Arbitrage

2 Arbitrage-free pricing approach

for bonds

For the lm, see Arbitrage (lm).

Not to be confused with Arbitration.
In economics and nance, arbitrage (US /rbtr/,
UK /btrd/, UK /btr/) is the practice of taking advantage of a price dierence between two or more
markets: striking a combination of matching deals that
capitalize upon the imbalance, the prot being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash ow at any probabilistic or temporal state and
a positive cash ow in at least one state; in simple terms,
it is the possibility of a risk-free prot after transaction
costs. For instance, an arbitrage is present when there is
the opportunity to instantaneously buy low and sell high.

This refers to the method of valuing a coupon bearing

nancial instrument by discounting its future cash ows
by multiple discount rates. By doing so, a more accurate
price will be obtained than if the price is calculated with
a present value pricing approach. Arbitrage-free pricing
is used for bond valuation and used to detect arbitrage
opportunities for investors.

For purpose of valuing the price of a bond its cash ows

can each be thought of as packets of incremental cash
ows with a large packet upon maturity, being the principal. Since the cash ows are dispersed throughout future
periods they must be discounted back to the present. In
In principle and in academic use, an arbitrage is riskthe present value approach, the cash ows are discounted
free; in common use, as in statistical arbitrage, it may
with one discount rate to nd the price of the bond. In
refer to expected prot, though losses may occur, and in
arbitrage-free pricing, multiple discount rates are used.
practice, there are always risks in arbitrage, some minor
(such as uctuation of prices decreasing prot margins), The present value approach assumes that the yield of the
some major (such as devaluation of a currency or deriva- bond will stay the same until maturity. This is a simplied
tive). In academic use, an arbitrage involves taking ad- model because interest rates may uctuate in the future,
vantage of dierences in price of a single asset or iden- which in turn aects the yield on the bond. The discount
tical cash-ows; in common use, it is also used to refer rate may be dierent for each of the cash ows for this
to dierences between similar assets (relative value or reason. Each cash ow can be considered a zero-coupon
instrument that pays one payment upon maturity. The
convergence trades), as in merger arbitrage.
discount rates used should be the rates of multiple zeroPeople who engage in arbitrage are called arbitrageurs
coupon bonds with maturity dates same as each cash ow
/rbtrr/such as a bank or brokerage rm. The
and similar risk as the instrument being valued. By using
term is mainly applied to trading in nancial instrumultiple discount rates the arbitrage-free price will be the
ments, such as bonds, stocks, derivatives, commodities
sum of the discounted cash ows. Arbitrage-free price
and currencies.
refers to the price at which no price arbitrage is possible.

The ideas of using multiple discount rates obtained from

zero-coupon bonds and discount a similar bonds cash ow
to nd its price is derived from the yield curve. The yield
curve is a curve of the yields of the same bond with different maturities. This curve can be used to view trends in
the markets expectations of how interest rates will move
in the future. In arbitrage-free pricing of a bond a yield
curve of similar zero-coupon bonds with dierent maturities is created. If the curve were to be created with
Treasury securities of dierent maturities they would be
stripped of their coupon payments through bootstrapping.
This is to transform the bonds into zero-coupon bonds.
The yield of these zero-coupon bonds would then be plotted on a diagram with time on the x-axis and yield on the
y-axis.

Arbitrage-free

If the market prices do not allow for protable arbitrage, the prices are said to constitute an arbitrage
equilibrium, or arbitrage-free market. An arbitrage
equilibrium is a precondition for a general economic
equilibrium. The no arbitrage assumption is used in
quantitative nance to calculate a unique risk neutral price Since the yield curve in a way displays the markets exfor derivatives.
pectations on how yields and interest rates may move,
1

4 EXAMPLES

the arbitrage-free pricing approach is more realistic than

using only one discount rate. With this, investors can
use this approach to value bonds and nd mismatches in
prices, resulting in an arbitrage opportunity. If a bond
valued with the arbitrage-free pricing approach turns out
to be priced higher in the market an investor could have
such an opportunity:

to trade it soon after at a worse price) is called 'execution

risk' or more specically 'leg risk'.[note 1]

