arbitrage

Arbitrage (of French. Arbitrage , from lat. Arbitratus "at will, free choice, free discretion") is in the business that without risk undertaken exploiting exchange rate , interest rate and price differences for the same time in different places for the purpose of profit-taking . The opposite is speculation , which exploits these differences within a certain period of time and is therefore fraught with risks.

General

In addition to speculation and hedging, arbitrage is one of the strategies in financial management . Arbitrage objects include financial instruments ( receivables , liabilities , securities , foreign exchange , types , precious metals , derivatives ) or commodities . In contrast to speculation, real estate and works of art are not suitable for arbitrage due to existing transaction barriers and / or a lack of market transparency. Land can only be acquired and sold through the time-consuming involvement of notaries and land registry offices , which is a decisive obstacle to transactions. In the case of works of art, market transparency and market liquidity are insufficient for arbitrage purposes.

The sole aim of the arbitrage is to make a profit , the arbitrageur has no interest in the arbitrage objects. Because of the asymmetry of transactions - buyers and sellers are usually not identical when opening and closing the same position - there is theoretically not always only one winner and one loser. Different time horizons (holding periods), directional decisions (long and short), strategies (arbitrage, hedge or speculation) make market participants and their success or failure confusing. Arbitrage deals are risk-free, since the arbitrageur already has all information about rates, interest rates or prices at the time the deal is concluded and his decisions can therefore be made with certainty .

species

A distinction is made between differential and equalization arbitrage. The difference arbitrage is the coupling of purchase and sales transactions at the same time and is the arbitrage in the strict sense. A difference arbitrage occurs when the arbitrageur a certain share of a stock exchange purchases (sold) to them at the same time on another stock exchange sell (buy) at a higher (lower) price. Also, short sales can be part of the arbitrage business. Then the short seller can by the immediate purchase the short sale to close out . In most cases, arbitrage incentives are created by the existence of spatially separated sub- markets (spatial arbitrage) , which then enable arbitrage profits if the market price difference exceeds the inter-local transaction costs ( securities commissions , interest , freight rates ).

The exchange arbitrage is that their own position is selected by various submarkets of the most favorable for the desired degree (buy or sell) to compensate. Compensation arbitrage is therefore merely a purchase or sale without a simultaneous counter-transaction, which is carried out on the sub-market with the lowest or highest of all known prices. If two alternatives are available, the arbitrageur chooses the cheaper alternative in the case of compensatory arbitrage. A balancing arbitrage forward exchange is about exists if the exporter ( importer ) its on foreign currency denominated receivable ( obligation ) by relating to the same due forward exchange sale (forward purchase) with the highest (lowest) forward rate covers.

In time arbitrage, the arbitrageur gains profits from transactions that occur at different times . Time arbitrage is not real arbitrage, because the transactions required to carry out the overall arbitrage transaction cannot be carried out at one point in time, but only at long intervals; it is therefore partly speculative. With the time arbitrage, the arbitrageur tries to take advantage of the price deviations of different maturities of individual (foreign exchange) futures transactions , especially by trading on the foreign exchange futures markets . If, as is the case here, there is a lack of synchronicity between buying and selling at the same time, the risk of price changes typical of speculation arises.

And the re-import (such as pharmaceutical products) is an arbitrage because the price differences of the same preparation are known and used by arbitrageurs (can). So far, however, the re-imports have been too low to push domestic prices down to foreign levels. Finally, tax arbitrage is a tax evasive act that is characterized by the legal structure of the situation of multinational companies that exploit a tax advantage through the different taxation in several countries ( low-tax country ).

In the case of drop shipments, a dealer actually acts as an intermediary between customer and supplier. In this case, the difference between the sales and purchase price results in the arbitrage.

history

The arbitrage of bills of exchange originally came from Italy ("arbitrio"), where it has been documented since the 14th century. It is concerned with buying bills of exchange where they are cheap and selling them where they are expensive. The correspondence of the trading house Stromeir from the year 1384 shows change arbitrage deals with Genoa. The arbitrage of bills of exchange, which was also very popular in Antwerp, particularly since around 1540, contained three elements. On the one hand they wanted to earn money from the local differences in exchange rates, on the other hand they speculated on their change and on the other hand they wanted the highest possible interest rates. According to the quoted source, Paul Behaim wanted to give money to Frankfurt and take it from Venice, but since the money has “hidden” (has become more liquid), nothing can be done with such “arbitrio”. The pioneering work Le Parfait Négociant (The Perfect Merchant) by Jacques Savary des Bruslons from 1675 takes up the Italian term and uses it with “arbitrage” in French, from where it was also adopted in the Anglo-Saxon and German-speaking countries. Savary goes into detail about the entrepreneurial function of arbitrage, especially among the numerous currencies and types of coins of that time.

