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Arbitrage

In economics, arbitrage is the practice of taking advantage of a state of
imbalance between two (or possibly more) markets: a combination of matching
deals are struck that exploit the imbalance, the profit being the difference
between the market prices. A person who engages in arbitrage is called an
arbitrageur.

For example, if you can buy items at one price at a factory outlet and sell
them for a higher price on an internet auction website such as eBay, you can
exploit the imbalance between those two markets for those items. The term
"arbitrage", however, is usually applied only to trading in money and
investment instruments (such as stocks, bonds, and other securities), not to
goods, and the difference in prices is usually referred to as "the spread",
so arbitrage is often defined as "playing the spread" in the money market.

Arbitrage has the effect of causing prices in different markets to converge.
As a result of arbitrage, the currency exchange rates, the price of
commodities, and the price of securities in different markets all tend to
converge to a fixed price. The speed at which the prices converge is one
measure of the efficiency of a market.

Examples

Here's a theoretical example: Suppose that the exchange rates (after taking
out the fees for making the exchange) in London are 5 = $10 = 1000 and the
exchange rates in Tokyo are 1000 = 6 = $10. Converting $10 to 6 in Tokyo
and converting that 6 into $12 in London, for a profit of $2, would be arbitrage.

One real-life example of arbitrage involves the stock market in New York and
the futures market in Chicago. When the price of a stock in New York and its
corresponding future in Chicago are out of sync, one can buy the less
expensive one and sell the more expensive. Because the differences between
the prices are likely to be small (and not to last very long), this can only
be done profitably with computers examining a large number of prices and
automatically exercising a trade when the prices are far enough out of
balance. The activity of other arbitrageurs can make this risky. Those with
the fastest computers and the smartest mathematicians take advantage of
series of small differentials that would not be profitable if taken individually.

Risks

Arbitrage is subject to a number of risks which become magnified when
leverage or borrowed money is used. It can be problematic if prices shift
adversely during the execution of trades. Another risk occurs if the items
being bought and sold are not identical and the arbitrage is conducted under
the assumption that the prices of the items are correlated or predictable.

Long-Term Capital Management lost $100 billion mis-managing this concept in
September 1998. LTCM had attempted to make money on the difference between
different bond instruments. For example, it would buy U.S treasury bonds and
sell Italian bond futures. The concept was that because Italian bond futures
had a less liquid market, in the short term Italian bond futures would have
a higher return than U.S. bonds, but in the long term, the prices would
converge. Because the difference was small, large amount of money had to be
borrowed to make the buying and selling profitable.

The downfall in this system began on August 17, 1998, when Russia defaulted
on its rouble debt and domestic dollar debt. Since the markets were already
nervous due to the Asian crisis, investors began selling non-U.S. treasury
debt and buying U.S. treasuries, which were considered a safe investment. As
a result the return on U.S. treasuries began decreasing because there were
many buyers, and the return on other bonds began to increase because there
were many sellers. This caused the difference between the returns of U.S.
treasuries and other bonds to increase, rather than to decrease as LTCM was
expecting. Eventually this caused LTCM to fold, and a bailout had to be
arranged to prevent a collapse in confidence in the economic system.

An ironic footnote is that they were right long-term (the LT in LTCM), and a
few months after they folded their portfolio became very profitable. However
the long-term does not matter if you cannot survive the short-term, and that
they failed to do.
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