In the simplest example, any good sold in one market

should sell for the same price in another. Traders may, for
example, nd 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 sim1. Investor goes short the bond at price at time t1 .
ple example ignores the cost of transport, storage, risk,
and other factors. True arbitrage requires that there be
2. Investor goes long the zero-coupon bonds making up no market risk involved. Where securities are traded on
the related yield curve and strip and sell any coupon more than one exchange, arbitrage occurs by simultanepayments at t1 .
ously buying in one and selling on the other.
3. As t>t1 the price spread between the prices will de- See rational pricing, particularly arbitrage mechanics, for
crease.
further discussion.
4. At maturity the prices will converge and be equal. Mathematically it is dened as follows:
Investor exits both the long and short position, realizing a prot.
P (Vt 0) = 1 and P (Vt = 0) > 0

If the outcome from the valuation were the reversed case

the opposite positions would be taken in the bonds. This where V0 = 0 and Vt denotes the portfolio value at time
arbitrage opportunity comes from the assumption that the t.
prices of bonds with the same properties will converge
upon maturity. This can be explained through market
eciency, which states that arbitrage opportunities will 4 Examples
eventually be discovered and corrected accordingly. The
prices of the bonds in t1 move closer together to nally
Suppose that an exchange rate (after taking out the
become the same at tT.
fees for making the exchange) in London is 5 =
1000 and the exchange rate in Tokyo is 1000 =
6. Converting 2000 to 12 in Tokyo and converting that 12 into 2400 in London, for a prot of
3 Conditions for arbitrage
400, would be arbitrage. In reality, this arbitrage
is so simple that it almost never occurs. But more
Arbitrage is possible when one of three conditions is met:
complicated foreign exchange arbitrages, such as the
spot-forward arbitrage (see interest rate parity) are
1. The same asset does not trade at the same price on
much more common.
all markets ("the law of one price").
One example of arbitrage involves the New York
2. Two assets with identical cash ows do not trade at
Stock Exchange and the Security Futures Exchange
the same price.
OneChicago (OCX). When the price of a stock on
the NYSE and its corresponding futures contract on
3. An asset with a known price in the future does not
OCX are out of sync, one can buy the less expensive
today trade at its future price discounted at the riskone and sell it on the more expensive market. Befree interest rate (or, the asset has signicant costs
cause the dierences between the prices are likely
of storage; as such, for example, this condition holds
to be small (and not to last very long), this can be
for grain but not for securities).
done protably only with computers examining a
large number of prices and automatically exercising
Arbitrage is not simply the act of buying a product in one
a trade when the prices are far enough out of balmarket and selling it in another for a higher price at some
ance. The activity of other arbitrageurs can make
later time. The transactions must occur simultaneously to
this risky. Those with the fastest computers (i.e.
avoid exposure to market risk, or the risk that prices may
lowest latency to respond to the market) and the
change on one market before both transactions are commost expertise take advantage of series of small difplete. In practical terms, this is generally possible only
ferences that would not be protable if taken indiwith securities and nancial products that can be traded
vidually.
electronically, and even then, when each leg of the trade is
Economists use the term "global labor arbitrage" to
executed the prices in the market may have moved. Missrefer to the tendency of manufacturing jobs to ow
ing one of the legs of the trade (and subsequently having

3
towards whichever country has the lowest wages per
unit output at present and has reached the minimum requisite level of political and economic development to support industrialization. At present,
many such jobs appear to be owing towards China,
though some that require command of English are
going to India and the Philippines. In popular
terms, this is referred to as oshoring. (Note that
oshoring is not synonymous with "outsourcing",
which means to subcontract from an outside supplier or source, such as when a business outsources
its payroll or cleaning. Unlike oshoring, outsourcing always involves subcontracting jobs to a dierent company, and that company can be in the same
country, even the same building, as the outsourcing
company.)
Sports arbitrage [1] numerous internet bookmakers
oer odds on the outcome of the same event. Any
given bookmaker will weight their odds so that no
one customer can cover all outcomes at a prot
against their books. However, in order to remain
competitive they must keep margins usually quite
low. Dierent bookmakers may oer dierent
odds on the same outcome of a given event; by taking the best odds oered by each bookmaker, a customer can under some circumstances cover all possible outcomes of the event and lock a small riskfree prot, known as a Dutch book. This prot
will typically be between 1% and 5% but can be
much higher. One problem with sports arbitrage
is that bookmakers sometimes make mistakes and
this can lead to an invocation of the 'palpable error' rule, which most bookmakers invoke when they
have made a mistake by oering or posting incorrect odds. As bookmakers become more procient,
the odds of making an 'arb' usually last for less than
an hour and typically only a few minutes. Furthermore, huge bets on one side of the market also alert
the bookies to correct the market.
Exchange-traded fund arbitrage Exchange Traded
Funds allow authorized participants to exchange
back and forth between shares in underlying securities held by the fund and shares in the fund itself,
rather than allowing the buying and selling of shares
in the ETF directly with the fund sponsor. ETF
trade in the open market, with prices set by market
demand. An ETF may trade at a premium or discount to the value of the underlying assets. When a
signicant enough premium appears, an arbitrageur
will buy the underlying securities, convert them to
shares in the ETF, and sell them in the open market. When a discount appears, an arbitrageur will
do the reverse. In this way, the arbitrageur makes
a low-risk prot, while keeping ETF prices in line
with their underlying value.

