In the simplest of terms, Arbitrage means to exploit price differential. Usually it meant looking at differing sources of an investment, and if there was a price difference between Source A and Source B - then the investor / dealer / broker / manager would buy from the lower priced source, and sell on the higher priced source. Example:- The price of Stock ABC was $20 per share on Exchange XYZ The price of the same Stock ABC on another Exchange 123 - was $15 The dealer would buy the stock from Exchange 123 for $15 - then sell on Exchange XYZ for $20 - making $5 per share profit (minus costs). Typically the price differential was very small - and trading had to be extremely quick and liquid - otherwise the markets could go against you in a very short time. Ten years ago Arbitrage was more commonplace than it is today - for a number of reasons. Nowadays, Arbitrage still exists, but either in limited formats and availability as direct arbitrage, or more commonly in Hedge Funds. Hedge Funds can have Arbitrage as one of their investment methodologies / strategies - and you will find that many of the past Arbitrage Managers have switched across to Hedge Funds. Even after the LTCM (Long Term Capital Management) scandal / fiasco a few years ago - Hedge Funds continue to grow, and today are the biggest and fastest growing investment style in the World. This doesn't mean that Arbitrage is dead - as it can be part of Hedge Funds. There are still some direct / explicit Arbitrage Funds available in the World. Most of these concentrate on M&A Arbitrage (Mergers and Acquisitions) - or more usually Mergers. The manager will actively seek companies which have been targeted as potentials for takeover, and buy into that company, in the hope the M&A activity will drive up the price. This method is often enhanced by the use of leveraging (gearing up / borrowing) (remember LTCM?) - and sometimes using Derivative Structures such as Options - or hedging methods such as selling short. Depending on the structure, methodology, management style, leveraging etc., the potential rewards can be substantial, but so can the risks. Not all Arbitrage investments are the same - just like any other asset class, I would strongly suggest that anyone considering this should perform their own Due Diligence and seek professional advice. One very common place where Arbitrage happens every day - by people just like you and me..... is eBay! Sellers are locating items for sale from sources which may sell them very cheaply (flee-markets, garage sales etc.) and then selling them online for a tidy little profit. These people are exploiting the price differential - arbitrage - and there's nothing wrong with that!! Its all about Supply and Demand - but thats another story! (the information contained herein is for information purposes only and should NOT be considered as advice or recommendation relating to the purchase or sale of any investment). |
