Ever since the stock markets have come in existence, arbitrage has always been present. Though, through natural evolution, one form of arbitrage may disappear but others take its place. In this article, I focus on equity arbitrage strategies that we deploy actively. We will not do justice, if we did not discuss the risks that go with equity arbitrage, so each strategy has inherent risks that are also addressed.
The simplest form of arbitrage exists when same equity (or its derivative) is trading at different prices in two different markets. This simple price arbitrage occurs due to inefficiencies in the market place, usually caused by aberrations in demand and supply in one market and should ideally entail no risk, if executed simultaneously in both markets.
Such arbitrage opportunities reflect minor pricing discrepancies between markets or related instruments. Per-transaction profits tend to be small, and they can be consumed entirely by transaction costs. Accordingly, most arbitrage is performed by institutions which have very low transaction costs and can make up for small profit margins by doing a large volume of transactions.
Arbitrage Strategies: Risks and Rewards
ADR-GDR Arb: Several equities are listed in local exchanges as well as foreign exchanges like New York or London, in the form of American Depository Receipt (ADR) or Global Depository Receipt (GDR). Theoretically speaking, the price of the ADR or GDR should be very close to the local underlying but that is not the case all the time. We find discrepancy in the price of ADR/GDR as against the local share price, cause of limited supply of the DRs. Usually, the DR would trade at a premium to local price and arbitrageurs can short the higher market and buy in the local market. However, in context of Asia this would entail an overnight risk since both the underlying and ADR/GDR market do not necessarily trade at the same time and one might find it difficult to buy and sell at the prices to lock in the profit. This arbitrage is fraught with local regulatory bottlenecks which may altogether prohibit short selling in the case the local trades at premium. The execution risk of gapped openings, due to overnight exposure (after one side of trade is done) is the key risk. Professionals can Manage this risk well by limiting exposure per security, based on liquidity and arbitrage spreads.
Convertible Bond Arb: Convertibles are hybrid financial instruments, providing income on the bond with option to participate in the capital appreciation of the stock. Historically convertibles have generated equity linked returns with less risk. In bull markets, convertibles have trailed global equity markets by only a few percentage points, while in bear markets convertibles offer considerably more downside support. Convertible securities are an appropriate investment vehicle for long-term investors seeking a high rate of return but with less risk than common stocks.
Convertibles trade within certain boundary conditions. If these boundaries are violated, an arbitrage profit is possible. For instance, if convertible trades below equity value (parity) then it can be purchased while simultaneously shorting an amount of stock equal to the conversion ratio. Upon conversion, the stock received can be used to cover the outstanding short position. For an equity investor the instrument is attractive for its asymmetrical equity sensitivity especially in case of rising share price environment and less sensitive when the share price is falling. For a fixed income investor, the purchase of a convertible is equivalent to the purchase of a straight bond together with the purchase of upside participation in any underlying share price appreciation. Exposure to convertibles inherently carries the credit risk of the corporation.
Cash Futures Arb: Cash future arbitrage is the safest form of arbitrage where in profit is captured through pricing inefficiencies between the cash and derivatives market. Future contract is an agreement to buy or sell a stock at a particular date in future. Theoretically, the price of the future contract has to be the current stock price plus the cost of capital required to buy the stock (to keep it for delivery at a future date) also called as Cost-of-Carry.
F = Future price of the stock
S = Current market price of the underlying stock/index
R = Risk free rate of return
T = Time in days
F= S* e^(r*t)
This is the fundamental basis (or formula) for pricing future contracts. Irrespective of what the underlying is an index or an individual stock. Thus, the future price should always reflect this premium.
An arbitrage opportunity exists if futures price are either greater than or less then the spot price plus cost-of-carry. In case the futures price are greater then cash price plus carry cost then sell the (overpriced) futures contract, buy the underlying asset in spot market and carry it until the maturity of futures contract. This is called "cash-and-carry" arbitrage. If futures are trading at discount to the spot then buy the (under priced) futures contract, short-sell the underlying asset in spot market and invest the proceeds of short-sale until the maturity of futures contract. This is called "reverse cash-and-carry" arbitrage.