price dierences between identical assets, they will

purchase and sell securities, assets and derivatives
with similar characteristics, and hedge any significant dierences between the two assets. Any difference between the hedged positions represents any
remaining risk (such as basis risk) plus prot; the
belief is that there remains some dierence which,
even after hedging most risk, represents pure prot.
For example, a fund may see that there is a substantial dierence between U.S. dollar debt and local
currency debt of a foreign country, and enter into a
series of matching trades (including currency swaps)
to arbitrage the dierence, while simultaneously entering into credit default swaps to protect against
country risk and other types of specic risk.

5 Price convergence
Arbitrage has the eect of causing prices in dierent
markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the
price of securities in dierent markets tend to converge.
The speed[2] at which they do so is a measure of market
eciency. Arbitrage tends to reduce price discrimination
by encouraging people to buy an item where the price is
low and resell it where the price is high (as long as the buyers are not prohibited from reselling and the transaction
costs of buying, holding and reselling are small relative to
the dierence in prices in the dierent markets).
Arbitrage moves dierent currencies toward purchasing
power parity. As an example, assume that a car purchased in the United States is cheaper than the same car in
Canada. Canadians would buy their cars across the border to exploit the arbitrage condition. At the same time,
Americans would buy US cars, transport them across the
border, then sell them in Canada. Canadians would have
to buy American dollars to buy the cars and Americans
would have to sell the Canadian dollars they received in
exchange. Both actions would increase demand for US
dollars and supply of Canadian dollars. As a result, there
would be an appreciation of the US currency. This would
make US cars more expensive and Canadian cars less so
until their prices were similar. On a larger scale, international arbitrage opportunities in commodities, goods,
securities and currencies tend to change exchange rates
until the purchasing power is equal.

In reality, most assets exhibit some dierence between

countries. These, transaction costs, taxes, and other costs
provide an impediment to this kind of arbitrage. Similarly, arbitrage aects the dierence in interest rates
paid on government bonds issued by the various coun Some types of hedge funds make use of a modied tries, given the expected depreciation in the currencies
form of arbitrage to prot. Rather than exploiting relative to each other (see interest rate parity).

Risks

RISKS

the problem is to execute two or three balancing transactions while the dierence persists (that is, before the
other arbitrageurs act). When the transaction involves a
delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the
reward through leverage. One way of reducing the risk is
through the illegal use of inside information, and in fact
risk arbitrage with regard to leveraged buyouts was associated with some of the famous nancial scandals of the
1980s such as those involving Michael Milken and Ivan
Boesky.

Arbitrage transactions in modern securities markets involve fairly low day-to-day risks, but can face extremely
high risk in rare situations,[2] particularly nancial crises,
and can lead to bankruptcy. Formally, arbitrage transactions have negative skew prices can get a small amount
closer (but often no closer than 0), while they can get very
far apart. The day-to-day risks are generally small because the transactions involve small dierences in price,
so an execution failure will generally cause a small loss
(unless the trade is very big or the price moves rapidly).
The rare case risks are extremely high because these
small price dierences are converted to large prots via 6.2 Mismatch
leverage (borrowed money), and in the rare event of a
For more details on this topic, see Convergence trade.
large price move, this may yield a large loss.
The main day-to-day risk is that part of the transaction
fails execution risk. The main rare risks are counterparty risk and liquidity risk that a counterparty to a large
transaction or many transactions fails to pay, or that one
is required to post margin and does not have the money
to do so.

