Thursday, October 19, 2017

Efficiently Inefficient #14 : Arbitrage

The final section of the book discusses arbitrage. The formal definition of arbitrage is the achievement of guaranteed profits by simultaneously buying low and selling high.

In practice, a guarantee is almost impossible.  Traders buy and sell securities that are almost the same to achieve a profit, sometimes incurring massive losses when their trades fail to diverge.

Arbitrage is too mathematical for a retail investor blog.

I will just briefly describe the sub-sections of this book under the Arbitrage trading section :

a) Fixed Income Arbitrage

Fixed income arbitrage covers the buying and selling of bonds of make a profit. One approach is based on trading the slope of the yield curve. If long term yields are expected to drop but short term yields are expected to rise, one form of arbitrage would be to simply buy 10-year bonds and sell 2 year bonds. Mathematical formulas employing bond duration calculations will be used to determine that proportion of long and short term bonds to buy. The best way to get a good handle of such trades is doing the CFA II exams.

b) Convertible Bond Arbitrage

I am not even sure if it is possible to perform this form of arbitrage here.

First you need a convertible bond. This is a bond that can be converted into the stock of a company. If the convertible bond is considered underpriced, the trader will buy the convertible bond and short the stock. Executing this trade requires the use of sophisticated programs that crunch option mathematics as a convertible bond consists of an underlying bond instrument embedded with a call option.

Let me know if you have any experience doing this.

c) Event-Drive Investments

I will jump into this form of investing next week as it is definitely possible to do this here. Suppose a counter is going to be delist and $1.00 will be delivered to investors per share in 3 months. If the current price is $0.95, this is a 5% return over 3 months. Event-drive hedge fund managers will buy up this stock with leverage to magnify their returns.

If the delisting fails, this trade can explode in your face.

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