# Arbitrage: Wikis

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# Encyclopedia

In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit.

In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets (relative value or convergence trades), as in merger arbitrage.

A person who engages in arbitrage is called an arbitrageur—such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

## Arbitrage-free

If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage equilibrium or arbitrage-free market. An arbitrage equilibrium is a precondition for a general economic equilibrium. The assumption that there is no arbitrage is used in quantitative finance to calculate a unique risk neutral price for derivatives.

## Conditions for arbitrage

Arbitrage is possible when one of three conditions is met:

1. The same asset does not trade at the same price on all markets ("the law of one price").
2. Two assets with identical cash flows do not trade at the same price.
3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities).

Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally only possible with securities and financial products which can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'.[note 1]

In the simplest example, any good sold in one market should sell for the same price in another. Traders may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other.

See rational pricing, particularly arbitrage mechanics, for further discussion.

Mathematically it is defined as follows:

$P(V_T \geq 0) = 1$ and $P(V_T \neq 0) > 0$

where Vt means a portfolio at time t.

## Examples

• Suppose that the exchange rates (after taking out the fees for making the exchange) in London are £5 = \$10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = \$12 = £6. Converting ¥1000 to \$12 in Tokyo and converting that \$12 into ¥1200 in London, for a profit of ¥200, would be arbitrage. In reality, this "triangle arbitrage" is so simple that it almost never occurs. But more complicated foreign exchange arbitrages, such as the spot-forward arbitrage (see interest rate parity) are much more common.
• One example of arbitrage involves the New York Stock Exchange and the Chicago Mercantile Exchange. When the price of a stock on the NYSE and its corresponding futures contract on the CME are out of sync, one can buy the less expensive one and sell it to the more expensive market. Because the differences between the prices are likely to be small (and not to last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the most expertise take advantage of series of small differentials that would not be profitable if taken individually.
• Economists use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of political and economic development to support industrialization. At present, many such jobs appear to be flowing towards China, though some which require command of English are going to India and the Philippines. In popular terms, this is referred to as offshoring. (Note that "offshoring" is not synonymous with "outsourcing", which means "to subcontract from an outside supplier or source", such as when a business outsources its bookkeeping to an accounting firm. Unlike offshoring, outsourcing always involves subcontracting jobs to a different company, and that company can be in the same country as the outsourcing company.)
• Sports arbitrage – numerous internet bookmakers offer odds on the outcome of the same event. Any given bookmaker will weight their odds so that no one customer can cover all outcomes at a profit against their books. However, in order to remain competitive their margins are usually quite low. Different bookmakers may offer different odds on the same outcome of a given event; by taking the best odds offered by each bookmaker, a customer can under some circumstances cover all possible outcomes of the event and lock a small risk-free profit, known as a Dutch book. This profit would typically be between 1% and 5% but can be much higher. One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the 'palpable error' rule, which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds. As bookmakers become more proficient, the odds of making an 'arb' usually last for less than an hour and typically only a few minutes. Furthermore, huge bets on one side of the market also alert the bookies to correct the market.
• Exchange-traded fund arbitrage – Exchange Traded Funds allow authorized participants to exchange back and forth between shares in underlying securities held by the fund and shares in the fund itself, rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. ETFs trade in the open market, with prices set by market demand. An ETF may trade at a premium or discount to the value of the underlying assets. When a significant enough premium appears, an arbitrageur will buy the underlying securities, convert them to shares in the ETF, and sell them in the open market. When a discount appears, an arbitrageur will do the reverse. In this way, the arbitrageur makes a low-risk profit, while fulfilling a useful function in the ETF marketplace by keeping ETF prices in line with their underlying value.
• Some types of hedge funds make use of a modified form of arbitrage to profit. Rather than exploiting price differences between identical assets, they will purchase and sell securities, assets and derivatives with similar characteristics, and hedge any significant differences between the two assets. Any difference between the hedged positions represents any remaining risk (such as basis risk) plus profit; the belief is that there remains some difference which, even after hedging most risk, represents pure profit. For example, a fund may see that there is a substantial difference between U.S. dollar debt and local currency debt of a foreign country, and enter into a series of matching trades (including currency swaps) to arbitrage the difference, while simultaneously entering into credit default swaps to protect against country risk and other types of specific risk.