Another risk occurs if the items being bought and sold

are not identical and the arbitrage is conducted under
the assumption that the prices of the items are correlated or predictable; this is more narrowly referred to as
a convergence trade. In the extreme case this is merger
arbitrage, described below. In comparison to the clasIn the academic literature, the idea that seemingly very
sical quick arbitrage transaction, such an operation can
low risk arbitrage trades might not be fully exploited beproduce disastrous losses.
cause of these risk factors and other considerations is of[3][4][5]
ten referred to as limits to arbitrage.

6.3 Counterparty risk

6.1

Execution risk

Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick
shift in prices makes it impossible to close the other at
a protable price. However, this is not necessarily the
case. Many exchanges and inter-dealer brokers allow
multi legged trades (e.g. basis block trades on LIFFE).
Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to prot from a price discrepancy between IBM on
the NYSE and IBM on the London Stock Exchange, they
may purchase a large number of shares on the NYSE and
nd that they cannot simultaneously sell on the LSE. This
leaves the arbitrageur in an unhedged risk position.
In the 1980s, risk arbitrage was common. In this form
of speculation, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events. The standard
example is the stock of a company, undervalued in the
stock market, which is about to be the object of a takeover
bid; the price of the takeover will more truly reect the
value of the company, giving a large prot to those who
bought at the current priceif the merger goes through
as predicted. Traditionally, arbitrage transactions in the
securities markets involve high speed, high volume and
low risk. At some moment a price dierence exists, and

As arbitrages generally involve future movements of cash,

they are subject to counterparty risk: if a counterparty
fails to fulll their side of a transaction. This is a serious
problem if one has either a single trade or many related
trades with a single counterparty, whose failure thus poses
a threat, or in the event of a nancial crisis when many
counterparties fail. This hazard is serious because of the
large quantities one must trade in order to make a prot
on small price dierences.
For example, if one purchases many risky bonds, then
hedges them with CDSes, proting from the dierence
between the bond spread and the CDS premium, in
a nancial crisis the bonds may default and the CDS
writer/seller may itself fail, due to the stress of the crisis, causing the arbitrageur to face steep losses.

6.4 Liquidity risk

Arbitrage trades are necessarily synthetic, leveraged
trades, as they involve a short position. If the assets used
are not identical (so a price divergence makes the trade
temporarily lose money), or the margin treatment is not
identical, and the trader is accordingly required to post
margin (faces a margin call), the trader may run out of
capital (if they run out of cash and cannot borrow more)
and be forced to sell these assets at a loss even though
the trades may be expected to ultimately make money. In

7.4

Convertible bond arbitrage

eect, arbitrage traders synthesize a put option on their duration-neutral book. The relative value trades may be
ability to nance themselves.[6]
between dierent issuers, dierent bonds issued by the
Prices may diverge during a nancial crisis, often termed same entity, or capital structure trades referencing the
a "ight to quality"; these are precisely the times when it same asset (in the case of revenue bonds). Managers aim
is hardest for leveraged investors to raise capital (due to to capture the ineciencies arising from the heavy paroverall capital constraints), and thus they will lack capital ticipation of non-economic investors (i.e., high income
"buy and hold" investors seeking tax-exempt income) as
precisely when they need it most.[6]
well as the crossover buying arising from corporations
or individuals changing income tax situations (i.e., insurers switching their munis for corporates after a large loss
7 Types of arbitrage
as they can capture a higher after-tax yield by osetting
the taxable corporate income with underwriting losses).
There are additional ineciencies arising from the highly
7.1 Spatial arbitrage
fragmented nature of the municipal bond market which
Also known as Geographical arbitrage is the simplest has two million outstanding issues and 50,000 issuers in
form of arbitrage. In case of spatial arbitrage, an arbs contrast to the Treasury market which has 400 issues and
(arbitrageurs) looks for pricing discrepancies across geo- a single issuer.
graphically separate markets. For example, there may be
a bond dealer in Virginia oering a bond at 100-12/23
and a dealer in Washington is bidding 100-15/23 for the
same bond. For whatever reason, the two dealers have not
spotted the aberration in the prices, but the arbs does. The
arb immediately buys the bond from the Virginia dealer
and sells it to the Washington dealer.

7.2

Merger arbitrage

Also called risk arbitrage, merger arbitrage generally consists of buying/holding the stock of a company that is the
target of a takeover while shorting the stock of the acquiring company.
Usually the market price of the target company is less
than the price oered 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.

