All Financial Wisdom

Financial Arbitrage Explained (part 2)

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Please see Part 1 before reading this…

Risks

Arbitrage transactions in modern financial markets usually suffer from low risk. Despite efficiencies in electronic transactions, it is almost impossible to close two or more transactions at the same time; Therefore, there is a possibility that when a part of the deal is closed, rapid price change makes it impossible to close the other party with a profit. There is also a risk that the counterpart of the deal will not comply. This risk is particularly important because in order to execute profitable arbitrage, the amounts to be transacted must be very large.

Another type of risk occurs if items that are bought and sold are not identical and arbitrage is conducted under the assumption that item prices are correlated or predictable. In an extreme case, this is risk arbitrage. Compared to the classic quick and profitable arbitrage transaction, this operation can lead to disastrous losses. During the 1980s, risk arbitrage was very common.

In this form of speculation, an investor trades a financial instrument that is clearly undervalued or overvalued, and it is expected that these discrepancies will be corrected in the future. The standard example is the action of a company, which is undervalued by the market, which is about to be bought by a company; The price of the purchase offer would probably reflect the company’s real value, thus giving a large profit to those who bought the stock before the offer.

Types of arbitration

Also called risk arbitrage, merger arbitrage consists of buying the stock of a company that will be bought by another, while taking a short position in the stock of the company that makes the purchase. Usually the market price of the company that is bought is less than the price offered by the company that buys it. This difference between the two prices depends on the probability and the time in which the purchase is made. Also, usually the stock price of the company that buys the other company falls, so the short sale produces a profit.

The bet in the merger arbitration is that the price difference will eventually be zero, when the purchase is completed. The risk, of course, is that the treatment of the merger of companies will be broken and therefore, the price differential will expand massively.

Arbitration of convertible bonds

A convertible bond is a bond that can be returned to the issuing company in exchange for a predetermined number of shares. A convertible bond can be viewed as a corporate bond with a call option of one share. The price of a convertible bond is sensitive to three main factors:

  1. Interest rate. When rates rise, the convertible portion of a convertible bond tends to decline, but the bond purchase option is appreciated. The bond, in its entirety, trends a little lower.
  2. Price of the stock. When the convertible bond share price rises, the bond price tends to rise as well.
  3. Spread of credit. If the confidence in the issuer of the bond falls (for a reduction in the rating, for example) and the credit spread expands, the bond price tends to fall, but in some cases, the stock option rises (Since the spread is correlated with volatility).

Because of the complexity and structure of a convertible bond, arbitrators usually employ sophisticated quantitative models to identify bonds that are actually priced below their real value. Arbitrage in convertible bonds consists of buying a convertible bond and covering two or three of the factors to achieve exposure to the third factor at an attractive price.

For example, an arbitrator could first buy a convertible bond, then sell fixed income instruments or interest rate futures (to hedge exposure to interest rates) and buy credit protection (to cover a possible deterioration of the issuer’s rating ). Eventually, what is left is something similar to a call option of the convertible bond stock, acquired at a very low price. You can then make money by selling some of the most expensive trading options on the market.

Interest rate arbitration

In interest rate arbitrage, an investor takes advantage of a foreign debt instrument that pays an interest rate higher than that offered in the local market. At the same time that the investor buys these foreign debt instruments, he hedges the exchange rate risk through a futures contract.

Arbitration and speculation

Unlike the arbitrageist who only possessed the asset for a moment, the speculator keeps it in his power for a certain time in order to benefit from a favorable future price variation, in exchange for which he runs a risk. The importance of the transition from arbitrage to speculation is that, in many cases, speculators anticipate changes in prices without having perfect information.

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