The French economist Antoine-Augustin Cournot used the arbitrage term in 1838 in his theory of wealth - based on mathematical foundations - about the connection of markets through convergence in the current sense. After that, individual local markets become increasingly dependent on one another through arbitrage. “It is clear that a commodity that is movable must move from the market where its value is lower to the market where its value is greater, until the difference in value between the two markets is no greater than the cost of transportation”.

William Stanley Jevons formulated in 1871 his " law of one price " ( English Law Of One Price , in short: LOOP ), after which economic agents their individual portfolios in the market equilibrium have realized so that the equilibrium price arbitrage are and achieving arbitrage profits no longer is possible. The law is based on the idea of arbitrage, according to which a uniform price can only apply to a good if spatial, temporal, material and personal preferences are omitted and perfect information is available ( perfect market ). The establishment of a uniform price is justified in this case by the fact that price differences are quickly recognized as an arbitrage opportunity in a perfect market and are exploited by the market participants.

In his book, which was first published in 1874, Léon Walras developed an arbitrage model that he later modified several times, according to which every trader only owns one commodity that he would like to exchange for another commodity, but this is only possible via an indirect exchange of a third commodity (Triangle arbitrage) . He described this as a complementary Arbitrage Exchange ( English complementary exchanges ). Walras first drew attention to the fact that the arbitrage in the currency markets is exactly the same process as the exchange process in the commodity markets, as it was developed by him in the work that was fundamental to price theory.

John Maynard Keynes examined exchange rate and interest rate arbitrage in 1923 and assumed that an interest rate arbitrage business would not be entered into until a minimum profit of 0.5% on an annual basis can be achieved. Paul Einzig also assumed similar transaction costs in 1937, 30 years later he reduced the minimum to 1/32%.

It was only after the reintroduction of currency convertibility in December 1958 that currency rate and interest rate arbitrage could gradually develop freely again because the free movement of currency and capital could develop. The trading of foreign currencies offered the possibility of profitable activities because of the trading techniques of arbitrage and speculation, which are aimed at exploiting exchange rate differences.

The arbitrage price theory, which was largely developed by Steven Ross in 1976, explains the risk-return relationship of a portfolio as a capital market model on the perfect capital market . It states that a risk-free profit can be made by buying and / or short selling the portfolio when the value of the portfolio is no longer zero.

According to Israel M. Kirzner , the entrepreneur procures information, evaluates it in a targeted manner and thereby uses information advantages over market imbalances for arbitrage and speculation. He thus sets a market process in motion that leads to a market equilibrium.

Functions

Existing price differences are recognized by arbitrageurs and used by arbitrage. This leads to a price increase through purchases in the cheaper market and through sales to a price decrease in the more expensive market. Therefore, the aggregated arbitrage takes on a price equalization function . Arbitrage takes place until the arbitrage profit is identical to the transaction costs. Spatial arbitrage ensures market liquidity , since the arbitrageur takes the arbitrage object from a market participant who is willing to sell , in order to leave it to a (other) market participant who is willing to buy it.

The arbitrageur also assumes an insurance function if, when buying from his willing counterparty, he takes over the inventory risk for the arbitrage object. There is no allocation of resources , however, because the acquisition costs of an arbitrage property are offset by sales proceeds, so that no funds are used.

Market transparency

A common feature of all types of arbitrage is the reliable information about the rates or prices determining the arbitrage profit and the simultaneous closing out (sale or purchase). The absence of these specific intertemporal price risks distinguishes arbitrage from speculation. The very high level of market transparency in the financial markets due to electronic trading reduces arbitrage opportunities and leads to freedom from arbitrage , because market participants adjust the prices of their products so quickly that arbitrage opportunities usually only exist for very short periods of time.