7.3

Municipal bond arbitrage

Second, 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 Libor or SIFMA
. The arbitrage manifests itself in the form of a relatively
cheap longer maturity municipal bond, which is a municipal bond that yields signicantly more than 65% 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. Positive, tax-free carry from
muni arb can reach into the double digits. The bet in this
municipal bond arbitrage is that, over a longer period of
time, two similar instrumentsmunicipal bonds and interest rate swapswill correlate with each other; they are
both very high quality credits, have the same maturity and
are denominated in U.S. dollars. Credit risk and duration
risk are largely eliminated in this strategy. However, basis
risk arises from use of an imperfect hedge, which results
in signicant, 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
ow accumulates. Since the ineciency is related to government tax policy, and hence is structural in nature, it has
not been arbitraged away.

Note, however, that many municipal bonds are callable,

Also called municipal bond relative value arbitrage, mu- and that this imposes substantial additional risks to the
nicipal arbitrage, or just muni arb, this hedge fund strat- strategy.
egy involves one of two approaches. It should be noted
that the term arbitrage is also used in the context of the
Income Tax Regulations governing the investment of pro- 7.4 Convertible bond arbitrage
ceeds of municipal bonds; these regulations, aimed at the
issuers or beneciaries of tax-exempt municipal bonds, A convertible bond is a bond that an investor can return
are dierent and, instead, attempt to remove the issuers to the issuing company in exchange for a predetermined
ability to arbitrage between the low tax-exempt rate and number of shares in the company.
A convertible bond can be thought of as a corporate bond
a taxable investment rate.
Generally, managers seek relative value opportunities with a stock call option attached to it.
by being both long and short municipal bonds with a The price of a convertible bond is sensitive to three major

factors:
interest rate. When rates move higher, the bond part
of a convertible bond tends to move lower, but the
call option part of a convertible bond moves higher
(and the aggregate tends to move lower).
stock price. When the price of the stock the bond is
convertible into moves higher, the price of the bond
tends to rise.
credit spread. If the creditworthiness of the issuer
deteriorates (e.g. rating downgrade) and its credit
spread widens, the bond price tends to move lower,
but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility).
Given the complexity of the calculations involved and the
convoluted structure that a convertible bond can have,
an arbitrageur often relies on sophisticated quantitative
models in order to identify bonds that are trading cheap
versus their theoretical value.

TYPES OF ARBITRAGE

7.6 Dual-listed companies

A dual-listed company (DLC) structure involves two
companies incorporated in dierent countries contractually agreeing to operate their businesses as if they were a
single enterprise, while retaining their separate legal identity and existing stock exchange listings. In integrated and
ecient nancial markets, stock prices of the twin pair
should move in lockstep. In practice, DLC share prices
exhibit large deviations from theoretical parity. Arbitrage
positions in DLCs can be set up by obtaining a long position in the relatively underpriced part of the DLC and a
short position in the relatively overpriced part. Such arbitrage strategies start paying o as soon as the relative
prices of the two DLC stocks converge toward theoretical parity. However, since there is no identiable date
at which DLC prices will converge, arbitrage positions
sometimes have to be kept open for considerable periods
of time. In the meantime, the price gap might widen.
In these situations, arbitrageurs may receive margin calls,
after which they would most likely be forced to liquidate
part of the position at a highly unfavorable moment and
suer a loss. Arbitrage in DLCs may be protable, but
is also very risky.[7][8]