## Price convergence

Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. The speed at which prices converge is a measure of market efficiency. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell it where the price is high, as long as the buyers are not prohibited from reselling and the transaction costs of buying, holding and reselling are small relative to the difference in prices in the different markets.

In reality, of course, one must consider taxes and the costs of travelling back and forth between the US and Canada. Also, the features built into the cars sold in the US are not exactly the same as the features built into the cars for sale in Canada, due, among other things, to the different emissions and other auto regulations in the two countries. In addition, our example assumes that no duties have to be paid on importing or exporting cars from the USA to Canada. Similarly, most assets exhibit (small) differences between countries, transaction costs, taxes, and other costs provide an impediment to this kind of arbitrage.

Similarly, arbitrage affects the difference in interest rates paid on government bonds, issued by the various countries, given the expected depreciations in the currencies, relative to each other (see interest rate parity).

## Risks

Arbitrage transactions in modern securities markets involve fairly low day-to-day risks, but can face extremely high risk in rare situations, particularly financial crises, and can lead to bankruptcy. Formally, arbitrage transactions have negative skew – prices can get a small amount closer (but often no closer than 0), while they can get very far apart. The day-to-day risks are generally small because the transactions involve small differences in price, so an execution failure will generally cause a small loss (unless the trade is very big or the price moves rapidly). The rare case risks are extremely high because these small price differences are converted to large profits via leverage (borrowed money), and in the rare event of a large price move, this may yield a large loss.

The main day-to-day risk is that part of the transaction fails – execution risk. The main rare risks are counterparty risk and liquidity risk – that a counterparty to a large transaction or many transactions fails to pay, or that one is required to post margin and does not have the money to do so.

In the academic literature, the idea that seemingly very low risk arbitrage trades might not be fully exploited because of these risk factors and other considerations often reffered to as limits to arbitrage.[1]

### Execution risk

Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. There is also counter-party risk, that the other party to one of the deals fails to deliver as agreed; though unlikely, this hazard is serious because of the large quantities one must trade in order to make a profit on small price differences.

Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk position.

In the 1980s, risk arbitrage was common. In this form of speculation, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current price—if the merger goes through as predicted. Traditionally, arbitrage transactions in the securities markets involve high speed and low risk. At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act). When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing the risk is through the illegal use of inside information, and in fact risk arbitrage with regard to leveraged buyouts was associated with some of the famous financial scandals of the 1980s such as those involving Michael Milken and Ivan Boesky.

### Mismatch

Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable; this is more narrowly referred to as a convergence trade. In the extreme case this is risk arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses.

### Counterparty risk

As arbitrages generally involve future movements of cash, they are subject to counterparty risk: if a counterparty fails to fulfill their side of a transaction. This is a serious problem if one has either a single trade or many related trades with a single counterparty, whose failure thus poses a threat, or in the event of a financial crisis when many counterparties fail.

For example, if one purchases many risky bonds, then hedges them with CDSes, profiting from the difference between the bond spread and the CDS premium, in a financial crisis the bonds may default and the CDS writer/seller may itself fail, due to the stress of the crisis, causing the arbitrageur to face steep loses.

### Liquidity risk

 “ The market can stay irrational longer than you can stay solvent. ”

Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a short position. If the assets used are not identical (so a price divergence makes the trade (temporarily) lose money), or the margin treatment is not identical, and the trader is accordingly required to post margin (faces a margin call), the trader may run out of capital (if they run out of cash and cannot borrow more) and go bankrupt even though the trades may be expected to ultimately make money. In effect, arbitrage traders synthesize a put option on their ability to finance themselves.[2]

Prices may diverge during a financial crisis, often termed a "flight to quality"; these are precisely the times when it is hardest for leveraged investors to raise capital (due to overall capital constraints), and thus they will lack capital precisely when they need it most.[2]

## Types of arbitrage

### Merger arbitrage

Also called risk arbitrage, merger arbitrage generally consists of buying the stock of a company that is the target of a takeover while shorting the stock of the acquiring company.

