Investment Philosophies: Successful Strategies and the Investors Who Made Them Work, 2nd Edition

CHAPTER 11

A Sure Profit: The Essence of Arbitrage

Arbitrage represents the holy grail of investing because it allows investors to invest no money, take no risk, and walk away with sure profits. In other words, it is the ultimate money machine that investors hope to access. In this chapter, we consider three types of arbitrage. The first is pure arbitrage, where, in fact, you risk nothing and earn more than the riskless rate. For pure arbitrage to be feasible, you need two assets with identical cash flows, different market values at the same point in time, and a given point in time in the future at which the values have to converge. This type of arbitrage is most likely to occur in derivatives markets—options and futures—and in some parts of the bond market. The second is near arbitrage, where you have assets that have identical or almost identical cash flows, trading at different prices, but there is no guarantee that the prices will converge and there exist significant constraints on forcing convergence. The third is speculative arbitrage, which is really not arbitrage in the first place. Here, investors take advantage of what they see as mispriced and similar (though not identical) assets, buying the cheaper one and selling the more expensive one. If they are right, the difference should narrow over time, yielding profits. It is in this category that we consider hedge funds in their numerous forms.

PURE ARBITRAGE

If you have two assets that have exactly the same cash flows ...