What is Arbitrage ?

This term basically means that a buyer buys some stock at a lower price and sells at a higher price, either in the same market or in a different market. There are two types of arbitrage. The first is called 'simple' or 'single point arbitrage'. Here one buys a stock or commodity or currency and sells it at a profit in another market where the demand may be high due to localized competitive forces. Let us say that a currency trader wants French Francs in exchange for dollars.

However, he may find that exchange rate for Swiss Francs better. He can buy the Swiss Francs and then buy the French Francs and end up with a profit, which might be higher than what if he had bought French Francs directly. He may even buy the Swiss Francs in Zurich and then buy the French Francs in Luxembourg. It is no longer applicable because we have a single currency €.

However, a modern currency trader engages in trading of $, €, £ and ¥, being the four major currencies of the world. Money is also a commodity and traded like any other.

The second type of arbitrage is called 'compound or multi point arbitrage'. A predator may be hunting for shares in some publicly quoted and traded company to take control. If the owners of the company sense that they would lose control, they can adopt what is known as a poison pill or the pacman defense or approach a ‘white knight’ to rescue them. The 'white knight' may end up as another predator gobbling up the company. Once the predator takes control of the company, he has to extend the same price offer to other minority shareholders who might be interested in selling their holdings. The predator to make up his losses will end up stripping the assets of the company. An arbitrageur is not a conventional investor. He is in it for short term gains and generally has inside information. Hence, the term 'insider trading’ is used to describe such transactions. It is illegal, but difficult to prove.

The largest stock exchanges in the world are Tokyo, Hong Kong, Frankfurt, London and New York. Because of the difference in time zones between the various stock exchanges, some arbitrageurs can take advantage by buying in one exchange and selling it in another exchange. It happened in the past when we did not have such instant communication facilities. Arbitrage is not meant for small investors. Arbitrageurs invest in millions and either make millions or lose millions in a short time. The character 'Gecko' played by the actor Michael Douglas in the movie 'Wall Street' is a typical arbitrageur. Both Martin Sheen and his son Charlie Sheen are also in the very good movie. If you watch the very authentic movie, it will be very easy to understand what goes on in stock exchanges like New York. The most infamous arbitrageur is Ivan Bosky, the father of so called 'junk bonds'. There was another guy called Mike Milliken. Arbitrage is not illegal. Since it is difficult to profit in arbitrage, without inside information, it has earned its notoriety.

Just like any other commodity, stock markets operate on the principle of supply and demand and arbitrageurs take advantage of this gap. In markets like essential commodities used by the common man, the market forces because of extremely competitive nature of the market place, decide the equilibrium and it is reached fairly quickly. However, in the stock markets the supply and demand gap is created artificially. Unfortunately, 80% of the small investors do not know the basic principles of investing in the stock markets. If you are a small investor, it is better you stay out of Secondary and 'Options and Futures' market. Mutual funds are fairly safe for a small investor but the returns will be low. They also invest in the stock markets, but know how to spread the risks. They are professionals and have access to information which a small investor may not have. But all investments in the stock markets carry risk. No one can guarantee absolute safety.

© May 15, 2007. www.madgopes.com. All rights reserved.

What is Arbitrage ? - To learn more about this author, visit Madhavan T Gopalachary's Website.

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