Arbitrage Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Arbitrage is the process whereby traders profit from price discrepancies between markets. Certain conditions must be met for arbitrage to occur. The profit opportunity must be a riskless one, meaning that the transactions (buying in one market and selling in the other) must occur as near to simultaneously as possible, and the prices at which the asset is traded are both known with certainty at the time of the trade. If these conditions are met, the trader will gain the profit without tying up any capital.

Arbitrage activities contribute to the “law of one price,” a fundamental economic assumption that an efficient market will ensure at any time only one price prevails for a particular asset. Arbitrage drives prices together and is implicit within the concept of a perfect market (another way of describing the “law of one price”). Buying increases demand for the cheaper asset forcing its price up, while the higher price in the other market falls as the cheaper asset is introduced into the supply to that market.

The English word arbitrage is derived from the French arbiter, meaning to umpire or referee and so, by extension, to resolve differences. Traders who perform these activities are arbitrageurs. In immature markets, opportunities for arbitrage will be greater than in mature markets with widespread access to information.

In practice, all trading activity involves transaction costs, even if only very small. For arbitrage profits, any transaction costs must be less than the difference between the two anomalous prices and known at the time of the trade. The profit will be the net value of the price differences less transaction costs. Examples of transaction costs might be dealing charges, or transaction taxes. There is rarely such a thing as an entirely riskless transaction. Even computerized trades of currencies, for example, will involve a transaction delay, even if only a matter of seconds, during which the opportunity may disappear.

Arbitrage is not speculation. Speculators take risks and expose themselves to changes in price of the assets in which they take a position. Their objective is profit but they are prepared to risk losses to make gains. Speculators back their own judgment and may misjudge the direction markets take. Arbitrageurs take a certain profit from temporary market price anomalies and in doing so will remove those anomalies. Some arbitrageurs are occasional opportunists, but others engage in the process full time. In efficient markets profits on arbitrage may appear to be small relative to the value of the transaction, but when adjusted to an equivalent annual return and taking into account the riskless nature of the profit, the return may be high. Many financial institutions conduct arbitrage operations on a regular basis. The scale of their operations means that a high volume of operations compensates for the low margins. By conducting their own in-house dealing operations scale economies minimize their transaction costs.

In the real economy, firms may practice price discrimination by segmenting buyers and charging different prices according to their different price elasticities of demand. Arbitrage may not be possible between the price segments because of barriers between them. For example, the recipient of a discount price could not sell at a smaller discount to the normal price to make a profit because of the supplier’s customer identity conditions. Thus a student could not sell a discount travel ticket to a full-fare-paying customer who had no student identification.

The principle of arbitrage is central to many important ideas in economics and financial theory. For example, arbitrage provides the logic for the “purchasing power parity” theory of international exchange rates. If prices in different countries are experiencing different rates of inflation, then exchange rates will alter to restore price parity. The Economist newspaper publishes a “Big Mac Index” based on the international price of hamburgers that identifies over or undervaluation of currencies based on this limited purchasing power comparison. Although the theory is inadequate as a full explanation of exchange rate movement, it sheds light on the importance of international price differences for the long-term path of a currency’s value.

“Interest rate parity” theory holds that the difference between future and spot (current) exchange rates reflects the differential between interest rates in the countries of the two currencies. Thus the practice of covered interest arbitrage seeks to take advantage of differences in interest rates in different countries while hedging (covering) the exchange rate exposure (risk of change) involved in dealing in a foreign currency. In the foreign exchange market, triangular arbitrage is a trading technique that exploits pricing anomalies between three currencies in different markets.

In markets for forward contracts (where two parties agree to a sale/purchase of a commodity or financial asset at some definite point in the future at an agreed price), the process of arbitrage ensures there is no difference between the current price of the asset and the forward price after allowing for the passage of time. In financial theory, the Modigliani and Miller propositions hold that all firms with the same potential earnings should sell at the same price, regardless of their capital structure, through arbitrage in the stock market. “Arbitrage pricing theory” has developed in recent years in an attempt to more accurately calculate the cost of capital for firms and their true value.

The term arbitrageur has been applied to entrepreneurs involved in the business of buying and selling companies or parts of companies and seeking a profit from perceived anomalies between the stock-market valuation of a company and the underlying value of the business. Regulatory arbitrage is the exploitation of variations in market regulations between countries.

Bibliography:

Madura, International Financial Management (Thomson South-Western, 2006);
L. Megginson and S. B. Smart, Introduction to Corporate Finance (Thomson South-Western, 2006);
Pilbeam, Finance and Financial Markets (Palgrave Macmillan, 2005).

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