What is arbitrage? People in the habit of watching CNN or foxnews coverage of the financial crisis may hear this word now and then, and if you hang out with hedge fund managers such annoying terms like arbitrage and alpha probably roll off their tongues whilst drunk.
Behold, I shall define Financial Arbitrage. Arbitrage, quick, dirty, and inaccurate description follows..
1. Say, a Starbucks at 5th and Vine is selling coffee beans by the pound for $1.50
2. Say, a Starbucks at Findlay and Race is selling coffee beans by the pound for $1.90 – opportunity costs are higher and local thugs like to waylay deliverymen and steal their beans for resale on the black market.
Plus the locals there will pay a higher premium because they are too plump to easily walk over to 5th and vine
without getting breathless.
Capiche? Good.
3. You go to 5th and Vine, buy 100lbs of coffee beans @ $1.50, drive half a block away from Findlay and Race, setup a table, and sell them for $1.75/lbs.
Then better, you go to Hyde Park Square and sell them for
$2.50/lbs
You buy low, and sell high.
Arbitrage is more complex however. In financial markets one purchases securities, stocks, derivatives, bonds, whatever, at one price on one market, for IMMEDIATE resale on another market to take advantage of the discrepancy in prices.
This introduces the element of simultaneity into the transaction.
The classic MBA/econ course definition emphasizes simultaneity and low or non existent risk. In arbitrage the resale is simultaneous with the purchase and at minimal to non existent risk.
Risk is to be defined as exposure to uncertainty of outcome of a particular course of action.
Potential outcomes are volatile, and hence uncertain.
Excessive deviation from the expected outcome, if
probable outcomes are to be charted, could define risk well.
Inefficient markets give rise to arbitrage opportunities. One market may lag behind another due to exchange rate changes not adjusting or political factors in the terrestrial locality that market is based in.
How does this pertain to you? The answer should be simple but there are complexities.
– Buying sugar in Zaire at one price, marking it up to reflect fees in closing a transaction and a profit margin for you, the trader, and reselling it to an importer in Belgium is to be defined as a quick and dirty form of arbitrage.
– A more sophisticated form would be buying Crude Oil at a fixed price pegged to a specific Platt’s price index e.g. buy @ Med. Then you resell at another Platt’s index price in which the product trades higher, e.g. Rotterdam, same API specs same Sulphur content, etc. (or you sell it, at say, New York Mercantile or Dubai index +/- some margin, or something)
– An illegal but highly profitable form of arbitrage would be exploiting tax and tariff discrepancies between political jurisdictions and buying cigarettes in one jurisdiction with lower tariffs and taxes, and reselling the same product in another one, with higher tariffs and taxes, profiting from the spread created by the discrepancies.
Cigarette smuggling is sexy, but introduces penitentary risks.
Since this particular example is fraught with risks – it is not a good example of a low risk arbitrage opportunity, but it suffices as a basic example of showing what is entailed.
– A final example is Real Estate “flipping” – defined as “contract flipping” or “double closings” you arrange TWO DEALS, One you BUY a property at price X, two you SELL the same property at the same closing at price X + (my profit margin) – (closing costs for both deals) = Arbitrage Opportunity.
Two purchase/sale contracts, one escrow agent, two deals,
you close deal 1 in room 1, literally walk to room 2 and close deal 2 and keep the spread. This is an established real estate practice, it is quite simply a form of arbitrage.
Financial AND physical Traders constantly look for arbitrage opportunities. Hedge Fund ^H^H^H^SCAM ARTISTS (eh.. I mean managers) spend a good deal of their time looking for arbitrage opportunities and playing one form of arbitrage off another to minimize the overall risk of their operations.
Arbitrage opportunities may be found anywhere. Production costs in one market being higher than in another one for a good in great demand in the first market, buying these goods in the second market and reselling them in the first.
Buy baby fomula in Kentucky, truck it to new yourk, hustle it to immigrant markets at your costs plus profit margin coming under their wholesale costs with taxes. This has been done, locally, with great benefit by individuals who shall not be named by myself.
You exploit differences in multiple prices for goods with the same specifications, etc., etc. and profit and try not to blow it on drugs, loose women, and playstation games. Youth, it is said, is wasted on the young, and intellect wasted on, well, most..
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