Financial arbitration: what it is – Dictionary of Economics

Financial arbitrage concept

Operations carried out to take advantage of situations of inefficiency in the markets. It is about taking advantage of the differences in the listing of securities that in some sense can be considered similar and that are listed on the same stock exchange, or of the same security that is listed on different stock exchanges. Arbitration can also be done in the derivatives market, in the fixed income market, between the derivatives market and the cash market, between the primary and secondary markets… The arbitrageur will sell the most expensive and will buy the cheapest, with which the possible inefficiency ends up disappearing, or being reduced to the limit of the transaction costs.

Arbitration is possible when at least one of the following conditions is met:

– The same asset is not sold at the same price in different markets.

– Two assets that produce the same cash flow are not transferred at the same price.

– An asset with a known price in the future is not sold today at its discounted future price at the risk-free rate of interest.

Types of arbitration

Merger Arbitrage: Also called risk arbitrage, merger arbitrage involves buying the stock of one company that will be bought by another, while taking a short position in the stock of the buying company. Usually the market price of the company that is bought is less than the price offered by the company that buys it. This difference between the two prices depends on the probability and the time in which the purchase is made. Also, usually the price of the share of the company that buys the other company falls, so the short sale produces a profit. The bet in merger arbitrage is that the price difference will eventually be zero when the purchase is completed. The risk, of course, is that the merger deal between the companies breaks down and therefore the price difference expands massively.

Convertible bond arbitrage: A convertible bond is a bond that can be returned to the issuing company in exchange for a predetermined number of shares. A convertible bond can be viewed as a corporate bond with a call option on a share. The price of a convertible bond is sensitive to three main factors:

– Interest rate. When rates go up, the convertible portion of a convertible bond tends to go down, but the bond’s call option appreciates. The bond as a whole is trending down a bit.

– Share price. When the convertible bond’s share price rises, the price of the bond tends to rise as well.

– ‘Spread’ of credit. If confidence in the company issuing the bond falls (due to a downgrade in the rating, for example) and the credit spread widens, the price of the bond tends to fall, but in some cases, the call option on the stock rises (since the spread is correlated with volatility).

Due to the complexity and structure of a convertible bond, arbitrators often employ sophisticated quantitative models to identify bonds that are actually priced at less than their fair value. Convertible bond arbitrage involves buying a convertible bond and hedging two or three of the factors to gain exposure to the third factor at an attractive price. For example, an arbitrator might first buy a convertible bond, then sell fixed-income instruments or interest rate futures (to hedge interest rate exposure) and buy credit protection (to hedge against a potential deterioration in the issuer’s rating). ). Eventually, what you are left with is something akin to a call option on the convertible bond stock, purchased at a very low price. The arbitrator can then make money by selling some of the most expensive trading options on the market.

Depository receipts: An American Depositary Receipt is an instrument that is offered as a share of a foreign company in the local market. For example, a Chinese company that wants to raise more money in a stock issue can issue depository receipts on the New York Stock Exchange and thus gain access to funds from the North American market. These instruments, known as American Depository Receipts or Global Depository Receipts, are initially traded at less than the real value because they are from foreign companies. However, in reality, an ADR can be exchanged for a normal share of the issuing company, for the same value in which the latter is traded. If a company’s ADR is trading for less than the company’s stock, an arbitrator can buy an ADR and sell it immediately, making a profit on the price difference.

Interest rate arbitrage: In interest rate arbitrage, an investor takes advantage of a foreign debt instrument that pays an interest rate higher than that offered in the local market. At the same time that the investor buys this foreign debt instrument, he hedges the exchange rate risk through a futures contract.