Volatility Arb: Volatility arbitrage is another market neutral strategy which involves buying or selling of options (calls/puts) depending on whether the volatility is high (sell) or low (buy). If an option is trading with a low implied volatility in other words if the option is cheap (have low time premium), then buy the option and simultaneously hedge it by short-selling the underlying stock. Thus locking in the profits over time as the actual volatility exceeds the implied volatility.
Similarly if an option is trading with a high implied volatility in other words if the option is expensive (have high time premium), then sell the option and hedge it by buying the underlying stock. Thus locking in the profits over time as the actual volatility reverts back to the historical implied volatility.
The amount of underlying to be bought or sold depends on the hedge ratio also called delta of the option. Delta is the rate of change of the option price per unit change in the underlying. However, this strategy involves continuous adjustment of the delta to keep the position delta neutral.
Statistical Arb: Statistical arbitrage is based on relative value with an approach of mean reversion. Statistical arb, also known as pairs trading, involves two highly correlated stocks, in other words, finding two stocks whose prices have moved together historically. When the spread between them widens, the overvalued stock is shorted and simultaneously the undervalued stock is bought. Profit is made when prices converge and the spread narrows. The key element for the successful implementation of this strategy is finding two (or more) stocks, sectors, indices that are highly correlated. Pairs trading also works on divergence wherein the spread between the two securities is narrow and the bet is taken on the divergence of the stock. In this case profit is incurred when the spread between the two securities widens.
Index Arb: In an efficient market, two assets with identical attributes must sell for the same price, and so should an identical asset trading in two different markets. If the prices of such an asset differ, a profitable opportunity arises to sell the asset where it is overpriced and buy it back where it is under priced. In index arbitrage, profit is locked in from temporary discrepancies between the prices of the stocks comprising an index and the price of their index futures. By buying either the stocks or the futures contract and selling the other, an investor can sometimes exploit market inefficiency for a profit. Like all arbitrage opportunities, index arbitrage opportunities disappear rapidly once the opportunity becomes well-known and many investors act on it.
Merger Arb: This is an event specific strategy wherein the arbitrageur would go long on the target shares and simultaneous short the acquiring company shares. Firm A which looks to acquire Firm B would offer a premium price to B's shareholders, which gives them the motivation to part with their shares either for a cash or stock in the acquiring or a mix of the two, whichever the case may be. This would bid up the price of the target company and acquiring company's shares normally fall succumbing to shorting pressure but there still would be a mis-pricing which arbitrageurs look to capture.
The simplest of all the merger deals is cash deal and would simply require the arbitrageur to buy the shares of the target company and lock in the difference between its current price and the one being offered. In a stock-for-stock deal, where in the target's shareholders are offered shares in the acquiring company; one can normally observe a mis-pricing and can be cashed on by buying the shares of the target and simultaneously shorting the acquirer's shares.
Whatever be the nature of the deal, be it a cash deal, stock for stock, or even a mix of the two, lesser the uncertainty surrounding the completion of the deal, lesser the gap. The strategy on surface although looks fairly simple but can prove to be catastrophic if the deal breaks off. Merger deals are exposed to market sentiments, regulatory guidelines, political environment and the time horizon, which subsequently contribute to the risks.
Arbitrage exists due to the inherent inefficiencies in the market place and it makes the efficient market theory look like a college professor's theoretical paradise. Professional investors are able to take advantage of these arbitrage opportunities (which have small spreads) due to the large investment amounts of monies, sophisticated trading programmes and sometimes better and quicker sources of information, that reduce the latency in the execution of trades.
An investor who aims to make slightly above risk free rate of returns (above US treasuries) with very limited market risks will be well served by having an allocation to arbitrage strategies.
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