What Is Arbitrage?
ARBITRAGE IS A FANCY financial term with French roots that's occasionally tossed around in investing conversations and write-ups. It's one of the more interesting concepts in finance, and it's something that every investor would love to take advantage of if given the opportunity.
But what exactly is it?
What Is Arbitrage?
At its core, arbitrage is the concept of a riskless profit. It means taking advantage of the mispricing of assets across different markets. Theoretically, a pure form of arbitrage would be buying an asset in one market and selling the same asset in another market at a higher price, simultaneously.
"These cross-market arbitrage strategies can get pretty complicated because computers are programmed to find unexpected relative differences in price between stocks, bonds, exchange rates and currency prices," says Robert Johnson, professor of finance at Creighton University in Omaha, Nebraska.
As you can imagine, the allure of easy money makes arbitrage a highly sought-after opportunity, and capital markets are typically quick to exploit such inefficiencies, closing them at a moment's notice.
That said, markets aren't always perfectly efficient, which means real arbitrage opportunities occasionally present themselves.
Famous Arbitrage Examples
ohnson highlights a famous arbitrage opportunity that came to light in December 1998, when Creative Computers spun off 20% of its online auction business Ubid. By the end of the trading day, Creative Computers' remaining 80% stake of subsidiary "Ubid" was worth almost $80 million more than Creative Computers itself, implying the rest of the company's assets were actually less than worthless. It was significant mispricing for a company worth less than $500 million.
"An arbitrageur would buy shares of Creative Computer and sell shares of Ubid until the implied negative valuation disappeared. Ideally, proceeds from the short sale of Ubid can be used to fund the purchase of Creative Computer so that no capital is required," Johnson says.
Modern-Day Arbitrage Examples
You don't have to turn to textbooks and case studies to find examples of arbitrage opportunities, however. The rationale for many spinoffs is based on a loose form of arbitrage when company management sees the market undervaluing its subsidiaries.
IAC (ticker: IAC), a diversified media and internet holding company, has rewarded its shareholders handsomely by practicing this precise strategy, growing businesses to the point of being able to offer shares in an IPO, then spinning off the remainder of the company if it looks like IAC is being undervalued compared with its subsidiary.
IAC's chairman, Barry Diller, is a media legend and has helped oversee seven such spinoffs, the most recent of which was online dating giant Match Group (MTCH), completed in July 2020. Since August 1995, the month Diller joined the company, IAC stock is up more than 18,000%.
Although not pure arbitrage by any means, this strategy clearly seems to have worked.
Other modern-day examples can be found in obscure areas of high finance.
"High-frequency traders seek arbitrage by buying order flow from brokerages so that they can position themselves in the 'buy'/'sell' trade," says Arvind Ven, CEO and founder of Capital V Group, an independent financial advisory firm.
Incidentally, selling order flow is a practice that helps allow retail brokerages like Robinhood to offer free trading. It's controversial, as its customers tend not to get the best trade execution as a result, and it creates a conflict of interest that pits high-frequency traders against retail investors, with apps like Robinhood in the middle.
There are also forms of arbitrage done daily in everyday life.
Labor arbitrage, where large companies offshore manufacturing to locations with lower labor costs, sees companies compete – arguably unfairly – in the same developed market with another product developed with higher labor costs, Ven says.
A looser use of the term still is merger arbitrage, also known as risk arbitrage, where investors will try to capitalize on price inefficiencies surrounding an announced merger for a low-risk gain. Shares of the company to be acquired typically trade at a discount to the deal's announced price, reflecting the risk a deal isn't completed or doesn't pass antitrust muster.
If an arbitrageur has unique insight into the likelihood of such a deal going through, trading on that knowledge is a form of merger arbitrage, although it's technically still not a riskless profit.