Five Arbitrage Techniques Every Investor Needs to Know

When one hears the term arbitrage it might bring to mind the name of a fancy perfume or perhaps the name of a famous museum (that's the Hermitage in St. Petersburg, Russia). But arbitrage is a whole field of profitable investing that for too many people is quite clandestine. In this installment of the Finance Professor, I will open your eyes to what arbitrage is and explain how you might be able to profit and avoid losses via five core arbitrage techniques.

To start off, we need a working definition of arbitrage:

Arbitrage is the simultaneous purchase and sale of securities, commodities or assets in order to profit from price discrepancies, with as little risk as possible.

Please note that:

1. An arbitrage requires more than one transaction or "leg."

2. The price discrepancy does not necessarily ensure a profit.

3. The risk may be quantified as being low, but it does exist and can lead to significant losses.

Now let's look at some very popular forms of arbitrage.

1. Risk Arbitrage

The theory: When one company seeks to acquire another company there is a discrepancy between the deal price offered by the acquirer and the market price of the target company

The strategy: In the event of a stock-for-stock deal, the arbitrageur will buy shares of the target company and sell shares of the acquiring company a ratio to equal that of the proposed transaction. In the event of a cash-for-stock deal, the arbitrageur will buy shares of the target company and borrow money to finance the transaction. As a result, when a new M&A (merger and acquisition) deal is announced, the target company shares will rise as the acquirer's share will tend to fall.

The risk: The acquirer walks away from the deal. This can occur because of "material adverse changes," such as what happened when the Harman International (HAR) acquisition (by a consortium of buyers) fell apart, or because of the loss of financing as occurred with Blackstone (BX) in its attempt to acquire PHH (PHH).

Sometimes the deal falls apart for other business reasons, such as what happened with the Tellabs (TLAB) acquisition of Ciena (CIEN) about a decade ago. That broken deal cost Long-Term Capital Management (the failed hedge fund ) a bundle.

As you can see, if a deal falls apart, it can result in significant losses for the arbitrageur. To give you a little perspective on the magnitude of the risk/reward tradeoff, typically the arbitrageur will gain (the reward) 3% to 5% on the transaction, but if the deal falls apart, the arbitrageur can stand to lose (the risk) 20% or at times, more.

2. Index Arbitrage

The theory: One can buy all the stocks in an index (like the S&P 500) relative to the value that is implied in the market price of the futures contracts underlying that index (see "Five Things Every Investor Should Know About Index Futures").

The strategy: The arbitrageur will buy all of the stocks underlying the index and sell the futures for the index. In the process, the investor will borrow money to buy the stocks, pay interest on the loan and earn dividends on the stocks. As such, the perceived profit is equal to:

Cost of stocks plus dividends on stocks minus interest costs minus futures value

Please note that the arbitrage can be reversed, whereby one shorts the stocks in the index and buys the futures contract.

The risk: In this example I provided, if interest rates increase or dividends decline from their anticipated rates, then the perceived profit will erode or potentially turn to a loss.

3. Carry Trade

The theory: Put simply, you borrow money at a lower interest rate and reinvest it at a higher interest rate, earning the differential in interest rates along the way.

The strategy: This can be done in the foreign currency (forex ) markets or may also be performed in the bond markets.

In the forex markets, the investor would buy a high-interest currency and finance that with the selling of low-interest rate currencies., As an example in the bond markets, one would sell the 2-year Japanese Government Bonds (JGB) at a yield to maturity of 9/16% (or 0.5625%), convert the Japanese Yen Proceeds (JPY) into US Dollars (USD) and then buy an equivalent amount of 2-Year U.S. Treasury Notes (2UST) with a yield to maturity of 2.00%. In doing so, the investor would be able to earn 1 7/16%, (or 1.4375%, less than the costs for a "repo" or reverse "repo" financing).