Can you smart guys explain to me

[Archaea]

some fundamental principles of arbitrage.

What are the fundamental assumptions? From what very little I know it involves the exchange of interest rates, but perhaps that's too simplistic.

Are there any good reads on the subject?

[BYU71]

some fundamental principles of arbitrage.

What are the fundamental assumptions? From what very little I know it involves the exchange of interest rates, but perhaps that's too simplistic.

Are there any good reads on the subject?

When the two Stanford Nobel Economics winners put together Long Term Capital and raised billions to do arbitrages, I thought I might read what they had to say on the subject.

Before I could get to reading their stuff though they had lost billions and caused some real financial panics in the late 90's.

I then decided I would just resign myself to the fact that I could never figure it out.

[Archaea]

When the two Stanford Nobel Economics winners put together Long Term Capital and raised billions to do arbitrages, I thought I might read what they had to say on the subject.

Before I could get to reading their stuff though they had lost billions and caused some real financial panics in the late 90's.

I then decided I would just resign myself to the fact that I could never figure it out.

I have some clients who claim to be experts in the field, and I just do the documents for certain organizational matters. But it bugs me I can't figure out what they're doing.

Can you at least explain some of the theories.

[jay santos]

http://en.wikipedia.org/wiki/Arbitrage

example, you bet on BYU +5, the line moves to BYU even. at that point you bet against BYU. if there are no transaction costs, you break even if BYU loses by more than 5 or wins, but you win if BYU wins by 1-5.

[Archaea]

This part is what concerns me.

Arbitrage transactions in modern securities markets involve fairly low risks. Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. There is also counter-party risk, that the other party to one of the deals fails to deliver as agreed; though unlikely, this hazard is serious because of the large quantities one must trade in order to make a profit on small price differences. These risks become magnified when leverage (http://en.wikipedia.org/wiki/Leverage_%28finance%29) or borrowed money is used.
Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable. In the extreme case this is risk arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses.
Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk position.
In the 1980s, risk arbitrage (http://en.wikipedia.org/wiki/Risk_arbitrage) was common. In this form of speculation (http://en.wikipedia.org/wiki/Speculation), one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current price—if the merger goes through as predicted. Traditionally, arbitrage transactions in the securities markets involve high speed and low risk. At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act). When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing the risk is through the illegal use of inside information (http://en.wikipedia.org/wiki/Insider_trading), and in fact risk arbitrage with regard to leveraged buyouts (http://en.wikipedia.org/wiki/Leveraged_buyout) was associated with some of the famous financial scandals of the 1980s such as those involving Michael Milken (http://en.wikipedia.org/wiki/Michael_Milken) and Ivan Boesky (http://en.wikipedia.org/wiki/Ivan_Boesky).

[BYU71]

I have some clients who claim to be experts in the field, and I just do the documents for certain organizational matters. But it bugs me I can't figure out what they're doing.

Can you at least explain some of the theories.


Stock X is being bought out at $40 a share. However it is currently trading at $39.50. An abitrager will step in and buy the stock at $39.50. He will have to factor in how long before the deal closes and the interest he could have made on the $39.50 vs the .50 gain.

It can get a lot more complicated when you have supposed imbalances in currencies, interest rates, futures , etc.

[Indy Coug]

IIRC (and it's been a few years now), if you believe in an efficient market, then arbitrage doesn't exist, or at least it is nearly impossible to correctly identify arbitrage opportunities and realize a gain on them.

[Archaea]

Stock X is being bought out at $40 a share. However it is currently trading at $39.50. An abitrager will step in and buy the stock at $39.50. He will have to factor in how long before the deal closes and the interest he could have made on the $39.50 vs the .50 gain.

It can get a lot more complicated when you have supposed imbalances in currencies, interest rates, futures , etc.

Because trades are not simultaneous and you're banking on a small difference in different markets, you have to buy a lot to make enough?

And if any party fails to perform and you have borrowed money, you're screwed?

[BYU71]

This part is what concerns me.

Where some of them have gotten out of control is when they think they have developed some super cool model. When the yen does such, interest rates do such. When oil does such, foreign currencies do such and on and on. These models can get very complicated.

If they work the difference you pick up is small, but done at such a grand scale you make huge sums of money. If it is working they can acquire more investors capital and even get banks to loan money and bet margin. At one point I think Long Term Capital had $6 billion of investor money in the deal and over $130 billion in borrowed money.

Here is how something could come unraveled. Take my simple Stock example. Arbitrager buys at $39.50. He also borrows to do it because the numbers work out and the more he has the better .50 a share will make him.

Hic cup occurs. Buying company has an SEC problem. Deal falls apart. Stock now at $35 a share and margin calls are coming. The more he gets margin calls, the more stock he is forced to put on the market and the stock falls further. Eventually he loses all his money and a lot of the lenders money.

[BigFatMeanie]

Where some of them have gotten out of control is when they think they have developed some super cool model. When the yen does such, interest rates do such. When oil does such, foreign currencies do such and on and on. These models can get very complicated.

If they work the difference you pick up is small, but done at such a grand scale you make huge sums of money. If it is working they can acquire more investors capital and even get banks to loan money and bet margin. At one point I think Long Term Capital had $6 billion of investor money in the deal and over $130 billion in borrowed money.

Here is how something could come unraveled. Take my simple Stock example. Arbitrager buys at $39.50. He also borrows to do it because the numbers work out and the more he has the better .50 a share will make him.

Hic cup occurs. Buying company has an SEC problem. Deal falls apart. Stock now at $35 a share and margin calls are coming. The more he gets margin calls, the more stock he is forced to put on the market and the stock falls further. Eventually he loses all his money and a lot of the lenders money.

That "hiccup" occurring is exactly what Indy's risk article talked about. It's the difference between Mediocristan and Extremistan.

[Flystripper]

some fundamental principles of arbitrage.

What are the fundamental assumptions? From what very little I know it involves the exchange of interest rates, but perhaps that's too simplistic.

Are there any good reads on the subject?

Arbitrage is riskless profit of any kind. What kind of arbitrage are you wondering about? Interest rate? Exchange rate? With transaction costs and efficient global markets true arbitrage is nearly impossible.

[hyrum]

Stock X is being bought out at $40 a share. However it is currently trading at $39.50. An abitrager will step in and buy the stock at $39.50. He will have to factor in how long before the deal closes and the interest he could have made on the $39.50 vs the .50 gain.

It can get a lot more complicated when you have supposed imbalances in currencies, interest rates, futures , etc.

This is the arbitrage I am most familiar with. They have to factor in whether the deal might fall trhough, whether there might be another bidder, etc. If its rock solid that there is no other bidder, the price will hold, and the deal will close, it is just a matter of the "time value of money". The arbitrage is just to give the seller his money today for a transaction that will close, and pay in cash, in the future. That difference should be on the order of the margin rate times the time difference.

There are other arbitrages, say seeing a low offer on a stock or currency in one market then turnaround and selling it at a better bid in another country or on another exchange. Of course once that is done the markets will often move back into alignment. I think it would be rare for an individual to regularly make money in such a fashion because the differences are rather small and the retail commisions and bid/ask spreads would eat up your potential profits.

[Indy Coug]

That "hiccup" occurring is exactly what Indy's risk article talked about. It's the difference between Mediocristan and Extremistan.

I'm glad you liked that article. :)

Contingencies is a fantastic magazine and I highly recommend it to everyone. You can read it online:

http://www.contingencies.org/

[BYU71]

That "hiccup" occurring is exactly what Indy's risk article talked about. It's the difference between Mediocristan and Extremistan.


I don't read articles because I already know it all.