Arbitrage

What is Arbitrage?
Arbitrage, in its truest form, involves earning a riskfree profit without the outlay of any capital.

Arbitrage is only possible because of inefficiencies in

markets, typically inefficiencies in information
transfer/processing.

The typical process involves simultaneously

purchasing an undervalued asset and selling an

economically equivalent overvalued asset, in the
process obtaining a risk-less profit on the price
differential.

Examples of True Arbitrage

An over simplified example of arbitrage would be two

gold dealers located next to each other. In the first shop

gold is bought and sold at $400/oz., while the second
store buys and sells gold for $425/oz. An investor could
make a guaranteed risk-free profit of $25/oz. by
purchasing gold from the cheaper shop and selling it at
the more expensive shop next door.

A common, more realistic illustration of true arbitrage is

that of Triangular Currency Arbitrage. It involves a
situation with three currencies that are traded in
different markets. When the observed exchange rate of
a currency in one market is not consistent with the
cross-rate in another market, there exists a true
arbitrage opportunity.
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Example: Triangular Currency

Arbitrage
There are 3 currencies: $ (US Dollars), (pounds), (euros)

Quoted exchange rates:

New York: /$= 1.5
London:
/=1.4
Berlin:
/$= 2

The proper / cross-rate in New York is: 2/1.5= 1.33 /

Exploitable Mispricing = Arbitrage Opportunity

Example: Triangular Currency

Arbitrage

Reminder of FX rates: New York: /$= 1.5 London: /=1.4 Berlin:

/$= 2
Spend $1 to buy 1.5 in New
York

Return $0.05 risk-free

profit back home to New
York

With 2.1 buy $1.05 (= 2.1/2)

in Berlin

With 1.5 buy 2.1 (1.5x1.4)

in London

An astute investor would recognize the arbitrage opportunity here and spend
$1 to buy 1.5. They would then go to London and buy (1.5x1.4)= 2.1. They
would then go back to NY and buy ( 2.1/2)=$1.05. In the process they have
made a $0.05 risk-less profit.
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Arbitrage In Todays Market

As data flow has become quicker and cheaper, true risk-free
arbitrage investment opportunities have become a rarity and
quickly disappear when they do arise.

Instead, todays arbitrage strategies are often based upon

theoretical or implied value pricing inefficiencies. These strategies

usually use sophisticated models that determine when an
abnormally high risk-adjusted return can be generated.

Difference: Data alone isnt enough. One needs to process the data
into information based on complex models.

The main risk in these arbitrage strategies are in the valuation

model used. They can be inaccurate and are often dependant on

key assumptions taken by the models developers.

Hedge Funds dominate todays arbitrage market as they have the

expertise and resources needed to develop and apply the complex
strategies involved. As well, hedge funds can apply short selling
and other crucial techniques needed to implement arbitrage
strategies, that mutual funds cannot.
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Illustration of a Real Arbitrage

Opportunity

MERGER ARBITRAGE

Merger Arbitrage

Merger arbitrage capitalizes on

the differences between the terms
of a proposed merger between
two companies, and the relative
current market prices of the
companies involved in the merger.

Daimler Benzs Acquisition of Chrysler

Corp.
Target Company: Chrysler Corp.
Acquiring Company:
Daimler Benz
Transaction Announced:
May 6, 1998
Expected Close:
December 15, 1998
Merger Terms:
One (1) Chrysler share = 0.624 Daimler Benz shares

May 6, 1998
Purchase Target Companys Stock
One (1) share Chrysler @ $59.88
(closing price on May 6 = $59.88)

+$66.60
- $59.88
$ 6.72

Sell Short Acquiring Companys Stock

0.624 share Daimler Benz @ $106.73 = $66.60
(closing price on May 6 = $106.73)

December 15, 1998

Exchange 1 Chrysler share for .624 Daimler shares

Close out Daimler short position with the .624 Daimler shares received
Rate of return in 7.3 months is 11.06% (unleveraged) plus bank interest of $6.72
Annualized rate of return = 19% (approx.)

Economic Justification for Why Such an Opportunity Exists

Target company stock price shoots up

But there is still risk: Will merger be approved by

shareholders/regulators? Will Daimler balk for some

reason?

Price now reflects a probability of merger, but accurate

probability requires sophisticated modeling.

Typical asset manager (e.g. Pension/Mutual Fund

manager) made money, and is now unable to asses the

risk-premium now built into stock.

Leave last few $ on table for Merger Arbitrageur who

provides liquidity for fund managers exit.
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Some Other Common Arbitrage

Strategies
(Each Described in Appendix 2)
Asset-backed securities arbitrage
Capital structure arbitrage
Closed-end fund arbitrage (illustrated in Appendix 1)
Convertible arbitrage
Event arbitrage
Fixed income arbitrage
Mortgage-backed securities arbitrage
Options arbitrage
Statistical arbitrage
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Attractiveness of Arbitrage Strategies

Proper arbitrage strategies will also offer investors

abnormal risk-adjusted returns, providing higher

returns than the market, with lower risk and volatility.

Arbitrage strategies are also generally market neutral.

This means that the success of the strategy is not
dependant on movements in the overall market.

Arbitrage can thus provide portfolio diversification,

because the majority of strategies have very low
correlations with the general market.

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Historical Performance of Arbitrage

Strategies
Strategy

Annualized
Return since
inception

Correlatio
n with
MSCI
World ($)

Sharpe Ratio

Merger Arbitrage (since

1993)

7.89%

0.46

0.95

Convertible Arbitrage
(since 1994)

8.82%

0.12

1.03

Fixed Income Arbitrage

(since 1994)

6.66%

0.04

0.75

Market Neutral (multi

strategy) (since 1994)

10.10%

0.36

2.1

MSCI World ($) (since

1994)

7.71%

0.27

*Data from CSFB/Tremont Hedge Fund Index

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The Future of Arbitrage

The future of Arbitrage can be thought of as intertwined with the
future of the hedge funds that are its main proponent.

