Arbitrage

Both a noun and a verb, arbitrage is a fancy way of stating a simple aim: to make money, typically through the simultaneous purchase and sale of related but not identical assets that are mispriced in relation to each other. A classic historical example of arbitrage was the shipment of gold between Paris and London whenever the price in one city was high enough relative to the price in the other to compensate the shipper (or arbitrageur) for his costs and risks. Not surprisingly, the greatest profits flowed to arbitrageurs with swift lines of communication (i.e., fast carrier pigeons) and relatively low transportation costs. In time, of course, improvements in communications and transportation eliminated or arbitraged away the opportunity to make consistently large profits exploiting gold price discrepancies between London and Paris.

Modern investors engage in countless forms of arbitrage. Some managers use the term to describe any profit-seeking strategy, including the simple purchase of an undervalued stock whose price they expect to be "arbitraged" upward to levels that are more reasonable in relation to industry or market norms, but the term is typically invoked to describe two-sided strategies involving the purchase and simultaneous sale of related securities. Examples include index arbitrage (e.g., buying a basket of stocks while simultaneously selling short a futures contract pegged to essentially the same stocks) and capital structure arbitrage (e.g., buying a company's convertible bonds while simultaneously selling short its common stock). An investment strategy known as event arbitrage involves the purchase of securities of companies experiencing a major corporate event such as an acquisition or reorganization. Managers engaged in event arbitrage typically use options or short selling techniques to insulate their returns from general market movements. The aim is to eliminate all forms of risk except the failure of the event in question (e.g., the collapse of an announced merger). The operative premise is that investors willing to shoulder such "event risk" will earn attractively high annualized returns, especially if they diversify their bets across a sufficient number of unrelated "events."