Risk Arbitrage, 2nd Edition

CHAPTER 2What Is Risk Arbitrage?

Webster's New World Dictionary offers this definition of arbitrage:

A simultaneous purchase and sale in two separate markets in order to profit from a price difference existing between them.

This definition accurately describes what is known as “classic” arbitrage, where the investor is purchasing and selling the same security in different markets.

An example would be: Rio Tinto PLC is an International Mining company that trades on both the London and New York Stock Exchanges.

• On a recent day, RIO traded at 2750 pence in London and traded at $43.66 in New York.
• If an arbitrageur bought RIO in London and simultaneously sold RIO on the New York Stock Exchange, assuming that the proper currency hedges could be executed between British pounds and American dollars, a guaranteed profit could be locked in.
• The relevant calculations are as follows: 2750/100 = 27.50 British pounds.
• £27.50 GBP × $1.58 (U.S./GBP conversion rate) = $43.45 (U.S. dollar equivalent purchase price).
• Gross profit = $43.66 (U.S. sales price) – $43.45 (Purchase price in U.S. dollars) = $0.21 profit per share.
• While the profit per share may seem small to some people, it would essentially be a riskless or guaranteed trade.

However, in risk arbitrage, profits are anything but guaranteed. Webster's goes on to describe risk arbitrage as follows:

A buying of a large number of shares in a corporation in anticipation of and with the expectation of making a profit from a merger or ...