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The Risk Free World Of Arbitrage

 


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A respected dictionary published in 1993 does not include the word ‘arbitrage’. That is an indication that this item is a recent addition to the English language. The word ‘arbiter’ is listed as naming a person who has control of something.

This may be a good clue to the precise meaning of a word that is used in economic and financial circles to name the practice of taking opposite positions in two or more markets in order control risk and make profits from price imbalances whether a market rises or falls.

Globalization, the Internet and computer technology have made such financial gambits much more feasible than was the case in previous eras. However, the fundamental practice of hedging bets is probably very ancient, and possibly rooted in agriculture. Farmers have long fought battles with unpredictable weather patterns and have hedged bets by planting two different crops in case one fails.

In the twenty-first century markets are very complex. For example, though commodities like gold oil and corn are quite tangible they are traded in many different complex guises as derivative contracts. If buy and sell positions are taken simultaneously on instruments, price fluctuations might enable a trader to profit from both rises and falls in the short term. Of course he will never need to take delivery of tons of corn or pork bellies to store in his kitchen.

In academic circles the word may take on an even more arcane meaning, referring to obscure statistical methodology which in theory enables a trader to make a profit without taking any risk. This is any trader's dream but relatively few traders are able to get it quite right in practice.

However, some professional traders do manage to make huge profits with relatively little risk. In many cases this is done by employing very large sums of money at small risk, so that profits are inflated by leverage. Theoretically the practice should be entirely free of risk since one position is balanced by a matching one.

Since financial markets are complex it is not surprising that varieties of arbitrage practices have developed in different financial instruments. Funded by large financial institutions arbitrageurs can employ sophisticated mathematical and statistical methods to exploit opportunities and return higher profits than they pay in order to borrow money. This is how investment banks were, until recently, able to awe ordinary people by their expertise in making money as if by magic, taking home excessive bonuses.

Opportunities are not always present in every market. In fact, some people claim that they only exist when markets are not functioning ‘normally’. In other words arbitrageurs need to be alert for malfunctioning in order to profit from extreme rises or falls resulting in profitable opportunities.

As recent events have illustrated, Hamlet was correct in advising his friend that ordinary people may know little of the full complexity of the world. Unforeseen economic and political events can upset the seemingly secure money making methods of even the most adroit arbitrageurs, forcing them to grovel for hand outs from irate, taxpaying ‘little men’ who know hardly anything about arbitrage . It is important to understand that like short selling or option trading there are certain risks with these investments.

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