What Is Arbitrage?

Arbitrage is a fancy financial term with French roots that’s occasionally tossed around in investing conversations and write-ups. It’s one of the more interesting concepts in finance, and it’s something that every investor would love to take advantage of if given the opportunity.

But what exactly is it?

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What Is Arbitrage?

At its core, arbitrage is the concept of a riskless profit. It means taking advantage of the mispricing of assets across different markets. Theoretically, a pure form of arbitrage would be buying an asset in one market and selling the same asset in another market at a higher price, simultaneously.

“These cross-market arbitrage strategies can get pretty complicated because computers are programmed to find unexpected relative differences in price between stocks, bonds, exchange rates and currency prices,” says Robert Johnson, professor of finance at Creighton University in Omaha, Nebraska.

As you can imagine, the allure of easy money makes arbitrage a highly sought-after opportunity, and capital markets are typically quick to exploit such inefficiencies, closing them at a moment’s notice.

That said, markets aren’t always perfectly efficient, which means real arbitrage opportunities occasionally present themselves.

Famous Arbitrage Examples

Johnson highlights a famous arbitrage opportunity that came to light in December 1998, when Creative Computers spun off 20% of its online auction business Ubid. By the end of the trading day, Creative Computers’ remaining 80% stake of subsidiary “Ubid” was worth almost $80 million more than Creative Computers itself, implying the rest of the company’s assets were actually less than worthless. It was significant mispricing for a company worth less than $500 million.

“An arbitrageur would buy shares of Creative Computer and sell shares of Ubid until the implied negative valuation disappeared. Ideally, proceeds from the short sale of Ubid can be used to fund the purchase of Creative Computer so that no capital is required,” Johnson says.

Modern-Day Arbitrage Examples

You don’t have to turn to textbooks and case studies to find examples of arbitrage opportunities, however. The rationale for many spinoffs is based on a loose form of arbitrage when company management sees the market undervaluing its subsidiaries.

IAC (ticker: IAC), a diversified media and internet holding company, has rewarded its shareholders handsomely by practicing this precise strategy, growing businesses to the point of being able to offer shares in an IPO, then spinning off the remainder of the company if it looks like IAC is being undervalued compared with its subsidiary.

[Read: How to Buy IPO Stock at Its Offer Price.]

IAC’s chairman, Barry Diller, is a media legend and has helped oversee seven such spinoffs, the most recent of which was online dating giant Match Group ( MTCH), completed in July 2020. Since August 1995, the month Diller joined the company, IAC stock is up more than 18,000%.

Although not pure arbitrage by any means, this strategy clearly seems to have worked.

Other modern-day examples can be found in obscure areas of high finance.

“High-frequency traders seek arbitrage by buying order flow from brokerages so that they can position themselves in the ‘buy’/’sell’ trade,” says Arvind Ven, CEO and founder of Capital V Group, an independent financial advisory firm.

Incidentally, selling order flow is a practice that helps allow retail brokerages like Robinhood to offer free trading. It’s controversial, as its customers tend not to get the best trade execution as a result, and it creates a conflict of interest that pits high-frequency traders against retail investors, with apps like Robinhood in the middle.

There are also forms of arbitrage done daily in everyday life.

Labor arbitrage, where large companies offshore manufacturing to locations with lower labor costs, sees companies compete — arguably unfairly — in the same developed market with another product developed with higher labor costs, Ven says.

A looser use of the term still is merger arbitrage, also known as risk arbitrage, where investors will try to capitalize on price inefficiencies surrounding an announced merger for a low-risk gain. Shares of the company to be acquired typically trade at a discount to the deal’s announced price, reflecting the risk a deal isn’t completed or doesn’t pass antitrust muster.

If an arbitrageur has unique insight into the likelihood of such a deal going through, trading on that knowledge is a form of merger arbitrage, although it’s technically still not a riskless profit.

Arbitrage for Individual Investors

How does the humble retail investor participate in arbitrage, though? While such opportunities are rare, they can actually be easier to find — the only catch is, you might find them with low-dollar items. Taking advantage of cheaply priced merchandise in local garage sales or even getting free things through services like The Freecycle Network may yield a return for the enterprising individual who notices higher prices on online auction sites like eBay ( EBAY) — but to a certain extent, any profits are merely a result of pricing your labor.

Discounted gift cards are a form of pure arbitrage in some sense, especially if you needed to buy something at a certain store anyway.

Gary Zimmerman is the CEO of MaxMyInterest, an online cash optimization and arbitrage service for high net worth investors. He provides an example of how a well-capitalized retail investor could seize a true arbitrage opportunity if the chance came.

[Read: Should You Buy Berkshire Hathaway (BRK.B) Stock?]

Consider the fact that Berkshire Hathaway has famously never split its stock, so the company now offers both Berkshire Hathaway A-shares ( BRK.A) and Berkshire Hathaway B-shares ( BRK.B). This is done to provide people of more modest means a way to own Berkshire, since one Class A-share trades for around $383,000 as of this writing.

One Class B-share entitles its owner to 1/1,500 of the economic ownership of a Class A-share.

“As you might expect, the share price performance of Berkshire A-shares and B-shares are nearly identical. If B-shares appreciated too much in value, investors would simply buy an A-share and convert it to 1,500 B shares and capture a free arbitrage,” Zimmerman says.

For this reason, however, B-shares seldom trade at a premium to their Class A cousins. Anyone trying the strategy outlined by Zimmerman would actually lose about 1.4% in the attempt. B-shares can’t be converted to A-shares.

Bottom Line

Given the prevalence of well-capitalized high-speed traders and hedge funds, most temporary price imbalances are “arbitraged away.” While there are occasional opportunities for individual investors to take advantage of such opportunities, it’s usually on a small-scale basis.

Perhaps the only arbitrage opportunities that are worth the time and effort for retail investors are the type that Johnson highlighted, in which a parent company trades at incredibly cheap levels compared with its holdings. Even then, you’ve still got to do the homework to find them.

As for the slight differences in asset prices sometimes observed in different markets — those are best left to the Wall Street pros.

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What Is Arbitrage? originally appeared on usnews.com

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