Usually the market price of the target company is less than the price offered by the acquiring company. The spread between these two prices depends mainly on the probability and the timing of the takeover being completed as well as the prevailing level of interest rates.

The bet in a merger arbitrage is that such a spread will eventually be zero, if and when the takeover is completed. The risk is that the deal "breaks" and the spread massively widens.

### Municipal bond arbitrage

Also called municipal bond relative value arbitrage, municipal arbitrage, or just muni arb, this hedge fund strategy involves one of two approaches.

Generally, managers seek relative value opportunities by being both long and short municipal bonds with a duration-neutral book. The relative value trades may be between different issuers, different bonds issued by the same entity, or capital structure trades referencing the same asset (in the case of revenue bonds). Managers aim to capture the inefficiencies arising from the heavy participation of non-economic investors (i.e., high income "buy and hold" investors seeking tax-exempt income) as well as the "crossover buying" arising from corporations' or individuals' changing income tax situations (i.e., insurers switching their munis for corporates after a large loss as they can capture a higher after-tax yield by offsetting the taxable corporate income with underwriting losses). There are additional inefficiencies arising from the highly fragmented nature of the municipal bond market which has two million outstanding issues and 50,000 issuers in contrast to the Treasury market which has 400 issues and a single issuer.

Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal bonds with the duration risk hedged by shorting the appropriate ratio of taxable corporate bonds. These corporate equivalents are typically interest rate swaps referencing Libor Libor#LIBOR-based derivatives or SIFMA(Security Industry and Financial Markets Association)[2] (merged with and preceded by BMA (short for Bond Market Association]) [3]). The arbitrage manifests itself in the form of a relatively cheap longer maturity municipal bond, which is a municipal bond that yields significantly more than 65% of a corresponding taxable corporate bond. The steeper slope of the municipal yield curve allows participants to collect more after-tax income from the municipal bond portfolio than is spent on the interest rate swap; the carry is greater than the hedge expense. Positive, tax-free carry from muni arb can reach into the double digits. The bet in this municipal bond arbitrage is that, over a longer period of time, two similar instruments—municipal bonds and interest rate swaps—will correlate with each other; they are both very high quality credits, have the same maturity and are denominated in U.S. dollars. Credit risk and duration risk are largely eliminated in this strategy. However, basis risk arises from use of an imperfect hedge, which results in significant, but range-bound principal volatility. The end goal is to limit this principal volatility, eliminating its relevance over time as the high, consistent, tax-free cash flow accumulates. Since the inefficiency is related to government tax policy, and hence is structural in nature, it has not been arbitraged away.

### Convertible bond arbitrage

A convertible bond is a bond that an investor can return to the issuing company in exchange for a predetermined number of shares in the company.

A convertible bond can be thought of as a corporate bond with a stock call option attached to it.

The price of a convertible bond is sensitive to three major factors:

• interest rate. When rates move higher, the bond part of a convertible bond tends to move lower, but the call option part of a convertible bond moves higher (and the aggregate tends to move lower).
• stock price. When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise.
• credit spread. If the creditworthiness of the issuer deteriorates (e.g. rating downgrade) and its credit spread widens, the bond price tends to move lower, but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility).

Given the complexity of the calculations involved and the convoluted structure that a convertible bond can have, an arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value.

Convertible arbitrage consists of buying a convertible bond and hedging two of the three factors in order to gain exposure to the third factor at a very attractive price.

For instance an arbitrageur would first buy a convertible bond, then sell fixed income securities or interest rate futures (to hedge the interest rate exposure) and buy some credit protection (to hedge the risk of credit deterioration). Eventually what he'd be left with is something similar to a call option on the underlying stock, acquired at a very low price. He could then make money either selling some of the more expensive options that are openly traded in the market or delta hedging his exposure to the underlying shares.

