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feaAn arbitrage opportunity exists if it is possible to make a gain that is guaranteed to be at

least equal to the risk free rate of return, with a chance of making a greater gain. This is

equivalent to the definition of an arbitrage opportunity as the possibility of a riskless gain

with a zero cost portfolio, because a portfolio that is guaranteed to make a profit can be

bought with borrowed money.

Arbitrage should not be possible as, if an arbitrage opportunity exists, then market forces

should eliminate it. Taking a simple example, if it is possible to buy a security in one market

and sell it at a higher price in another market, then no-one would buy it at the more expensive

price, and no one would sell it at the cheaper price. The prices in the two markets would

converge.

Arbitrage between markets is the simplest type of arbitrage . ore complex strategies such as

arbitraging the price of a security against a portfolio that replicates its cash flows. These

range from the relatively simple, such as delta and gamma hedges, to extremely complex

strategies based on quantitative models.

uch of financial theory !and therefore most methods for valuing securities" are ultimately

built on the assumption that securities will trade at prices that make arbitrage impossible. #n

particular, if there is no arbitrage then a risk neutral pricing measure exists and vice versa.

Although this result is not something that is used by most investors, it is of great importance

in the theory of financial economics.

Although arbitrage opportunities do exist in real markets, they are usually very small and

quickly eliminated$ therefore the no arbitrage assumption is a reasonable one to build

financial theory on.

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%hen persistent arbitrage opportunities do exist it means that there is something badly wrong

with financial markets. &or example, there is evidence that during the dotcom boom the value

of internet related tracker stocks and listed subsidiaries was not consistent with the market

value of parent companies' an arbitrage opportunity existed and persisted.

#n economics and finance, arbitrage is the practice of taking advantage of a price difference

between two or more markets' striking a combination of matching deals that capitalize upon

the imbalance, the profit being the difference between the market prices. %hen used by

academics, an arbitrage is a transaction that involves no negative cash flow at any

probabilistic or temporal state and a positive cash flow in at least one state$ in simple terms, it

is the possibility of a risk-free profit after transaction costs. &or instance, an arbitrage is

present when there is the opportunity to instantaneously buy low and sell high.

#n principle and in academic use, an arbitrage is risk-free$ in common use, as in statistical

arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are

always risks in arbitrage, some minor !such as fluctuation of prices decreasing profit

margins", some ma(or !such as devaluation of a currency or derivative". #n academic use, an

arbitrage involves taking advantage of differences in price of a single asset or identical cash-

flows$ in common use, it is also used to refer to differences between similar assets !relative

value or convergence trades", as in merger arbitrage.

)eople who engage in arbitrage are called arbitrageurs such as a bank or brokerage firm. The

term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives,

commodities and currencies.

1 Conditions for Arbitrage

Arbitrage is possible when one of three conditions is met'

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• The same asset does not trade at the same price on all markets !*the law of one

price*".Two assets with identical cash flows do not trade at the same price.

• An asset with a known price in the future does not today trade at its future price

discounted at the risk-free interest rate !or, the asset has significant costs of storage$ as

such, for example, this condition holds for grain but not for securities".

• Arbitrage is not simply the act of buying a product in one market and selling it in another

for a higher price at some later time. The transactions must occur simultaneously to avoid

exposure to market risk, or the risk that prices may change on one market before both

transactions are complete. #n practical terms, this is generally possible only with securities

and financial products that can be traded electronically, and even then, when each leg of

the trade is executed the prices in the market may have moved. issing one of the legs of

the trade !and subsequently having to trade it soon after at a worse price" is called

+execution risk+ or more specifically +leg risk+.

#n the simplest example, any good sold in one market should sell for the same price in

another. Traders may, for example, find that the price of wheat is lower in agricultural regions

than in cities, purchase the good, and transport it to another region to sell at a higher price.

