Risky arbitrage

By Felix Salmon
September 17, 2009
law of one price to become roughly true, and in turn belief in the law of one price is the central faith of any arbitrageur, who will pick up on price discrepancies safe in the knowledge that sooner rather than later the law will turn those trades into profits.

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The existence of arbitrage, and arbitrageurs, is a necessary precondition for having a reasonably efficient market. Arbitrage allows the law of one price to become roughly true, and in turn belief in the law of one price is the central faith of any arbitrageur, who will pick up on price discrepancies safe in the knowledge that sooner rather than later the law will turn those trades into profits.

The problem is that the law of one price is not some kind of physical law with replicable effects, and sometimes it disappears entirely. So this kind of thing is actually true of all arbitrage:

DLC arbitrage is characterized by substantial idiosyncratic return volatility and a high incidence of large negative returns.

DLC (dual-listed company) arbitrage — where you look at the share price of the same company in different countries, and bet that they’ll converge — is one of the purest forms of arbitrage there is. But it’s not surprise to learn that it comes with “a high incidence of large negative returns”: any arbitrage strategy is ultimately a game of picking up nickels in front of a steamroller. Unless you have unlimited liquidity and never need to worry about margin calls, the market is likely to move against you just until you give up, at which time it will snap back to where you would have made a huge profit. Just ask the guys at LTCM, or the stat-arb hedgies who blew up in 2007.

This is why only the biggest and most liquid companies tend to try their hands at arbitrage: it’s very much a don’t-try-this-at-home strategy. Even if you’re convinced that the trade is risk-free, it really isn’t.

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Comments
4 comments so far

as the old saying goes, markets can remain irrational longer than you can remain solvent.

Posted by howard | Report as abusive

So how is the bet structured? If they converge on a price lower than either when the bet begins does it still profit?

Posted by zach | Report as abusive

Good article but ‘arbitrage’ is just another form of zero-sum game financial speculation in already listed financial instruments. It offers no economic benefits. That’s why the BoE QE is failing as its just shuffling cash around between investments – gilts to equities.

To create economic growth cash needs to be invested in new projects that have the potential to create new streams of economic wealth.

think you mean 1997. gosh, has it been that long?

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