### Depository receipts

A depository receipt is a security that is offered as a "tracking stock" on another foreign market. For instance a Chinese company wishing to raise more money may issue a depository receipt on the New York Stock Exchange, as the amount of capital on the local exchanges is limited. These securities, known as ADRs (American Depositary Receipt) or GDRs (Global Depositary Receipt) depending on where they are issued, are typically considered "foreign" and therefore trade at a lower value when first released. However, they are exchangeable into the original security (known as fungibility) and actually have the same value. In this case there is a spread between the perceived value and real value, which can be extracted. Since the ADR is trading at a value lower than what it is worth, one can purchase the ADR and expect to make money as its value converges on the original. However there is a chance that the original stock will fall in value too, so by shorting it you can hedge that risk.

### Dual-listed companies

A dual-listed company (DLC) structure involves two companies incorporated in different countries contractually agreeing to operate their businesses as if they were a single enterprise, while retaining their separate legal identity and existing stock exchange listings. In integrated and efficient financial markets, stock prices of the twin pair should move in lockstep. In practice, DLC share prices exhibit large deviations from theoretical parity. Arbitrage positions in DLCs can be set-up by obtaining a long position in the relatively underpriced part of the DLC and a short position in the relatively overpriced part. Such arbitrage strategies start paying off as soon as the relative prices of the two DLC stocks converge toward theoretical parity. However, since there is no identifiable date at which DLC prices will converge, arbitrage positions sometimes have to be kept open for considerable periods of time. In the meantime, the price gap might widen. In these situations, arbitrageurs may receive margin calls, after which they would most likely be forced to liquidate part of the position at a highly unfavorable moment and suffer a loss. Arbitrage in DLCs may be profitable, but is also very risky, see [3]. Background material is available at [4].

### Regulatory arbitrage

Regulatory arbitrage is where a regulated institution takes advantage of the difference between its real (or economic) risk and the regulatory position. For example, if a bank, operating under the Basel I accord, has to hold 8% capital against default risk, but the real risk of default is lower, it is profitable to securitise the loan, removing the low risk loan from its portfolio. On the other hand, if the real risk is higher than the regulatory risk then it is profitable to make that loan and hold on to it, provided it is priced appropriately.

This process can increase the overall riskiness of institutions under a risk insensitive regulatory regime, as described by Alan Greenspan in his October 1998 speech on The Role of Capital in Optimal Banking Supervision and Regulation.

Regulatory Arbitrage was used for the first time in 2005 when it was applied by Scott V. Simpson, a partner at law firm Skadden, Arps, to refer to a new defence tactic in hostile mergers and acquisitions where differing takeover regimes in deals involving multi-jurisdictions are exploited to the advantage of a target company under threat.

In economics, regulatory arbitrage (sometimes, tax arbitrage) may be used to refer to situations when a company can choose a nominal place of business with a regulatory, legal or tax regime with lower costs. For example, an insurance company may choose to locate in Bermuda due to preferential tax rates and policies for insurance companies. This can occur particularly where the business transaction has no obvious physical location: in the case of many financial products, it may be unclear "where" the transaction occurs.

Regulatory arbitrage can include restructuring a bank by outsourcing services such as IT. The outsourcing company takes over the installations, buying out the bank's assets and charges a periodic service fee back to the bank. This frees up cashflow usable for new lending by the bank. The bank will have higher IT costs, but counts on the multiplier effect of money creation and the interest rate spread to make it a profitable exercise.

Example Sell the IT installations for 40 million USD. With a reserve ratio of 10%, the bank can create 400 million in additional loans (there is a time lag, and the bank has to expect to recover the loaned money back into its books). The bank can often lend (and securitize the loan) to the IT services company their acquisition cost for the IT installations. This can be at preferential rates, as the sole client using the IT installation is the bank. If the bank can generate 5% interest margin on the 400 million of new loans, the bank will increase interest revenues by 20 million. The IT services company is free to leverage their balance sheet as aggressively as they and their banker agree to. This is the reason behind the trend towards outsourcing in the financial sector. It is actually more expensive to outsource the IT operations as the outsourcing adds a layer of management and increases overhead.

