Arbitrage

What Is Arbitrage?

Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset's listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms. Arbitrage exists as a result of market inefficiencies and it both exploits those inefficiencies and resolves them. An example of this simultaneous buying and selling of an asset while taking advantage of any price disparity, could involve the purchase of gold, which for instance, is sold in the US, the UK, Tokyo, and a host of other national exchange: then selling it on a different exchange.

Another possibility could be to enter into a private transaction with someone for an asset that has an established market to liquidate it on, or a separate willing buyer, that is offering a higher price.

A non-financial asset example of a private sale:

Say you are out with the family or friends, and you come across a rummage sale. On a whim, you happen to stop and do a spot of shopping. While doing so, you come across a vase that you recognize to be antique and quite valuable. The rummage sale operator is only asking $25.00 for it, and after a bit of haggling, you pay $20.00. As you know what the vase is, what it is truly worth, and know exactly where to sell it, you have taken your $20.00 purchase, and sold it for $200.00.

A financial example of a private sale:

Your friend John, whom you have known from your club for many years has gotten himself in a bit of a financial bind. He asks you, quite confidentially, if you would be willing to buy his holdings in XYZ stock at a discount from its current market price.

You know that John is not employed by the company he is looking to sell stock in, nor is he affiliated with it. As the discount he is offering is generous - 10% - you tell him, yes. You then conclude this private transaction, and then sell it the following week, making a tidy 10% profit for yourself.

Remember: there is no rule that states you must purchase or sell assets, of any kind, through a broker or an exchange. Two or more people are more than allowed to conclude any legal business transaction that they so desire.

Understanding Arbitrage

Arbitrage can be used whenever any stock, commodity, or currency may be purchased in one market at a given price and simultaneously sold in another market at a higher price. The situation creates an opportunity for a risk-free profit for the trader. Arbitrage provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods of time. With advancements in technology, it has become extremely difficult to profit from pricing errors in the market. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly, and the opportunity is eliminated, often in a matter of seconds.

A Simple Arbitrage Example

As a straightforward example of arbitrage, consider the following. The stock of Company X is trading at $20 on the New York Stock Exchange (NYSE) while, at the same moment, it is trading for $20.05 on the London Stock Exchange (LSE). A trader can buy the stock on the NYSE and immediately sell the same shares on the LSE, earning a profit of 5 cents per share. The trader can continue to exploit this arbitrage until the specialists on the NYSE run out of inventory of Company X's stock, or until the specialists on the NYSE or LSE adjust their prices to wipe out the opportunity. Types of arbitrages include risk, retail, convertible, negative, statistical, and triangular, among others.

A Complicated Arbitrage Example

A trickier example can be found in triangular arbitrage. In this case, the trader converts one currency into another at one bank, converts that second currency to another at a second bank, and finally converts the third currency back to the original currency at a third bank. Each of the banks would have the information efficiency to ensure that all of its currency rates were aligned, thus requiring the use of three financial institutions for this strategy. For example, assume you begin with $2 million. You see that at three different institutions the following currency exchange rates are immediately available:

First, you would convert the $2 million to euros at the 0.894 rate, giving you 1,788,000 euros.
Next, you would take the 1,788,000 euros and convert them to British pounds at the 1.276 rate, giving you 1,401,254 pounds.
Next, you would take the pounds and convert them back to U.S. dollars at the 1.432 rate, giving you $2,006,596.
Your total risk-free arbitrage profit would be $6,596.

What Is Arbitrage, Again?

Arbitrage is trading that exploits the tiny differences in price between identical assets in two or more markets. The arbitrage trader buys the asset in one market and sells it in the other market at the same time in order to pocket the difference between the two prices. There are more complicated variations in this scenario, but all depend on identifying market "inefficiencies." Arbitrageurs, as arbitrage traders are called, are usually working on behalf of large financial institutions or funds. It usually involves trading a substantial amount of money, and the split-second opportunities it offers can be identified and acted upon only with highly sophisticated software.

Why Is Arbitrage Important?

In the course of making a profit, arbitrage traders enhance the efficiency of the financial markets. As they buy and sell, the price differences between identical or similar assets narrow. The lower-priced assets are bid up while the higher-priced assets are sold off. In this manner, arbitrage resolves inefficiencies in the market’s pricing and adds liquidity to the market. This is why arbitrage is important to the markets as a whole. To the Fund, and many others, it is important because profit can be earned simply by identifying these disparities, and through the orderly liquidation of assets into another asset class.

How Does This Apply?

As the “long-winded” explanation and examples above are all completely accurate and detailed, the question that remains is what does it have to do with how fund(s) (SPV’s - Special Purpose Vehicles) generate profit?

The answer:

For one form of asset, specifically a Standby Letter of Credit (SBLC):