What is arbitrage and how does it work?
Originally the term arbitrage referred to the activity of simultaneously selling and buying a security at different geographical locations. Why would one do that? Well there’s a very simple answer. Before the development of the internet it was not that rare, that a share of a company traded for a different price in New York than it did in London. Therefore, a trader was able to make a risk free profit off of the price difference. To put it in other words, arbitrage is the pursuit of exploiting a price inefficiency.
Today price differences of identical securities are highly unlikely, that is why nowadays arbitrage traders buy and sell similar securities and hedge the disparities.
Arbitrage is a trade that exploits the price differences of identical or similar financial instruments on different markets or in different forms.
Arbitrage strategies aim to be market neutral; in other words, through a combination of different financial instruments the arbitrageur seeks to generate returns with minimal volatility. Market neutral strategies minimize market exposure by pursuing a beta of zero, meaning that performance is uncorrelated with the market. The targeted return is to be made solely through alpha, relating to the skill of the manager.
There are different market neutral strategies. The three most common ones are; fixed income arbitrage, convertible bond arbitrage and statistical arbitrage. All strategies work with highly complex securities, utilize derivative instruments and use leverage to generate more attractive returns.
An important principle of arbitrage is convergence. It is expected that the price mismatches will get offset over time, meaning that the price will come to an efficient level. This process however can sometimes take a long time. In such cases arbitrage traders have to wait until a profit can be realized. This is why arbitrage hedge funds often have a long lock-up period during which investors cannot redeem their invested capital.
Fixed income arbitrage
As the name suggests, fixed income arbitrage is an investment strategy that exploits price disparities between fixed income securities such as treasury bills, corporate bonds or municipal bonds.
Convertible bond arbitrage
Convertible bond arbitrage refers to strategies that aim to capitalize on inconsistencies between convertible bonds and their underlying stocks.
Statistical arbitrage is a heavily quantitative and computational approach to trading. It involves large numbers of securities and very short holding periods (sometimes not even one second).
Limits of arbitrage
One very prominent example of a fund that collapsed because of the limits of arbitrage is LTCM (Long-Term Capital Management). The fund placed huge bets on the convergence of the prices of certain bonds. These bond prices were guaranteed to converge in the long run. In the short term however, due to the East Asian crisis and the Russian government defaulting on its debt, panicked investors drove prices further apart. Overpriced but liquid securities became more expensive, and undervalued but illiquid securities became cheaper. This caused the fund to face margin calls. Since LTCM did not have enough liquidity to cover these calls, they were forced to close out their positions at huge losses. Additionally, because LTCM had a lot of imitator pursuing similar strategies, the divergence of prices further increased as these competitors simultaneously liquidated their positions. Consequently, the fund collapsed in the late 1990s.
As we can see, there is also risk involved in arbitrage strategies. Arbitrage traders depend on rational and efficient markets. This means that prices will converge over time and that any type of financial instrument can be sold or bought at any time. And of course arbitrage requires liquidity. Not only do markets need to be liquid, the fund depends heavily on its liquidity to ensure not being forced to close out positions at unfavorable times.