Arbitrage

(redirected from arbitrages)
Also found in: Dictionary, Thesaurus, Financial, Encyclopedia.
Related to arbitrages: arbitrageurs

Arbitrage

The simultaneous purchase in one market and sale in another of a security or commodity in hope of making a profit on price differences in the different markets.

In its simplest form, arbitrage is "buying low and selling high." In this sense, any trader who buys something in one market—whether it is a commodity like grain, financial Securities such as stock in a company, or a currency such as the Japanese yen—and sells it in another market at a higher price is engaged in arbitrage. That trader is called an arbitrageur. In economic theory, arbitrage is a necessary activity in any market, helping to reduce price disparities between different markets and to increase a market's liquidity (ability to buy and sell).

Arbitrage can be divided into the categories of riskless and risk. As an example of riskless arbitrage, imagine that the price of Microsoft Corporation common stock on the Pacific Coast Stock Exchange is less than the price of the same stock on the New York Stock Exchange. A trader who buys Microsoft stock at the lower price on the Pacific Coast exchange and simultaneously sells it for a higher price on the New York exchange is engaging in an essentially riskless transaction. Aided by the speed of modern communications, the buying and selling occur at virtually the same time. This type of exchange occurs daily in the currency market, where a trader may buy French francs at a lower price in London and sell them at a higher price in Singapore.

Much arbitrage falls into the risk category. This type of arbitrage is not always completed with a sale at a higher price; it involves a risk that the price of the item being traded will fall before the trader can sell it. Risk Arbitrage came into prominence during the 1980s, when investors began to take advantage of a business atmosphere encompassing a large number of company Mergers and Acquisitions. In a merger or acquisition, one company buys or takes over another company. When the management of the targeted company does not want to be acquired by a particular investor or group of investors, the merger is called a hostile takeover. Quite often, the aggressors in such takeovers are smaller in terms of assets than their targets. A hostile takeover is usually initiated when someone believes that the stock of a particular company is lower than its potential value, whether because of poor management or because of a lack of information about the true value of that company.

One way that hostile takeovers are initiated is through a device called the cash tender offer. The party attempting to initiate the takeover announces that it will pay cash for the target company's stock at a price well above the current market value. At this point, risk arbitrageurs become involved in the game. They buy stock from shareholders in the target company, then attempt to sell that stock at the higher price to the party attempting the takeover. If the takeover succeeds and the arbitrageurs receive a higher price for their stock, they profit; if the takeover fails or the arbitrageurs receive a lower price for their stock, they lose. Gauging the risk of a takeover's failure is therefore crucial to an arbitrageur's success.

An arbitrageur who purchases securities on the basis of inside information—that is, information about a pending takeover that is not available to the general public—violates the Securities Exchange Act of 1934 (§ 10[b], as amended, 15 U.S.C.A. § 78j[b]). However, purchasing securities on the basis of rumors about an imminent takeover is not illegal.

Ivan F. Boesky was one example of a risk arbitrageur who was found guilty of engaging in insider trading. Boesky profited enormously from the many corporate takeovers of the mid-1980s. By 1985, he had become famous in financial circles and had published a book, Merger Mania: Arbitrage: Wall Street's Best Kept Money-Making Secret, that extolled the opportunities in risk arbitrage and the benefits the practice gave to the market. In 1986, only one year later, Boesky admitted that he had illegally traded on insider information obtained from Drexel Burnham Lambert, the securities firm that arranged the financing of many of the takeovers of the era. In return for a reduced sentence of three years in prison, Boesky agreed to pay a $100 million penalty and to cooperate with the government's continuing investigation. Boesky named Drexel employee Michael R. Milken as a member of the insider trading network. In 1990, Boesky was released from prison after serving two years.

Further readings

Boesky, Ivan. 1985. Merger Mania. New York: Holt, Rinehart.

"Complex Plan of Finance Successfully Navigates Arbitrage Rules." 2003. Tax Management Memorandum 44 (February 10): 60–61.

Steuerle, Gene. 2002. "Defining Tax Shelters and Tax Arbitrage." Tax Notes 95 (May 20): 1249–50.

Stokeld, Fred. 2001. "IRS on the Prowl for Illegal Arbitrage. Tax Notes 92 (September 10): 1396–98.

Cross-references

Bonds "Michael R. Milken" (sidebar); Corporations; Securities; Securities and Exchange Commission.

See: adjudication, arbitration, collective bargaining, intercession
References in periodicals archive ?
Arbitrage is not gambling; rather it is creating value in volatile markets so that investment risks are measures and rewarded.
It becomes easier to look at options and barriers to apply arbitrage to inner city assets by examining them thought the prism of established markets and how they parallel inner city asset classification.
Arbitrage depends on the spreads or differences between purchase and re-sale.
One of the best ways to express the arbitrage risk model is to show how to calculate or measure risks.
Luckner (2008) finds that there exist virtually few substantial pure arbitrage opportunities regarding market predictions; and the achieving the forecast accuracy highly depends on the selection of appropriate measures.
Current Debates about CIRP Validity and Arbitrage Effectiveness
Japanese Yen" CIRP deviations have substantially lost their statistical significance since 2000, which implies the diminishing of covered interest arbitrage opportunities between the US and Japan.
2011) test the CIRP validity for BRIC nations, showing that profitable arbitrage opportunities do exist in those emerging economies during the early 2000s, but remain very limited due to transaction costs and regulative policies in their currency and capital markets.
Despite attention from governments, international organizations, and academics, the issue of international tax arbitrage has proven a difficult and at times intractable one.
Harnessing the costs of international tax arbitrage will not always be the appropriate response to every particular international tax arbitrage transaction, but it should be considered when other, more traditional responses prove inadequate.
1) For example, in statements to the Tax Section of the American Bar Association, Hal Hicks, Internal Revenue Service (Service) associate chief counsel (international), stated that "[p]ractitioners should expect the Service to focus on international tax arbitrage during 2006, especially on how U.
3) The primary reason why this aspect is unique to international tax arbitrage as opposed to other conflicts of laws, such as the overlap of U.