Convertible arbitrage consists of buying a convertible

bond and hedging two of the three factors in order to gain
exposure to the third factor at a very attractive price.
A good illustration of the risk of DLC arbitrage is the
For instance an arbitrageur would rst buy a convertible position in Royal Dutch Shellwhich had a DLC strucbond, then sell xed income securities or interest rate fu- ture until 2005by the hedge fund Long-Term Capisee also the discussion below).
tures (to hedge the interest rate exposure) and buy some tal Management (LTCM,
[9]
Lowenstein
(2000)
describes
that LTCM established
credit protection (to hedge the risk of credit deterioraan
arbitrage
position
in
Royal
Dutch
Shell in the sumtion). Eventually what he'd be left with is something simmer
of
1997,
when
Royal
Dutch
traded
at an 8 to 10
ilar to a call option on the underlying stock, acquired at
percent
premium.
In
total
$2.3
billion
was
invested, half
a very low price. He could then make money either sellof
which
long
in
Shell
and
the
other
half
short
in Royal
ing some of the more expensive options that are openly
Dutch
(Lowenstein,
p.
99).
In
the
autumn
of
1998
large
traded in the market or delta hedging his exposure to the
defaults
on
Russian
debt
created
signicant
losses
for
the
underlying shares.
hedge fund and LTCM had to unwind several positions.
Lowenstein reports that the premium of Royal Dutch had
increased to about 22 percent and LTCM had to close
7.5 Depository receipts
the position and incur a loss. According to Lowenstein
A depositary receipt is a security that is oered as a (p. 234), LTCM lost $286 million in equity pairs trading
tracking stock on another foreign market. For instance and more than half of this loss is accounted for by the
a Chinese company wishing to raise more money may Royal Dutch Shell trade.
issue a depository receipt on the New York Stock Exchange, as the amount of capital on the local exchanges
is limited. These securities, known as ADRs (American 7.7 Private to public equities
depositary receipt) or GDRs (global depository receipt)
depending on where they are issued, are typically consid- The market prices for privately held companies are typered foreign and therefore trade at a lower value when ically viewed from a return on investment perspective
rst released. Many ADRs are exchangeable into the (such as 25%), whilst publicly held and or exchange listed
original security (known as fungibility) and actually have companies trade on a Price to earnings ratio (P/E) (such
the same value. In this case there is a spread between the as a P/E of 10, which equates to a 10% ROI). Thus, if
perceived value and real value, which can be extracted. a publicly traded company specialises in the acquisition
Other ADRs that are not exchangeable often have much of privately held companies, from a per-share perspeclarger spreads. Since the ADR is trading at a value lower tive there is a gain with every acquisition that falls within
than what it is worth, one can purchase the ADR and ex- these guidelines. Exempli gratia, Berkshire Hathaway. A
pect to make money as its value converges on the original. hedge fund that is an example of this type of arbitrage
However, there is a chance that the original stock will fall is Greenridge Capital, which acts as an angel investor retaining equity in private companies which are in the proin value too, so by shorting it one can hedge that risk.

7.9

Telecom arbitrage

cess of becoming publicly traded, buying in the private

market and later selling in the public market. Private to
public equities arbitrage is a term which can arguably be
applied to investment banking in general. Private markets
to public markets dierences may also help explain the
overnight windfall gains enjoyed by principals of companies that just did an initial public oering (IPO).

7.8

Regulatory arbitrage

For more details on this topic, see Jurisdictional arbitrage.

Regulatory arbitrage is where a regulated institution takes
advantage of the dierence between its real (or economic) risk and the regulatory position. For example, if
a bank, operating under the Basel I accord, has to hold
8% capital against default risk, but the real risk of default
is lower, it is protable to securitise the loan, removing
the low risk loan from its portfolio. On the other hand,
if the real risk is higher than the regulatory risk then it is
protable to make that loan and hold on to it, provided
it is priced appropriately. Regulatory arbitrage can result
in parts of entire businesses being unregulated as a result
of the arbitrage.
This process can increase the overall riskiness of institutions under a risk insensitive regulatory regime, as described by Alan Greenspan in his October 1998 speech
on The Role of Capital in Optimal Banking Supervision
and Regulation.
The term Regulatory Arbitrage was used for the rst
time in 2005 when it was applied by Scott V. Simpson, a partner at law rm Skadden, Arps, to refer to a
new defence tactic in hostile mergers and acquisitions
where diering takeover regimes in deals involving multijurisdictions are exploited to the advantage of a target
company under threat.
In economics, regulatory arbitrage (sometimes, tax arbitrage) may be used to refer to situations when a company
can choose a nominal place of business with a regulatory,
legal or tax regime with lower costs. For example, an
insurance company may choose to locate in Bermuda due
to preferential tax rates and policies for insurance companies. This can occur particularly where the business
transaction has no obvious physical location: in the case
of many nancial products, it may be unclear where the
transaction occurs.