With the increasing size, number and success of hedge funds in

recent years it is likely that the use of arbitrage strategies will only
increase and in the process become less foreign to the average
investor.

Ironically, there is the possibility that the increased usage of

arbitrage strategies will actually cause its own demise. As more

and more fund managers look for arbitrage opportunities, those
available will increasingly disappear and become harder and
harder to find. Arbitrage takes advantage of market inefficiencies
and it is not impossible to envision a time in the future when these
inefficiencies will be removed and the market will hold true to the
market efficiency hypothesis.

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Appendix 1
Illustration of another Arbitrage
Strategy

CLOSED-END FUND ARBITRAGE

Closed-End Fund Arbitrage:

NAV/PRICE
A Closed-End Fund is an exchange-listed fund that

collects money from investors through an IPO and

then invests in a pool of assets, usually focused on a
particular security, sector or country.

Units may trade at a premium or discount to NAV in

response to investor sentiment.

Profit from closing the spread between the units

market price and its NAV

Buy units at a discount

Hedge out changes in the NAV

Pursue strategy to redeem at NAV

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Appendix 2

DESCRIPTIONS OF SOME OTHER

ARBITRAGE STRATEGIES

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Asset-Backed Securities Arbitrage

This strategy involves the purchase of odd-lot asset-backed

securities. Institutions purchase new issues in full-lot
allocations, then reduce them over time by amortizing the
assets. Odd lots trade at a discount to full lots because of a
lack of institutional appeal, and thus present profit
opportunities to the arbitrageur.

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Capital Structure Arbitrage

This strategy seeks securities within a companys capital

structure that are mispriced relative to similar or more junior
securities. Typically, equity holders are more optimistic than debt
holders. This creates opportunities to short over-valued equities
against under-valued debt. As well, the prices of debt
instruments of the same issuer and similar seniority will be
affected by differences in maturities or coupons. These price
differentials will be eliminated on a reorganization or bankruptcy,
providing opportunities to capture the spread between them.

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Closed-End Fund Arbitrage

One CEF arbitrage strategy focuses on yield-to-maturity
trades. Positions are acquired at a discount in funds that are
in the process of opening or closing. The long position in a
CEF is hedged with a basket of indexes and securities that are
highly correlated to the CEFs underlying portfolio.
A second CEF arbitrage strategy focuses on U.S. fixed income
CEFs and trades fixed income CEFs on a relative value basis.
This manager buys CEFs that it believes to be trading at an
extreme discount, and where it believes market forces may
reduce the discount and hedges by shorting fixed income
CEFs which it believes to be trading at an extreme premium.
Net duration exposure is hedged with Treasuries.

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Convertible Arbitrage
This strategy looks for mispricing between a convertible security
and the underlying stock. Convertible securities have a theoretical
value that is based on a number of factors, including the value of
the underlying stock. When the trading price of a convertible
moves away from its theoretical value, an arbitrage opportunity
exists. Hedge funds focusing on convertible arbitrage would
typically buy an undervalued convertible and sell the underlying
stock short in anticipation of either the stock moving down in value
to match the convertible, or the convertible moving up in value to
match the price of the stock. The movement of either the
convertible security or the underlying stock generates profit for the
hedge fund when the values of the two securities move towards
their intrinsic values, while the short sale of the underlying stock
helps to protect against stock specific and general market risk.
Certain convertible hedge fund managers make use of hedging
instruments to provide additional protection against credit risk.

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Event Arbitrage

Event-Driven Arbitrage takes advantage of opportunities that

arise as a result of events that could cause a change or
perception of change in a securitys value: material litigation,
technological breakthroughs or obsolescence, acquisitions or
divestitures, new management, proposed legislation, change
of research coverage, or any event that could cause a change
or perception of change in a securities value.

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Fixed Income Arbitrage

Fixed Income Arbitrage involves the purchase and

simultaneous short sale of fixed income or debt securities.
Fixed income arbitrage strategies include mortgage-backed
securities arbitrage, basis trading, international credit spread
trading, calendar spread trading, yield curve arbitrage,
intermarket spread trading, and rate cap hedging.

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Mortgage-Backed Securities
Arbitrage
Mortgage-Backed Securities Arbitrage is a subset of fixed
income arbitrage. The strategy generally involves the
purchase of mortgage-backed securities and the short sale of
other fixed income securities of the same term, such as
government bonds.

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Option Arbitrage
Option Arbitrage commonly refers to an equity trading
strategy utilizing options, such as calls, puts, and warrants.
The value of an option and the way it is priced in the market
is based on sophisticated pricing models involving a number
of variables including volatility, share price, exercise price,
time to option expiration, and the risk free rate. Volatility is a
measure of the tendency of a market price or yield to vary
over time. As volatility is usually the only variable not known
with certainty in advance, arbitrage opportunities may arise
when the theoretical and market values of volatility differ.
Volatility traders profit from the difference between the
volatility priced into an option and the volatility actually
realized in the market. The strategy involves buying options
deemed to be under priced on a volatility basis and selling
overpriced options.

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Statistical Arbitrage
Short-term pricing misalignments in financial instruments
occur daily. These divergences are typically small and of
short duration, and the costs of execution would normally
offset the potential profit. Statistical arbitrage managers use
proprietary models to identify securities that are mispriced
relative to other securities with similar trading
characteristics. The source of return is the models ability to
use available information efficiently while maintaining very
low execution costs. By tracking a vast number of market
inefficiencies simultaneously, the aim is to exploit several
such inefficiencies to generate returns in excess of
transaction costs.

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