What Is Arbitrage?

There is a way to profit when investing by exploiting the inefficiencies of the stock market. The market occasionally provides low risk transactions for shrewd investors. This is known as arbitrage. Arbitrage is the process of taking advantage of a mispricing of a financial asset in a particular market. There are arbitrage opportunities in bonds, currencies, commodities and other assets. The stock market occasionally offers up arbitrage opportunities that investors can make money from.

Finding an arbitrage opportunity is not always easy and requires quick action when you come across them. That’s because there are lots of investors and traders who spend all day looking for arbitrage situations and will swoop in and act quickly. You can often find some of the best arbitrage opportunities in merger transactions and takeover bids.

This is because the stock of a company that is about to be acquired or merged with another company often trades at values that are lower or higher than the true acquisition price. This could be for a number of reasons.

One of the main reasons that a stock will trade at a significant discount to its acquisition price is because investors don’t believe that the deal will be approved. For example, shares of Rohm & Haas were trading for just $50 a share two years ago despite a buyout offer from Dow Chemical for $78. The stock was trading $28 below its takeover value because of investor pessimism. Dow Chemical bought Rohm and Haas for $78 a few months later, and arbitrage investors were rewarded with a 56% premium.

Another reason that a stock may be mispriced is because investors are just not quite sure how much a company is willing to pay for a stock. Companies often bid on a stock by offering a range of prices. For example, a company could offer $30 to $40 for a stock. Investors don’t know whether the offer will be on the lower end towards $30 or on the upper end at $40. Bold investors that are willing to invest in situations like these are often rewarded.

You can often take advantage of these arbitrage opportunities to carve out small profits for your portfolio. They are very low risk propositions that offer a nice payout. One of the ways to profit from an arbitrage situation is to get long shares of a company and buy the stock. The best time to buy is normally a few days after a takeover announcement so that shares have had a chance to settle.

Another option is to buy call options that you will give you the right to buy shares at the strike price. This is a lot cheaper than buying the individual stocks. You can always exercise the option or sell it at a premium on the market. If you don’t want to exercise the option then you can just let it lapse.
You can also short a stock if you believe a deal will fall through or believe that a company will lower its bid. Most merger deals fail due to a lack of financing or being unable to obtain governmental or shareholder approval.

There are quite a few ways that you can earn profits by exploiting the price differences that occur when arbitrage opportunities present themselves.

Comments

  1. says

    I can’t think of the name off the top of my head, but IndexIQ (which has a ton of quant/hedge replication funds) actually has a merger arbitrage ETF. If I remember correctly from the prospectus, the underlying index that the fund is modeled after actually outperformed the S&P.

  2. Lewin says

    I’m by no means an expert, but if the definition of arbitrage is “exploiting the inefficiencies of the stock market… [providing] riskless transactions…” I’m not sure your two examples qualify. In both cases there was probably substantial risk involved. Here is my logic.

    The pre-takeover price reflects the bid value, minus some amount that reflects investor uncertainty about whether the takeover will occur. That is, the uncertainty is already built into the price. If the bid falls through, the stock price is likely to drop. The current price HAS to reflect the takeover bid to some extent, unless you are the only investor around (or one of very few) who think that the takeover will happen and everybody else things it will never happen.

    Or am I off base here?

  3. Mike@javainvestor.com says

    I agree with Lewin that these transactions are not as risk free as they might appear. I once invested in a company (a small amount) on the expectation of a buyout at a substantial premium. But, both companies got caught up in the financial upheaval so the trade didn’t work.

    Another variable is how the offer is made. One made with all cash is different than one with stock and cash. Since the stock is a moving target, this can create an uncertainty in the potential of the arbitrage transaction.

  4. says

    @Lewin and Mike. Your comments are noted. I have adjusted the working so it’s not ‘riskless’ anymore. You are both correct riskless investments do not exist. You can however minimize risk through various means.

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