Arbitrage is a method, or concept, that has been around for
thousands of years, but there is still no set definition of what it is. Your
stock broker may give you one definition, while a commodities broker may tell
you it's something else. Heck, most investors have no clue what it's about.
The basic premise of the arbitrage theory is that investors (or
speculators) force a profit making opportunity to exist. In its most simple
form, the definition should look something like, "Buy in a cheap market
and immediately sell in a more expensive market."
A good example would be the farmers markets found in two different
villages. John, an arbitrage junky, goes to the Cheap Village and sees that
oranges are selling for $3 per bushel. Through the grapevine, he's heard that
oranges sell for $3.50 in Expensive Village. John takes all his cash and buys
oranges at $3 per bushel in Cheap Village, then walks to Expensive Village and
immediately sells the oranges for $3.50 per bushel. This is basic
arbitrage--John has created a profit making opportunity of $0.50 per bushel.
This theory has been used for a long time, at least conceptually.
There are four keys to arbitrage, outlined as follows...
Information: John had to know that the oranges
were selling for $3 in Cheap Village and $3.50 in Expensive Village.
Profit Opportunity: John had to see a
profit making opportunity, that's the key motivation to arbitrage.
Judgment: John had to use his judgment and
determine the risk/reward factor.
Decision: John had to make the decision whether
to actually carry out his arbitrage scheme.
These four keys seem obvious, but they're the result of many years
of testing, discussion, thought, and evaluation. Stephen Ross initiated an
important, and now infamous, arbitrage study in 1976. His study began with
comparisons to the Capital Asset Pricing Model, where he pointed out that the
CAPM only takes market risk into account when pricing securities. The obvious
problem with the CAPM is that there are other considerable risks to securities
pricing, such as the industry, sector, interest rates, and so on.
Ross argued that the Arbitrage Pricing Theory is a multi-factor
model and that it does account for non-market risks. The problem with the APT
theory is that we don't know exactly what risks of what magnitude should be
identified. For example, when pricing a stock, one investor may put heavy
weight on interest rate risk, while another investor puts heavy weight on
industry risk. For the theory to be validated, all investors would have to
consider the same factors at the same magnitude.
So in conclusion, there is still no set definition of arbitrage.
Anyone will find several different definitions when checking dictionaries,
encyclopedias, and financial glossaries. But to have a basic understanding of
what the arbitrage theory represents, there are three important things to
remember.
- Create
a profit making opportunity.
- Buy
in a cheap market, sell in an expensive market.
- Garbage
in, garbage out; this relates to the APT and the fact that investors will
put different weights on different factors.