What the hell is an "arbitrage?"

[Nevernose]

If you're like me, then you have no idea what in the hell "arbitrage" means. Thank you, Enron, for bringing the word to the forefront. I was curious, so I assumed that maybe someone on DU might be curious as well. Relevant definitions from the OED follow:

Noun
3. Comm. The traffic in Bills of Exchange drawn on sundry places, and bought or sold in sight of the daily quotations of rates in the several markets, each operation being based in theory on the calculation known as ARBITRATION of Exchange, q.v. Also, the similar traffic in Stocks, so as to take advantage of the difference of price at which the same stock may be quoted at the same time in the exchange markets of distant places.

1875 Encycl. Brit. II. 311/2 The great Government loans are..the natural subject-matter of arbitrage. 1881 Daily News 27 Apr. 6 Foreign arbitrage brokers. 1882 Pall Mall G. 24 June 1 He cannot..tell what the outcome of the unfathomable arbitrage business will be.

Verb
intr. To engage in arbitrage (see ARBITRAGE 3). Hence arbitraging vbl. n.

1900 S. A. NELSON ABC of Wall Street 126 Arbitraging, trading in two markets in order to profit by the difference in prices. 1923 J. M. KEYNES Tract on Monetary Reform iii. 129 The surcharge representing the profit of a bank for arbitraging between spot and forward transactions may much exceed the moderate figure indicated above. 1953 Economist 16 May 461/1 Possible for authorized banks in these countries to arbitrage between the six currencies concerned.


I;m not at my work computer, so I have no idea what "arbitrage" means in a legal sense.

[Lucky Luciano]

1. ok

here is the deal....Arbitrage is a transaction that should theoretically create a guaranteed profit. Example:

Say gold is 375/oz in Hong Kong and 378 in London...if you can buy it in HK and flip it in London quickly then you lock in a guaranteed profit.

Another example...Say company ABCD buys company WXYZ where ABCD is priced at 100 and WXYZ is priced at 75....say the offer to WXYZ is one for one on shares. In theory this should increase the price of WXYZ to 100, but it does not. It often will go to 93 or something because it usually takes a long time for the deal to close (Technically this is not a risk free thing given that the deal could fall apart eventually, but let us assume this does not happen). Assume ABCD stays at 100. That means that there should be $7/share available to lock in for profit if you sell ABCD short and buy WXYZ long at 93. As the day for closing approaches, you will see the prices come closer and closer until they are in unison and you will have locked in the guaranteed $7/share from the arbitrage on closing day.

If you know anything about options:

Let us say that stock ABCD is priced at 75.
Let us say that you have some ABCD call options with a strike price of 65. Since the options are in the money by 10 points, it should guarantee that one option contract is worht AT LEAST $1,000 (10 X 100 shares). Teh call option gives you the right to purchase ABCD at 65, so if the stock is currently at 75, then it makes sense that the option should be worth AT LEAST 10, but if for some reason it is selling for 9.90, then a savvy investor with a lot of money to avoid being eaten by commissions (most likely the options specialist in the trading pit who sees these brief and rare moments and can act immediately) will exercise as many options as they can get their hands on until the price comes to a more sensible level - so he would be locking in $.10 per share and this would give him $100 per contract...if he can get a hold of 100 contracts and exercise them, then he locks in $10,000 for himself - another example of arbitrage. I saw this happen with a friend who was on the OTHER end of the calls and it pissed him, but that is the way it goes!

There are countless other examples.

[Yupster]

2. It's trading to take advantage of usually brief price anomalies

For instance, you notice that gold is selling for 288 an ounce in London, but 286.75 in Hong Kong. You quickly buy a contract for $ 50 million worth in Hong Kong and then sell it in London to profit the difference in price.

It usually only lasts a brief period of time before the prices catch up to each other, but with computers, there are sometimes brief opportunities that can be caught. On the other hand, computers are much quicker to tell a market that it is out of whack with other markets, so the prices even themselves out quicker.

Anyway, that's what an arbitrage trader does.

It was real big in the 90's where the stock market tech bubble and the birth of the internet led to many excesses of arbitrage trading.

[immune2irony]

3. Taking a good from where it's cheap to where it's dear

If Enron wasn't manipulating the market, they would be performing a service by shifting electricity from where it was cheap and in surplus and transferring it to energy-starved California.

That's arbitrage, and in most market situations, it's a good thing, balancing prices between markets and making dealers more competitive, which is good for the consumer.