Chapter 1

Derivation of Risk Arbitrage

The simple definition of “arbitrage”—buying an article in one market and selling it in another—has undergone considerable refinement over the decades. Arbitrage had its origin in the late Medieval period when Venetian merchants traded interchangeable currencies in order to profit from price differentials. This “classic” arbitrage, as it was and continues to be carried on, is a practically riskless venture in that the profit, or spread, is assured by the convertibility of the instruments involved.
Communications, rudimentary as they were, assumed strategic importance on the European financial scene. The notable London merchant bank of Rothschild, as the story goes, staged an unprecedented “coup de bourse” by use of carrier pigeons to receive advance notice of Wellington’s victory at Waterloo. Upon learning the news, Rothschild began, with much ado, selling various securities, particularly British Government Bonds, on the London Stock Exchange. This was naturally interpreted as a Wellington defeat, thereby precipitating a panicky selling wave. The astute—and informed—Rothschild then began quietly purchasing, through stooges, all the Government Bonds that were for sale. When an earthbound messenger finally brought the news of an allied victory, Rothschild had a handsome profit.
As identical securities began to be traded on the different European exchanges, and as communications evolved from the pigeon to ...

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