Complete Guide To Investment Companies, Funds And REITs

AAA

Hedge Funds - Arbitrage Strategies

Arbitrage is the exploitation of an observable price inefficiency and, as such, pure arbitrage is considered riskless. Consider a very simple example: Acme stock currently trades at $10 and a single stock futures contract due in six months is priced at $14. The futures contract is a promise to buy or sell the stock at a predetermined price. So, by purchasing the stock and simultaneously selling the futures contract, you can, without taking on any risk, lock in a $4 gain before transaction and borrowing costs.

In practice, arbitrage is more complicated, but three trends in investing practices have opened up the possibility of all sorts of arbitrage strategies: the use of derivative instruments, trading software and various trading exchanges. For example, electronic communication networks and foreign exchanges make it possible to take advantage of "exchange arbitrage," the arbitraging of prices among different exchanges.

Only a few hedge funds are pure arbitrageurs, but when they are, historical studies often prove they are a good source of low-risk, reliably-moderate returns. But, because observable price inefficiencies tend to be quite small, pure arbitrage requires large, usually leveraged investments and high turnover. Further, arbitrage is perishable and self-defeating; if a strategy is too successful, it gets duplicated and gradually disappears.

Most so-called arbitrage strategies are better labeled "relative value." These strategies do try to capitalize on price differences, but they are not risk free. For example, convertible arbitrage entails buying a corporate convertible bond, which can be converted into common shares while simultaneously selling short the common stock of the same company that issued the bond. This strategy tries to exploit the relative prices of the convertible bond and the stock; the arbitrageur of this strategy would think the bond is a little cheap and the stock is a little expensive. The idea is to make money from the bond's yield if the stock goes up, but to also make money from the short sale if the stock goes down. However, as the convertible bond and the stock can move independently, the arbitrageur can lose on both the bond and the stock, which means the position carries risk.

Related Readings:

Event-Driven Strategies
Related Articles
  1. Active Trading Fundamentals

    How Hedge Funds Front-Run Index Funds to Profit

    Understand what front running is, and learn how hedge funds use this investing strategy to profit from the anticipated stock buys of index funds.
  2. Mutual Funds & ETFs

    Top 5 Chinese Mutual Funds

    Learn about some of the most popular and best performing mutual funds that offer investors exposure to the important emerging market economy of China.
  3. Mutual Funds & ETFs

    ETF Analysis: Schwab US Large-Cap

    Discover how the Schwab U.S. Large-Cap exchange-traded fund is managed, the index it tracks and the investors for which it is most appropriate.
  4. Mutual Funds & ETFs

    ETN Analysis: Rogers Intl Commodity Energy Total Return

    Learn more about the Rogers International Commodity Total Return, which is an exchange-traded note that tracks a broad index of commodity futures.
  5. Investing Basics

    What is a Settlement Date?

    A settlement date is the day a security trade must be settled.
  6. Investing Basics

    Explaining Risk-Adjusted Return

    Risk-adjusted return is a measurement of risk for an investment or portfolio.
  7. Investing

    Five Things to Consider Now for Your 401(k)

    If you can’t stand still, when it comes to checking your 401 (k) balance, focus on these 5 steps to help channel your worries in a more productive manner.
  8. Fundamental Analysis

    Calculating Return on Net Assets

    Return on net assets measures a company’s financial performance.
  9. Mutual Funds & ETFs

    ETF Analysis: ProShares UltraPro Nasdaq Biotech

    Obtain information about an ETF offerings that provides leveraged exposure to the biotechnology industry, the ProShares UltraPro Nasdaq Biotech Fund.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI Europe Financials

    Learn about the iShares MSCI Europe Financials fund, which invests in numerous European financial industries, such as banks, insurance and real estate.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Derivative

    A security with a price that is dependent upon or derived from ...
  3. Real Estate Investment Trust - ...

    A REIT is a type of security that invests in real estate through ...
  4. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  5. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  6. Dividend Yield

    A financial ratio that shows how much a company pays out in dividends ...
RELATED FAQS
  1. Where do penny stocks trade?

    Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>
  2. Where can I buy penny stocks?

    Some penny stocks, those using the definition of trading for less than $5 per share, are traded on regular exchanges such ... Read Full Answer >>
  3. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  4. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  5. How are American Depository Receipts (ADRs) priced?

    The price of an American depositary receipt (ADR) is determined by the bank or other financial institution that issues it. ... Read Full Answer >>
  6. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!