### Telecom arbitrage

Telecom arbitrage companies allow phone users to make international calls for free through certain access numbers. Such services are offered in the United Kingdom; the telecommunication arbitrage companies get paid an interconnect charge by the UK mobile networks and then buy international routes at a lower cost. The calls are seen as free by the UK contract mobile phone customers since they are using up their allocated monthly minutes rather than paying for additional calls.

Such services were previously offered in the United States by companies such as FuturePhone.com.[5] These services would operate in rural telephone exchanges, primarily in small towns in the state of Iowa. In these areas, the local telephone carriers are allowed to charge a high "termination fee" to the caller's carrier in order to fund the cost of providing service to the small and sparsely-populated areas that they serve. However, FuturePhone (as well as other similar services) ceased operations upon legal challenges from AT&T and other service providers.[6]

### Statistical arbitrage

Statistical arbitrage is an imbalance in expected nominal values. A casino has a statistical arbitrage in every game of chance that it offers—referred to as the house advantage, house edge, vigorish or house vigorish.

## The debacle of Long-Term Capital Management

Long-Term Capital Management (LTCM) lost 4.6 billion U.S. dollars in fixed income arbitrage in September 1998. LTCM had attempted to make money on the price difference between different bonds. For example, it would sell U.S. Treasury securities and buy Italian bond futures. The concept was that because Italian bond futures had a less liquid market, in the short term Italian bond futures would have a higher return than U.S. bonds, but in the long term, the prices would converge. Because the difference was small, a large amount of money had to be borrowed to make the buying and selling profitable.

The downfall in this system began on August 17, 1998, when Russia defaulted on its ruble debt and domestic dollar debt. Because the markets were already nervous due to the Asian financial crisis, investors began selling non-U.S. treasury debt and buying U.S. treasuries, which were considered a safe investment. As a result the price on US treasuries began to increase and the return began decreasing because there were many buyers, and the return on other bonds began to increase because there were many sellers. This caused the difference between the prices of U.S. treasuries and other bonds to increase, rather than to decrease as LTCM was expecting. Eventually this caused LTCM to fold, and their creditors had to arrange a bail-out. More controversially, officials of the Federal Reserve assisted in the negotiations that led to this bail-out, on the grounds that so many companies and deals were intertwined with LTCM that if LTCM actually failed, they would as well, causing a collapse in confidence in the economic system. Thus LTCM failed as a fixed income arbitrage fund, although it is unclear what sort of profit was realized by the banks that bailed LTCM out.

## Etymology

"Arbitrage" is a French word and denotes a decision by an arbitrator or arbitration tribunal. (In modern French, "arbitre" usually means referee or umpire). In the sense used here it is first defined in 1704 by Mathieu de la Porte in his treatise "La science des négocians et teneurs de livres" as a consideration of different exchange rates to recognize the most profitable places of issuance and settlement for a bill of exchange ("L'arbitrage est une combinaison que l’on fait de plusieurs changes, pour connoitre [connaître, in modern spelling] quelle place est plus avantageuse pour tirer et remettre").[7]

## Notes

1. ^ As an arbitrage consists of at least two trades, the metaphor is of putting on a pair of pants, one leg (trade) at a time. The risk that one trade (leg) fails to execute is thus 'leg risk'.

