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. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  2. Trading

    Covered Interest Arbitrage

    Covered interest arbitrage is a trading strategy in which an investor uses a forward currency contract to hedge against exchange rate risk.
  3. Investing

    Arbitrage Opportunities in Spread Betting

    While the opportunities are few and far between, investors may use arbitrage to take advantage of price differences in financial spread betting.
  4. Trading

    Make Money Through Risk Arbitrage Trading

    Risk arbitrage provides a valuable trading strategy for M&A or other corporate actions eligible stocks. Investopedia explains how it works.
  5. Investing

    3 Mutual Funds Focusing on Arbitrage Profits (MERFX, ARBFX)

    Get details on three of the most popular mutual funds for investors interested in arbitrage trading.
  6. Investing

    How ETF Arbitrage Works

    ETF arbitrage brings the market price of ETFs back in line with net asset values when divergence happens. But how does ETF arbitrage work?
  7. Investing

    Hedge Funds Hunt For Upside, Regardless Of The Market

    Hedge funds seek positive absolute returns, and engage in aggressive strategies to make this happen.
  8. Investing

    Conversion Arbitrage

    This stock/options combination helps traders take advantage of market mispricing. Find out how.
  9. Trading

    Trade Takeover Stocks With Merger Arbitrage

    This high-risk strategy attempts to profit from price discrepancies that arise during acquisitions.
  10. Investing

    Arbitrage Pricing Theory: It's Not Just Fancy Math

    What are the main ideas behind arbitrage pricing theory? We provide a simple explanation of the model and how to use it.
Frequently Asked Questions
  1. Do interest rates increase during a recession?

    Learn why interest rates do not rise in a recession; in fact, the opposite happens. Identify the factors that reduce interest ...
  2. What is the difference between deflation and disinflation?

    Learn what deflation and disinflation are, how supply and demand affect price levels, and the difference between deflation ...
  3. What rights do all common shareholders have?

    Learn what rights all common shareholders have, and understand the remedies that can be taken if those rights are violated ...
  4. What does CHIPS UID mean?

    Learn what CHIPS UID stands for and how it facilitates the transfer of funds as the back-end of the ACH network for both ...
Trading Center