What Is Arbitrage?

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What Is Arbitrage?

  1. Technically, arbitrage consists of purchasing a commodity or security in one market for immediate sale in another market (deterministic arbitrage).
  2. Popular usage has expanded the meaning of the term to include any activity which attempts to buy a relatively underpriced item and sell a similar, relatively overpriced item, expecting to profit when the prices resume a more appropriate theoretical or historical relationship (statistical arbitrage).
  3. In trading options, convertible securities, and futures, arbitrage techniques can be applied whenever a strategy involves buying and selling packages of related instruments.
  4. Risk arbitrage applies the principles of risk offset to mergers and other major corporate developments. The risk offsetting position(s) do not insulate the investor from certain event risks (such as termination of a merger agreement on the risk of completion of a transaction within a certain time) so that the arbitrage is incomplete.
  5. Tax arbitrage transactions are undertaken to share the benefit of differential tax rates or circumstances of two or more parties to a transaction.
  6. Regulatory arbitrage transactions are designed to provide indirect access to a risk management market where one party is denied direct access by law or regulation.
  7. Swap driven arbitrage transactions are motivated by the comparative advantages which swap counter-parties enjoy in different debt and currency markets. One counterparty may borrow at a relatively lower rate in the intermediate or long term United States dollar market, while the other may have a comparative advantage in floating rate sterling.

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