Question

CASE STUDY

ARBITRAGE: IS THERE SUCH A THING AS A ‘FREE LUNCH’?

With financial markets operating twenty-four hours a day, seven days a week throughout the world it is no surprise that there tend to be price discrepancies in the securities being traded. It is the manipulation of these discrepancies by a relatively small group of professionals that is referred to as arbitrage. Those who partake in this activity are called arbitrageurs.

Arbitrage has existed in some form or another since the middle ages. An early example of ‘exchange rate arbitrage’ took place in fairs held in large cities throughout Europe where traders came, each with their own country’s currency, to buy and sell goods. An exchange rate would be agreed upon and each fair generally had a fixed exchange rate which allowed arbitrageurs take advantage in the different locations i.e. sell goods in fairs where your currency was weak and buy in those where it was strong.

From here the bill of exchange was introduced which involved four people. Two people managing the exchange of the money, one in France and one in England for example. A person would go to the ‘taker’ in France and pay the going exchange rate for sterling. He would then have a person pick up the sterling in England from the English ‘payer’. These took anything up to six months to be completed and cashed in. It was possible, if one had a network of correspondents in the major banking locations, to take advantage of the ability to communicate the state of the markets. Since the introduction of coinage there were huge differences in the value of currencies due to the clipping of coins. Clipping involved clipping small pieces off a silver or gold coin and melting down these pieces to make new coins which led to both clipped coins and new coins having less metal content than the original coins. In the 17th Century coins were made with serrated edges to avoid this practise.

Early arbitrage took place with the trading of goods and the exchange of money. With the development of financial markets it was inevitable that arbitrage would find its place within the trading of securities. Initially arbitrage consisted of moving goods and information over large distances which was ideal for manipulation of any discrepancies available. In modern arbitrage however information is processed in seconds and this leaves a very small gap where arbitrage can take place. True arbitrage opportunities are few and far between, becauseIt was not until academics began looking at price options and strategy that arbitrage took on a whole new meaning in financial markets. For Fisher Black and Myron Scholes’ model of option pricing to work the market has to have two types of people operating in them. Firstly those who don’t know what they were doing and those who do. It’s the people who understand the pricing of securities that can manipulate the market to make a risk free profit.

Black was unable to partake in the venture but Scholes took the model and joined with economist Robert Merton and the experienced trader John Meriwether and together they set up the firm called Long Term Capital Management (LTCM) in 1994. The company worked with the theory of convergence, going long on cheap options and short on higher priced options in the hope that they would converge and LTCM would make a ‘risk free’ profit. The returns from these transactions were relatively small and required additional capital. This was done through leveraging against their existing assets. At the final stages of the company this ratio was a massive 42:1. Perold 1999 (cited in Mallaby 2010)

The Black – Scholes models “most important assumption is that the underlying market such as stocks – functions properly.” (Dunbar 2000, p.43) This assumption left them unprepared for the events of 1998. Russia announced default on its debts and the markets reacted by moving to safer financial assets. LTCM were unable to make up for the losses they sustained and in order to avoid a chain reaction involving all the companies which had invested in LTCM the company was bailed out by the Federal Reserve.

The fact that arbitrage exists is proof that only the weak form of the Efficient Market Hypothesis (EMH) holds where the only data available for prices is in the past and not all information is included in the price. Arbitrage is believed to smooth out the many, irrational fluctuations in the market. Because, if prices are too high due to positive events they will be brought back down to their rightful value once arbitrage has taken place and vice versa. As is evident from the case of LTCM, arbitrage does involve risk and large amounts of capital as stated by Shleifer and Vishny (1997) which leaves the question ‘is there such a thing as a free lunch?’

Questions?

1. Using this case study, explain the effects of external factors on markets?
2. With the advent of computers and the internet arbitrage has a smaller gap in which to occur. Discuss.

Answer 1

External effects includes outside factor apart from the factors affecting one's portfolios in such cases those external factors either environment,medical,political can significantly affects one's financial position and hence are the risk to be assumed while making portfolio decision as was seen in the Russian debt crisis leading to conservatism amongst the investors.

With the advent of computer age and trade speeds is quicker than ever with exchanges across the globe boasts of quicker trades and corresponding reflection in prices arbitrage opportunities are very rare to find and if are there are to be grabbed within seconds before market achieve Equilibrium.Hence, if wants to earn arbitrage window of opportunity is very small.