7
40 million USD. With a reserve ratio of 10%, the bank
can create 400 million USD in additional loans (there is a
time lag, and the bank has to expect to recover the loaned
money back into its books). The bank can often lend (and
securitize the loan) to the IT services company to cover
the acquisition cost of the IT installations. This can be
at preferential rates, as the sole client using the IT installation is the bank. If the bank can generate 5% interest
margin on the 400 million of new loans, the bank will increase interest revenues by 20 million. The IT services
company is free to leverage their balance sheet as aggressively as they and their banker agree to. This is the reason behind the trend towards outsourcing in the nancial
sector. Without this money creation benet, it is actually more expensive to outsource the IT operations as the
outsourcing adds a layer of management and increases
overhead.
According to PBS Frontlines 2012 four-part documentary, Money, Power, and Wall Street, regulatory arbitrage, along with asymmetric bank lobbying in Washington and abroad, allowed investment banks in the preand post-2008 period to continue to skirt laws and engage in the risky proprietary trading of opaque derivatives, swaps, and other credit-based instruments invented
to circumvent legal restrictions at the expense of clients,
government, and publics.
Due to the Aordable Care Acts expansion of Medicaid
coverage, one form of Regulatory Arbitrage can now be
found when businesses engage in Medicaid Migration,
a maneuver by which qualifying employees who would
typically be enrolled in company health plans elect to enroll in Medicaid instead. These programs that have similar characteristics as insurance products to the employee,
but have radically dierent cost structures, resulting in
signicant expense reductions for employers.[10]

7.9 Telecom arbitrage

Main article: International telecommunications routes

Telecom arbitrage companies allow phone users to make

international calls for free through certain access numbers. Such services are oered in the United Kingdom;
the telecommunication arbitrage companies get paid an
interconnect charge by the UK mobile networks and then
buy international routes at a lower cost. The calls are seen
as free by the UK contract mobile phone customers since
Regulatory arbitrage can include restructuring a bank by they are using up their allocated monthly minutes rather
outsourcing services such as IT. The outsourcing com- than paying for additional calls.
pany takes over the installations, buying out the banks Such services were previously oered in the United States
assets and charges a periodic service fee back to the bank. by companies such as FuturePhone.com.[11] These serThis frees up cashow usable for new lending by the bank. vices would operate in rural telephone exchanges, priThe bank will have higher IT costs, but counts on the marily in small towns in the state of Iowa. In these armultiplier eect of money creation and the interest rate eas, the local telephone carriers are allowed to charge
spread to make it a protable exercise.
a high termination fee to the callers carrier in order
Example: Suppose the bank sells its IT installations for to fund the cost of providing service to the small and

10

SEE ALSO

sparsely populated areas that they serve. However, Fu- 9 Etymology

turePhone (as well as other similar services) ceased operations upon legal challenges from AT&T and other ser- Arbitrage is a French word and denotes a decision by
vice providers.[12]
an arbitrator or arbitration tribunal. (In modern French,
"arbitre" usually means referee or umpire.) In the sense
used here it is rst dened in 1704 by Mathieu de la Porte
in his treatise "La science des ngociants et teneurs de
7.10 Statistical arbitrage
livres" as a consideration of dierent exchange rates to
recognize the most protable places of issuance and setMain article: Statistical arbitrage
tlement for a bill of exchange ("L'arbitrage est une combinaison que lon fait de plusieurs changes, pour connoitre
Statistical arbitrage is an imbalance in expected nominal [connatre, in modern spelling] quelle place est plus avan[14]
values.[2][13] A casino has a statistical arbitrage in every tageuse pour tirer et remettre".)
game of chance that it oersreferred to as the house
advantage, house edge, vigorish or house vigorish.

10 See also

The fall of Long-Term Capital

Management

10.1 Types of nancial arbitrage

Arbitrage betting
Covered interest arbitrage

Main article: Long-Term Capital Management

Fixed income arbitrage

Long-Term Capital Management (LTCM) lost 4.6 billion

U.S. dollars in xed income arbitrage in September 1998.
LTCM had attempted to make money on the price difference between dierent bonds. For example, it would
sell U.S. Treasury securities and buy Italian bond futures.
The concept was that because Italian bond futures had a
less liquid market, in the short term Italian bond futures
would have a higher return than U.S. bonds, but in the
long term, the prices would converge. Because the difference was small, a large amount of money had to be
borrowed to make the buying and selling protable.

