential or spread prevailing at least temporarily because of conditions particular to each market.

Profits through arbitrage would be impossible if the prices of the currencies, commodities, or securities traded in were adjusted to exact parties.  Through the operation of world markets, there is an international price level for the principal commodities, foreign currencies, and international securities.  Each local market, however, such as New York or London, is affected by temporary disturbances and conditions, which will result in prices, after allowing for costs of transactions required in arbitrage, out of equivalence or parity.  When permitted by exchange restrictions and regulations, therefore, successful arbitrage transactions in foreign exchange consist of buying (or going long) in the weak market and simultaneously selling (technically going short, with delivery from the long position) in the strong market.  Besides permissive exchange regulations or complete freedom of exchange transactions, exchange arbitrage also depends upon efficient telegraphic or cable connections between the markets operated in, a knowledge of international price movements, capacity to make rapid computations in order to take advantage of frequently very temporary price conditions, and, finally, a large capital, because arbitrage profits are small in comparison with the amount of money involved.  Arbitrage houses in widely separated markets must be in constant communication and keep each other informed on market prices and trends.  Arbitrage transactions between two houses are usually conducted on a joint account basis, profits being equally divided between the engaging parties.

Foreign Exchange. 

Simple two-point arbitrage in foreign exchange may be illustrated by the following example.  Suppose that sterling is selling in New York at $2.395, but is available at $2.39 in London.  The arbitrage would be effected by selling sterling in New York for $2.395 and having a London bank or foreign exchange firm sell dollars in London for $2.39, to obtain the sterling needed for delivery in New York.  The gross profit ($0.05 per pound sterling) would be significant on a substantial transaction.  Such arbitrage transactions usually occur on the basis of cable rates, which are spot prices not tying up funds in forward or future funds.  The selling in the strong market would tend to lower prices there, and the buying in the weak market would tend to raise prices there, thereby tending to restore equivalence in rates.

Three-point arbitrage may be illustrated by the following.  Situation:  cable rate on pounds in New York, $2.40; Canadian dollars in New York, $1.00; cable rate on pounds in Toronto, $2.38.  Action:  sell pounds in New York for $2.40, buy $2.40 of Canadian dollars; then buy pounds in Toronto, costing only $2.38.  Net result:  $0.02 per pound profit, gross.

Arbitrage in Securities.  

Security arbitrage may occur in stock rights, convertible securities, exchange offers, reorganizations, mergers, and consolidations, both within one market and in multiple markets.  Arbitrage in securities “dually listed” (traded in on more than one registered national securities exchange) may also occur between different domestic exchanges, as well as in international securities markets.

Arbitrage in corporate takeovers, which have been numerous in recent years, typically takes the form of buying the acquiree’s stock upon announcement of the definite intention of the acquirer corporation to acquire the acquiree and selling short the stock of the acquirer corporation.  Such arbitrage is particularly likely if the acquirer corporation has “sweetened up” the offer for the acquiree above previously prevailing market prices or upon encountering competition for the takeover or regulatory or acquiree demurrer further sweetens up the offer.  The risk is that the acquisition might nevertheless fail to occur.  The speculation for takeover arbitrage nevertheless fail to occur.  The speculation for takeover arbitrage profits in recent years has been so high that in 1981 mere rumors of an acquisition offer for an oil company which did not materialize, led stampeding speculators to run the oil company’s stock to excessive levels from which it plummeted with a decline of 37.25 points in one day.  Reliable information and prompt action, as well as hedging methods (just in case the acquisition does not go through) to protect the arbitrage itself, such as use of options, are of the essence for professional arbitrageurs.

Arbitrage in the Money Market.  

The money market may also abound in opportunities for arbitrage, including such situations as yield spreads, yield patterns, and interest rate changes.

From an economic standpoint, the effect of arbitrage dealings is to correct maladjustments in the prices of foreign exchange, or securities, or commodities.  It is a force tending to equalize, i.e., establish parties among markets for the same item through competition of arbitrageurs.  For instance, when prices in one market tend to sag, advance until the equilibrium is restored.  Conversely, when the prices tend to advance out of line, arbitrageurs will offer freely, until prices recede to the level called for by equivalence.

BIBLIOGRAPHY

BALLARD, F.L., JR., ABCs of Arbitrage, 1988.
WERSWEILLEN, R., ed. Arbitrage, 1987.


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