Inefficiencies in markets present opportunities -Arbitrage!

On the Money
From the  April 2, 2010 print edition

The R&B singer Billy Preston pined in 1974, “Nothin’ from nothin’ leaves nothin’. You gotta bring me somethin’ if you wanna be with me.”

If a person wanted to bring Billy “something,” but had “nothing,” what could they do? Where do any of us turn when we crave “something from nothing”?

The answer? Arbitrage.

Arbitrage is defined to be the simultaneous purchase and sale of a security (or anything else for that matter) in order to profit from a difference in the price. This usually takes place on separate exchanges or marketplaces.

For example, if the price of a stock on the New York Stock Exchange is $10 per share, but is $8 on the Frankfurt exchange, the $2 difference could be an immediate profit requiring zero investment.

How it works:

The arbitrageur sells on the New York exchange while simultaneously buying on the Frankfurt exchange. Because the transactions theoretically are simultaneous, there’s an immediate gain of $2 per share.

Furthermore, since the gain is guaranteed by the disparity in price, there’s no limit on the number shares that could bought and sold. A 100 million-share purchase coupled with a simultaneous 100 million-share sale nets the arbitrageur a quick $200 million.

The concept of arbitrage isn’t limited to financial instruments. The procedure could be applied to any situation where there is an immediate opportunity to buy and sell concurrently at different prices. It can happen even on eBay.

For example, Wal-Mart is selling the “Barbarella” DVD for $10. However, the last copies of it on eBay have sold for an average of $25. The arbitrageur buys copies of the movie at Wal-Mart, then sells them on eBay for an almost-instant profit of $15.

But this won’t continue for long, as one of three things (the application of the “Efficient Market Hypothesis”) should happen:

• Wal-Mart runs out of “Barbarella.”
• Wal-Mart raises the price on the remaining copies because of increased demand.
• The supply of “Barbarella” DVDs skyrockets on eBay, which causes the price to fall.

This kind of arbitrage is common. Many eBay sellers will go to flea markets and yard sales, looking for collectibles that the seller doesn’t know the true value of and has priced too low. For instance, buying rare collections of video games for $10, then selling them on eBay for $100.

This example isn’t quite pure arbitrage because it requires a small amount of “something” to establish the initial inventory. And as more information enters the marketplace (both at Wal-Mart and eBay), the price difference will close and become equal.

This equalization is known as an “efficient” market. In an efficient market, all information is known across all trading places. With a sufficient number of participants buying and selling, prices will equalize, making pure arbitrage impossible. Timing is critical.

One of the most alluring and active areas of arbitrage is currency exchange, particularly cross-currency arbitrage. This usually involves complex mathematics, such as matrix algebra, and the ability to execute trades quickly before the disparity is discovered.

For example, while traveling in Europe we discover that, given certain circumstances, we can exchange dollars for francs, francs for pounds, pounds for deutsche marks and finally the deutsche marks for the original dollars – spawning a small profit. Using elementary matrix algebra to search for an unbalanced matrix, we can instantly identify a profitable currency arbitrage opportunity.

Without recounting all the intricate details of the calculations here, suffice it say that with a PC and real-time currency data feeds, it’s easy to create hundreds of matrices – each containing a different set of exchange rates. The system then could automatically alert the user about temporary currency exchange imbalances that could be exploited before economic forces restore equilibrium.

For those interested in exploring cross-currency arbitrage more closely, visitwww.forexondemand.com, www.ac-markets.com or www.fxdd.com.

Sound too complicated? Wait, there’s more.

Consider arbitrage as it relates to derivatives. In this case, synthetic securities are created by combining an asset with one or more options or futures contracts. This hybrid security then is used as a basis for searching out other single or combined securities for an arbitrage trade.

Timing, of course, is everything. The forces of the efficient market hypothesis generally close arbitrage windows of opportunity very quickly.

Another important factor is transaction costs. The fees brokers charge to execute the trades must be considered in the calculations. In other words, the price difference must be large enough to cover the broker’s charges.

There may be no such thing as a free lunch, but arbitrage remains a very attractive buffet.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.