Arbitrage

Not to be confused with Arbitration. In economics and finance, arbitrage /rbtr/ 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. When 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 at zero cost. In 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 major (such as devaluation of a currency or derivative).

Short (finance)
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Schematic representation of short selling in two steps. The short seller borrows shares and immediately sells them. The short seller then waits, hoping for the stock price to decrease, when the seller can profit by purchasing the shares to return to the lender. In finance short selling (also known as shorting or going short) is the practice of selling securities or other financial instruments that are not currently owned, with the intention of subsequently repurchasing them ("covering") at a lower price. In the event of an interim price decline, the short seller will profit, since the cost of repurchase will be less than the proceeds received upon the initial (short) sale. Conversely, the short seller will incur a loss in the event that the price of a shorted instrument should rise prior to repurchase. The potential loss on a

short sale is theoretically unlimited in the event of an unlimited rise in the price of the instrument, however in practice the short seller will be required to post margin or collateral to cover losses, and any inability to do so on a timely basis would cause its broker or counterparty to liquidate the position. In the securities markets, the seller generally must borrow the securities in order to effect delivery in the short sale. In some cases, the short seller must pay a fee to borrow the securities and must additionally reimburse the lender for cash returns the lender would have received had the securities not been loaned out. Historically, short selling is going against the upward trend of the stock market, with the S&P 500 and S&P 90 index realizing an average gain of approximately 9.77% return between 1926 and 2011. Short selling is most commonly done with instruments traded in public securities, futures or currency markets, due to the liquidity and real-time price dissemination characteristic of such markets and because the instruments defined within each class are fungible.

A Description of Efficient Capital Markets An efficient capital market is one in which stock prices fully reflect available information. To illustrate how an efficient market works, suppose the F-stop Camera Corporation (FCC) is attempting to develop a camera that will double the speed of the auto-focusing system now available. FCC believes this research has a positive NPV. Now consider a share of stock in FCC. What determines the willingness of investors to hold shares of FCC at a particular price? One important factor is the probability that FCC will be the first company to develop the new auto-focusing system. In an efficient market, we would expect the price of the shares of FCC to increase if this probability increases. p. 431Suppose FCC hires a well-known engineer to develop the new auto-focusing system. In an efficient market, what will happen to FCC's share price when this is announced? If the engineer is paid a salary that fully reflects his contribution to the firm, the price of the stock will not necessarily change. Suppose instead that hiring the engineer is a positive NPV transaction. In this case, the price of shares in FCC will increase because the firm can pay the engineer a salary below his true value to the company. When will the increase in the price of FCC's shares occur? Assume that the hiring announcement is made in a press release on Wednesday morning. In an efficient market, the price of shares in FCC will immediately adjust to this new information. Investors should not be able to buy the stock on Wednesday afternoon and make a profit on Thursday. This would imply that it took the stock market a day to realize the implication of the FCC press release. The efficient market hypothesis predicts that the price of shares of FCC stock on Wednesday afternoon will already reflect the information contained in the Wednesday morning press release. The efficient market hypothesis (EMH) has implications for investors and for firms: Because information is reflected in prices immediately, investors should only expect to obtain a normal rate of return. Awareness of information when it is released does an investor no good. The price adjusts before the investor has time to trade on it. Firms should expect to receive fair value for securities that they sell. Fair means that the price they receive from issuing securities is the present value. Thus, valuable financing opportunities that arise from fooling investors are unavailable in efficient capital markets. Figure 14.1 presents several possible adjustments in stock prices. The solid line represents the path taken by the stock in an efficient market. In this case, the price adjusts immediately to the new information with no further price changes. The dotted line depicts a slow reaction. Here it takes the market 30 days to fully absorb the information. Finally, the broken line illustrates an overreaction and subsequent correction back to the true price.