and Amsterdam through Paris, is evidently 36s. Flemish for £1 sterling: for as 3 Fr.: 54d. Flem. :: 24 Fr.: 36s. Flem.
Now, when the actual or direct price (as seen by a quotation of otherwise advised) is found to differ from the arbitrated price, advantage may be made by drawing or remitting indirectly; that is, by drawing on one place through another, as on Amsterdam through Paris; […]
To exemplify this by familiar illustrations, suppose the arbitrated price between London and Amsterdam to be, as before stated, 36s. Flemish for £1 sterling; and suppose the direct course, as given in Lloyd's list, to be 37s. Flemish, then London, by drawing directly on Amsterdam, must give 37s. Flemish for £1 sterling; whereas, by drawing through Paris he will give only 36s. Flemish for £1 sterling; it is, therefore, the interest of London to draw indirectly on Amsterdam through Paris.
As securities markets began to develop and expand globally during the nineteenth century, arbitrage began to expand beyond simple currency exchanges. This is reflected in how Otto Swoboda expands the definition of arbitrage in his book Börse und Actien, first published in Cologne in the year 1869:4
Under arbitrage, that is decision, we understand the comparison of notations of any one place with those of another in order to use any arising difference, relative to exchange rates as well as security quotes, and thereby those who enter into such arbitrages (bring together) differences in prices between to places in their favor. […] Early arbitrages occurred only in exchange rates, and only when a merchant owed another in a different location a certain amount or had a claim. He would then compare quotations in different places to see in which it would be most favorable to cover the debt or cover the claim. Only later a trade of its own developed from this, so that even without preceeding commerce a speculation in currencies or funds was effected.
The analysis of n-grams of books digitized by Google in Figure 1.1 shows the occurrence of the term arbitrage in printed books over time. In the early days of book printing, arbitrage appears to have been used frequently. However, it is the comparatively small number of books in print then that inflates the relative use of this term.
Figure 1.1 Frequency of the Occurrence of the Term Arbitrage in Printed Books
It is not until another century later, the 1960s, that merger arbitrage first appears in print, followed by risk arbitrage a few years later. The analysis of n-grams in Figure 1.2 shows the explosive growth of the usage of these terms since then. It is no surprise that the late 1960s gave rise to growing interest in arbitraging mergers, as this coincided with a wave of aggressive merger activity in England and the United States, which led to the adoption of many laws still in place today, such as the City Code. This will be discussed in more detail later. While risk arbitrage dominated as a description of the strategy discussed in this book for many years, merger arbitrage became more popular as a term in the late 1990s, and has surpassed risk arbitrage as the dominant term since the year 2005.
Figure 1.2 Frequency of the Occurrence of the Terms Merger Arbitrage and Risk Arbitrage in Books
Unfortunately, the early descriptions of arbitrage are echoed in many modern-day definitions. Merriam-Webster's 11th Collegiate Dictionary defines it as:[
1. The nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies
2. The purchase of the stock of a takeover target especially with a view to selling it profitably to the raider
While the second definition in Merriam-Webster relates to the subject matter at hand in this book, both definitions fail to capture all the different facets and breadth of arbitrage properly. In a world of instant global communications, the first type of arbitrage is rarely viable. A much better definition of arbitrage is that used by economists, who define arbitrage as a “free lunch”: an investment strategy that generates a risk-free profit. Academic finance theory formalizes this definition as a self-financing trading strategy that generates a positive return without risk. Three different degrees of arbitrage can be distinguished, as shown in Table 1.1.
Table 1.1 Orders of Arbitrage
Source: Nassim Taleb, Dynamic Hedging: Managing Vanilla and Exotic Options (New York: John Wiley & Sons, Inc., 1997). Reprinted with permission of John Wiley & Sons, Inc.
A simple location arbitrage in commodities would be the purchase of crude oil in Rotterdam, the rental of a tanker, and the simultaneous resale of the oil in New York. Today, most arbitrage activity occurs in financial markets. An arbitrageur might take positions in a currency spot rate, forward rate, and two interest rates. Arbitrage transactions of this type are known as cash-and-carry arbitrage. This type of arbitrage can be understood easily as the purchase of oil and the simultaneous sale of an oil futures contract for the delivery of that oil at a later time. (An arbitrageur would also have to arrange for storage.) In practice, few such simple arbitrage opportunities are available in today's markets. The key idea in arbitrage is the absence of risk. Arbitrageurs eliminate risk by taking positions that in the aggregate offset each other and compensate arbitrageurs for their efforts with a profit. Arbitrageurs are often referred to affectionately through the abbreviation “arb.”
Arbitrage in general plays an important economic function because it makes markets more efficient. Whenever a price discrepancy arises between two similar instruments or products, arbitrageurs will seek to profit from the discrepancy. Such discrepancies can arise temporarily in any market – oranges, stocks, lease rates for dry bulk carrier vessels, or sophisticated financial derivatives. As soon as arbitrageurs identify a price discrepancy, they will buy in the cheaper market and sell in the more expensive one. Through their actions, they increase the price in the cheap market and reduce the price in the more expensive market. In due time, prices in the two markets will return to balance. Ultimately, this benefits all other market participants, who know that prices will never diverge significantly from their fair value.
Suppose government regulations were introduced to curtail the activities of arbitrageurs. This would leave market participants with two options:
1. Accept the price in their local market and risk overpaying.
2. Research all other markets to find the “true” value of the product.
In either case, there are costs involved – either the cost of overpaying (or underselling) or the information cost of price discovery. Both outcomes are not optimal and will make markets less efficient.
It is also important to recognize that arbitrage is not a synonym for speculation. Speculators assume market risk in their trades. They will acquire an asset with the hope of reselling it at a higher price in the future. There are two differences between speculation and arbitrage:
1. In speculation, the purchase and acquisition are not made simultaneously, so speculators face prices that can change with the passage of time. They assume full market risk until they sell. Arbitrageurs, however, will execute the purchase and sale simultaneously.
2. Speculators do not know at which price they will be able to sell. There is no guarantee that they will be able to sell at a higher price. Arbitrageurs,
Otto Swoboda, “Börse und Actien,” Verlag Wilh. Hassel, Cologne, 1869. Excerpt translated by the author.