## References

1. ^ See e.g. Shleifer, Andrei, and Robert Vishny, 1997, The limits of arbitrage, Journal of Finance 52, 35-55.
Xiong, Wei, 2001, Convergence trading with wealth effects, Journal of Financial Economics 62, 247-292.
Kondor, Peter, 2009. Risk in Dynamic Arbitrage: Price Effects of Convergence Trading Journal of Finance 64(2),638-658,
2. ^ a b The Basis Monster That Ate Wall Street, D. E. Shaw & Co.
3. ^ de Jong, A., L. Rosenthal and M.A. van Dijk, 2008, The Risk and Return of Arbitrage in Dual-Listed Companies, June 2008.[1]
4. ^ Lowenstein, R., 2000, When genius failed: The rise and fall of Long-Term Capital Management, Random House.
5. ^ Ned Potter (2006-10-13). "Free International Calls! Just Dial ... Iowa". Retrieved 2008-12-23.
6. ^ Mike Masnick (2007-02-07). "Phone Call Arbitrage Is All Fun And Games (And Profit) Until AT&T Hits You With A \$2 Million Lawsuit". Retrieved 2008-12-23.
7. ^ See "Arbitrage" in Trésor de la Langue Française.
• Greider, William (1997). One World, Ready or Not. Penguin Press. ISBN 0-7139-9211-5.
• Special Situation Investing: Hedging, Arbitrage, and Liquidation, Brian J. Stark, Dow-Jones Publishers. New York, NY 1983. ISBN 0870943847; ISBN 9780870943843

News

# 1911 encyclopedia

Up to date as of January 14, 2010

### From LoveToKnow 1911

ARBITRAGE, the term applied to the system of equalizing prices in different commercial centres by buying in the cheaper market and selling in the dearer. These transactions, or their converse, are mainly confined to stocks and shares, foreign exchanges and bullion; and are for the most part carried on between London and other European capitals and largely with New York. When prices in London are affected by financial or political causes, all other markets are sooner or later influenced, as London is the banking and financial centre for the commerce of the world. It may, however, also occur that some local event of importance initiates a rise or fall in a particular market which must ultimately affect other countries. For instance, a crisis in France would immediately depress all French securities, and by exciting the fears of capitalists would stimulate transfers of funds and raise all the exchanges against France.

In ordinary times those engaged in arbitrage operate with a very small margin of profit. The great improvement in postal, telegraphic and telephonic communication enables operators to close transactions with amazing rapidity, while competition reduces the margin of profit to a minimum. Operations in American stocks and shares are carried on between London and New York on a vast scale, while transactions in African mining shares are undertaken to a considerable extent between London and Paris. The frequent fluctuations in the prices of the latter securities offer a large and fruitful field to bold operators possessed of large resources, while those who have small means often succumb in a commercial crisis. As regards foreign exchange and bullion, arbitrage operators stand on a fairly safe foundation, the fluctuations being slight and involving little or no risk, although they yield a very small margin of profit. Arbitrage operations are for these reasons resorted to frequently by one country in supplying the requirements of another. The slightest advantage in any market is put to profit, and as the margin in ordinary exchange transactions is minute, the ability to operate in this cross fashion renders business possible, which would otherwise be impracticable. To give concrete instances of the working of arbitrage the following may be cited: On the 21st of May 1906 the exchange on London in Vienna was telegraphed from that city 24 kronen cents; London, requiring to purchase remittances, found that Antwerp had some Vienna to sell, and arranged to buy there. The transactions worked out as follows:The direct exchange in Antwerp on London being 25.252, and Antwerp's selling price of Vienna being 105 francs for ioo kronen, on dividing 25.252 by 105 an exchange of 24.054 was obtained or 2 cent cheaper than the direct exchange between Vienna and London.

Again a portion of the proceeds of the Russian loan of 1906 had to be remitted to Berlin from Paris. Having exhausted local balances in Berlin, Paris on one side, and Berlin on the other, sought to prevent gold shipments from Berlin, and thus cause stringency in that money market. On the 21st of May 1906 Berlin was therefore seeking to sell Paris in London at 81.35 marks for ioo francs, and draw on London for the proceeds at 20.50. This transaction produced a parity between the exchanges of 25.20, which left a small margin in London.

