AMeaning and explanation of Arbitrage
In finance, arbitrage refers to the practice of taking advantage of a of the difference between the prices of two or more markets – striking an arrangement of matching deals that capitalize upon the difference, the profit being the difference between the market prices. While being used by the academics, an arbitrage refers to a transaction involving no negative cash flows at any temporal or probabilistic state and a positive cash flow in at least one state. Putting it simple, it is the possibility of a risk free profit at zero cost.
Types of Arbitrage
The different types of arbitrage include:
- Merger Arbitrage
Also referred as risk arbitrage, merger arbitrage usually includes buying the target company’s stock. Generally, the market price of the target company is below the price proffered by the acquiring company. The swell between these two prices depends primarily upon the probability and the timing of the takeover being accomplished in addition to the prevailing level of interest rates.
- Municipal bond arbitrage
Also referred as municipal bond relative value arbitrage, muni arb, or municipal arbitrage, this prevaricate fund strategy includes one of two approaches. Usually, managers seek relative value opportunities by being both long as well as short municipal bonds through a duration-neutral book. The relative value trades might be among different issuers, different bonds issued by the same company or capital structure trades referencing the similar asset.
Besides, the second approach involves the manager to build leveraged portfolios of AAA- or AA-rated tax-exempt municipal bonds with the duration risk enclosed by shorting the apposite ratio of taxable corporate bonds.
- Convertible bond arbitrage
This is a bond that can be returned by an investor to the issuing company in exchange for an encoded number of shares in the company. Moreover, a convertible bond arbitrage can be considered as a corporate bond with a stock call option attached to it.
- Regulatory arbitrage
Regulatory arbitrage is the one that includes a regulated institution to take the advantage of the difference between the regulatory position and the real risk.
- Statistical arbitrage
The statistical arbitrage refers to a discrepancy in the expected nominal value.