Political arbitrage
Remarketing arbitrage
Risk arbitrage
Statistical arbitrage
Triangular arbitrage
Uncovered interest arbitrage
Volatility arbitrage

The downfall in this system began on August 17, 1998,

when Russia defaulted on its ruble debt and domestic dol- 10.2 Related concepts
lar debt. Because the markets were already nervous due
to the Asian nancial crisis, investors began selling non Algorithmic trading
U.S. treasury debt and buying U.S. treasuries, which were
Arbitrage pricing theory
considered a safe investment. As a result, the price on
US treasuries began to increase and the return began de Coherence (philosophical gambling strategy), analcreasing because there were many buyers, and the return
ogous concept in Bayesian probability
(yield) on other bonds began to increase because there
were many sellers (i.e. the price of those bonds fell). This
Cointelation
caused the dierence between the prices of U.S. trea Ecient-market hypothesis
suries and other bonds to increase, rather than to decrease
as LTCM was expecting. Eventually this caused LTCM
Immunization (nance)
to fold, and their creditors had to arrange a bail-out. More
controversially, ocials of the Federal Reserve assisted
Interest rate parity
in the negotiations that led to this bail-out, on the grounds
Intermediation
that so many companies and deals were intertwined with
LTCM that if LTCM actually failed, they would as well,
No free lunch with vanishing risk
causing a collapse in condence in the economic system.
Thus LTCM failed as a xed income arbitrage fund, al TANSTAAFL
though it is unclear what sort of prot was realized by the
Value investing
banks that bailed LTCM out.

11

Notes

[1] As an arbitrage consists of at least two trades, the

metaphor is of putting on a pair of pants, one leg (trade)
at a time. The risk that one trade (leg) fails to execute is
thus 'leg risk'.

12

References

[1] http://www.arb2win.com
[2] Mahdavi Damghani, Babak (2013).
The NonMisleading Value of Inferred Correlation: An Introduction to the Cointelation Model. Wilmott 2013 (1): 5061.
doi:10.1002/wilm.10252.
[3] Shleifer, Andrei; Vishny, Robert (1997). The limits of arbitrage. Journal of Finance 52: 3555.
doi:10.1111/j.1540-6261.1997.tb03807.x.
[4] Xiong, Wei (2001). Convergence trading with wealth
eects. Journal of Financial Economics 62: 247292.
doi:10.1016/s0304-405x(01)00078-2.
[5] Kondor, Peter (2009). Risk in Dynamic Arbitrage: Price
Eects of Convergence Trading. Journal of Finance 64
(2): 638658. doi:10.1111/j.1540-6261.2009.01445.x.
[6] The Basis Monster That Ate Wall Street (pdf). D. E.
Shaw & Co. Retrieved February 12, 2011.
[7] de Jong, A.; Rosenthal, L.; van Dijk, M.A. (June 2008).
The Risk and Return of Arbitrage in Dual-Listed Companies. Retrieved February 12, 2011.
[8] Mathijs A. van Dijk. Dual-listed Companies. Retrieved
January 30, 2013.
[9] Lowenstein, R. (2000). When genius failed: The rise and
fall of Long-Term Capital Management. Random House.
[10] What is Medicaid migration and how does it apply to brokers?". Employee Benet News. June 25, 2014.
[11] Ned Potter (2006-10-13). Free International Calls! Just
Dial ... Iowa. Retrieved 2008-12-23.
[12] Mike Masnick (2007-02-07). Phone Call Arbitrage Is
All Fun And Games (And Prot) Until AT&T Hits You
With A $2 Million Lawsuit. Retrieved 2008-12-23.
[13] Mahdavi Damghani, Babak (2013). De-arbitraging With
a Weak Smile: Application to Skew Risk. Wilmott 2013
(1): 4049. doi:10.1002/wilm.10201.
[14] See Arbitrage in Trsor de la Langue Franaise.

Greider, William (1997). One World, Ready or Not.

Penguin Press. ISBN 0-7139-9211-5.
Special Situation Investing: Hedging, Arbitrage, and
Liquidation, Brian J. Stark, Dow-Jones Publishers.
New York, NY 1983. ISBN 0-87094-384-7; ISBN
978-0-87094-384-3

13 External links
What is Arbitrage? (About.com)
ArbitrageView.com Arbitrage opportunities in
pending merger deals in the U.S. market
Information on arbitrage in dual-listed companies on
the website of Mathijs A. van Dijk.
What is Regulatory Arbitrage. Regulatory Arbitrage
after the Basel ii framework and the 8th Company
Law Directive of the European Union.
Institute for Arbitrage.
Institute for Stock Market Courses.

10

14

14
14.1

TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

Text and image sources, contributors, and licenses

Text

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Images

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