This type of price arbitrage is the most common, but this simple example ignores the cost of

transport, storage, risk, and other factors. *True* arbitrage requires that there be no market

risk involved. %here securities are traded on more than one exchange, arbitrage occurs by

simultaneously buying in one and selling on the other.

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CHP 2: TYPES OF ARBITRAGE

1 Satia! Arbitrage

Also known as eographical arbitrage is the simplest form of arbitrage. #n case of spatial

arbitrage, an arbitrageurs looks for pricing discrepancies across geographically separate

markets. &or example, there may be a bond dealer in irginia offering a bond at //-0102

and a dealer in %ashington is bidding //-3102 for the same bond. &or whatever reason, the

two dealers have not spotted the aberration in the prices, but the arbitrageur does. The

arbitrageurs immediately buy the bond from the irginia dealer and sells it to the %ashington

dealer.

2 "erger Arbitrage

Also called risk arbitrage, merger arbitrage generally consists of buying1holding the stock of

a company that is the target of a takeover while shorting the stock of the acquiring company.

4sually the market price of the target company is less than the price offered by the acquiring

company. The spread between these two prices depends mainly on the probability and the

timing of the takeover being completed as well as the prevailing level of interest rates.

The bet in a merger arbitrage is that such a spread will eventually be zero, if and when the

takeover is completed. The risk is that the deal *breaks* and the spread massively widens.

# "$ni%ia! Bond Arbitrage

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Also called municipal bond relative value arbitrage, municipal arbitrage, or (ust muni

arbitrageurs, this hedge fund strategy involves one of two approaches.

enerally, managers seek relative value opportunities by being both long and short municipal

bonds with a duration-neutral book. The relative value trades may be between different

issuers, different bonds issued by the same entity or capital structure trades referencing the

same asset !in the case of revenue bonds". anagers aim to capture the inefficiencies arising

from the heavy participation of non-economic investors !i.e., high income *buy and hold*

investors seeking tax-exempt income" as well as the *crossover buying* arising from

corporations+ or individuals+ changing income tax situations !i.e., insurers switching their

muni for corporates after a large loss as they can capture a higher after-tax yield by offsetting

the taxable corporate income with underwriting losses". There are additional inefficiencies

arising from the highly fragmented nature of the municipal bond market which has two

million outstanding issues and 3/,/// issuers in contrast to the Treasury market which has

5// issues and a single issuer.

6econd, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal

bonds with the duration risk hedged by shorting the appropriate ratio of taxable corporate

bonds. These corporate equivalents are typically interest rate swaps referencing 7ibor or

6#&A. The arbitrage manifests itself in the form of a relatively cheap longer maturity

municipal bond, which is a municipal bond that yields significantly more than 839 of a

corresponding taxable corporate bond. The steeper slope of the municipal yield curve allows

participants to collect more after-tax income from the municipal bond portfolio than is spent

on the interest rate swap$ the carry is greater than the hedge expense. )ositive, tax-free carry

from muni arbitrageurs can reach into the double digits. The bet in this municipal bond

arbitrage is that, over a longer period of time, two similar instruments municipal bonds and

interest rate swaps will correlate with each other$ they are both very high quality credits, have

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the same maturity and are denominated in 4.6. dollars. :redit risk and duration risk are

largely eliminated in this strategy. ;owever, basis risk arises from use of an imperfect hedge,

which results in significant, but range-bound principal volatility. The end goal is to limit this

principal volatility, eliminating its relevance over time as the high, consistent, tax-free cash

flow accumulates. 6ince the inefficiency is related to government tax policy, anAn arbitrage

opportunity exists if it is possible to make a gain that is guaranteed to be at least equal to the

risk free rate of return, with a chance of making a greater gain. This is equivalent to the

definition of an arbitrage opportunity as the possibility of a riskless gain with a zero cost

portfolio, because a portfolio that is guaranteed to make a profit can be bought with borrowed

money.





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money.




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2 "erger Arbitrage


















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flow accumulates. 6ince the inefficiency is related to government tax policy, an

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