Two instances of arbitrage of stocks are the following: - On the 24th of March 1906, Japanese exchequer bonds, series 2 and 3, were bought in Tokio at 934 and were paid for by telegraphic transfer at 244 pence per yen, and were sold in London the same day at 94 for payment on arrival of bonds. It took five weeks for the transmission of the bonds to London, where they were dealt in on the fixed basis of exchange, namely 242 pence per yen. The London price works out thus: 93.2 5 X 24.375 -92'77, 24.50 to which must be added the loss of interest, as the firm in London paid cash on the 24th of March for the telegraphic transfer, and did not recover payment until the arrival of the bonds from Tokio five weeks later. The following is a computation of the transaction: - London price. 92.77 Five weeks at 5% 45 English stamp 2% on nominal amount 50 Insurance ,- o ho t2 93'84 This sum represents the net cost to the arbitrage house in London, and the money paid on the 28th of April left a profit of about - 1 - 3 z °7 0. The bonds being "to bearer" insurance was necessary for the safety in this, as in all similar transactions.

In the next example, however, this expense was unnecessary, the bonds being "inscribed." On the 21st of May 1906 American Steel common shares were sold for cash in New York at 411 dollars per share, and were bought in London at 4 2' for the account day, May 31st. These figures are explained by the fact that transactions in the United States stocks and shares are on the fixed basis of five dollars per pound sterling, while as regards payments in New York the exchange varies daily. Railway shares are generally ioo dollars each. In the London market, however, five shares of ioo dollars would be £ioo nominal. These shares, therefore, cost in London, at the purchase price of 4 2 3'x 4 2: 4: 5. The money realized in New York for five shares at 411 3 6 was 205.93 dollars. A cheque on London was bought at 4 dollars 854 cents, realizing X42: 8: 9. It should be noted that the shares in these cases are generally lent by the New York correspondent, thus saving loss of interest. The resulting profit in this particular instance was 4s. 4d. for each five shares, divided between the London and New York arbitrage firms. Arbitrage operations with distant countries such as India are large and mainly profitable. Arbitrage with India consists chiefly in buying bills of exchange in London, such as India Council rupee bills amounting to about 16 millions sterling annually, and commercial bills drawn against goods exported to India. The counter-operation consists in purchasing in India, for short or long delivery, sterling bills drawn against exports to Great Britain of Indian produce, such as cotton, tea, indigo, jute and wheat. These operations greatly facilitate trade and the moving of produce from the interior of India to the seaports. Without this assistance Great Britain's enormous trade could not be carried on, and she would have to revert to the primitive system of barter. The same advantages are afforded to her vast trade with China and Japan, with the material difference that the supply of government council bills is confined to the Indian trade. The balance of trade with all countries is generally settled by specie shipments; hence, with the Far East, silver and gold play an important part in arbitrage.

It will thus be seen that arbitrage fills a useful place in commerce; the profits are small because the competition is great; nevertheless huge transactions employing thousands of clerks result from this system.

The literature of the subject is extremely meagre. Lord Goschen's Theory of Foreign Exchanges (London, 1866) is general and theoretical, but throws great light upon particular aspects of the philosophy of arbitrage, without touching specially on the details of the subject itself. The principal other works are: Kelly's Cambist (1811, 1835); Otto Swoboda, Die kaufmcinnische Arbitrage (Berlin, 1873), and Borse and Actien (Cologne, 1869); Coquelin et Guillaumin, Dictionnaire de l'economie politique (Paris, 1851-1853); Ottomar Haupt, London Arbitrageur (London, 1870); Charles le Touze, Traite theorique et pratique du change (Paris, 1868); Tate, Modern Cambist (London, 1868); Simon Spitzer, Ueber Miinzand Arbitragenrechnung (Vienna, 1872); J. W. Gilbart, Principles and Practice of Banking (London, 1871); G. Clare, The A B C of Foreign Exchanges (2nd ed., 1895); Money Market Primer and Key to the Exchanges (2nd ed., 1900); J. Pallain, Les Changes strangers et les prix (Paris, 1905). (Sw.)