Chapter 19. Arbitrage and Hedge Funds

We will engage in arbitrage from time to time—sometimes on a large scale—but only when we like the odds.[162]

Warren Buffett

The fancy word arbitrage is nothing to be afraid of. An arbitrage is nothing more than the simultaneous buying and selling of one or more securities that are either identical or similar to each other. Think about stock brokerage firms such as Charles Schwab. Beyond the brokerage fee, brokers often make a small profit from a transaction when buying a stock from one client and selling the same stock to another client because the buying and selling prices are slightly different. Essentially, the broker plays a little game of arbitraging the profit between the buyer and the seller.

An arbitrage is not risk-free, because the brokerage firm, like a wholesaler, carries inventory. Some of the deals that such middlemen or arbitrageurs put together are more sophisticated than simply holding inventory. Many hedge funds specialize in similar deals, and from time to time, Buffett has also engaged in arbitrage deals. There is no reason for you to be completely averse to them if you understand the risks involved.

Arbitrage in Merger Deals

One common form of arbitrage that many can take advantage of is mergers. Consider the merger between General Re and Berkshire Hathaway in 1998 (discussed in Chapter 8). According to the deal, 200 shares of General Re would be transferred into 21 shares of Berkshire Hathaway, class B. If there was no uncertainty ...

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