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Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
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.
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
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.
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.
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.
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.
money market may also abound in opportunities for arbitrage, including
such situations as yield spreads, yield patterns, and interest rate changes.
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.
F.L., JR., ABCs of Arbitrage, 1988.