In banking , proprietary trading arbitrage is mostly done in the form of currency and interest rate differential arbitrage . Currency arbitrage occurs when different exchange rates for one currency are exploited at the same time in different currency markets. Of interest difference arbitrage occurs when between states existing different interest rates are exploited. If the interest rate abroad is higher (lower) than in Germany, it is worth investing (borrowing) through a currency swap in the form of a combined cash purchase (spot sale) and forward sale (forward purchase) in the relevant foreign currency. This interest rate differential arbitrage is worthwhile until the swap rate is identical to the arbitrage profit.

Making a profit

In contrast to risky speculation, in which there is also the risk of a loss , in arbitrage the achievement of an arbitrage profit is certain; the sure arbitrage profit is called “free lunch”. To make a profit, the difference between the two courses must be greater than the intertemporal transfer costs. The arbitrage profit is a speculative profit according to § 23 Income Tax Act (EStG) in Germany and often also internationally taxable if certain arbitrage objects were the basis of the profit.

Economic impact

Arbitrage is mostly judged useful in economics because it creates market efficiency . In the context of globalization criticism, a disproportion between the actual trading volume and the amounts traded on the currency markets is viewed as worthy of criticism. These foreign exchange transactions are almost entirely arbitrage transactions between different currencies, which are processed electronically within seconds, which can result in very high trading volumes during the day. These arbitrage trades are sometimes referred to as interest rate arbitrage (better: currency carry trades to avoid confusion). These are speculative transactions to take advantage of interest rate differentials in individual currencies.

Joseph Schumpeter contrasted the arbitrage entrepreneur with the innovative, creative entrepreneur . Schumpeter values the performance of the creative entrepreneur higher, but at the same time recognizes that the arbitrage entrepreneur unwittingly promotes competition, since he makes knowledge that was previously only available to him (and the prerequisite for his arbitrage activity) accessible to the market .

Arbitrage condition

The arbitrage condition means that it will not be possible in the long term to realize a risk-free profit by buying and selling assets in a market, since the prices will eventually adjust.

In the following, the individual prerequisites as well as the processes taking place in the markets which are necessary for the arbitrage condition to set in are presented. Markets are connected in a special way, on which prices for the same good are formed in geographically different markets. If these prices differ from one another, so that regionally different prices result, it is possible to use the price differences through so-called arbitrage transactions in order to generate profits.

example

Existence of two investment options:

A. Investment of an amount in the form of buying cows at the livestock market at the time and price per cow, selling after a period ( ) at the price per cow

{\ displaystyle K}

{\ displaystyle x}

{\ displaystyle t_ {0}}

{\ displaystyle P_ {0}}

{\ displaystyle t_ {1}}

{\ displaystyle P_ {1}}

B. Investment of amount K by buying a bond with secure interest for a period (from to )

{\ displaystyle i}

{\ displaystyle t_ {0}}

{\ displaystyle t_ {1}}

( The following calculations based on Varian )

The future value from Appendix A is thus (without taking interest effects into account) as: ${\ displaystyle V}$

(1)

{\ displaystyle V = P_ {1} \ cdot x}

Since the entire amount K was invested, the following applies . Thus one obtains . Inserting in (1) leads to: ${\ displaystyle t_ {0}}$ ${\ displaystyle P_ {0} \ cdot x = K}$ ${\ displaystyle x = K / P_ {0}}$

(2)

{\ displaystyle V = P_ {1} / P_ {0} \ cdot K}

The future value of Appendix B corresponds to:

(3)

{\ displaystyle V = K + i}

If it applies now or so, arbitrage is possible. ${\ displaystyle P_ {1} / P_ {0} \ cdot K>}$ ${\ displaystyle <K + i}$

This is intended as an example for the case

(4) are shown.

{\ displaystyle K + i> P_ {1} / P_ {0} \ cdot K}

In this case, if an individual were in possession of a cow ( ) and were to sell it at a price per cow of , he would receive sales proceeds of . Would that amount in Appendix B to invest, it would receive at the time : . ${\ displaystyle x = 1}$ ${\ displaystyle P_ {0}}$ ${\ displaystyle K = P_ {0} \ cdot 1 = P_ {0}}$ ${\ displaystyle t_ {1}}$ ${\ displaystyle V = P_ {0} + i}$

Changing over (4) results in , inserting and then shortening results in . Thus, the individual would receive more at the time than it would need to buy the cow back at the price of. Thus one would achieve a risk-free profit - arbitrage would exist. ${\ displaystyle (K + i) \ cdot P_ {0}> P_ {1} \ cdot K}$ ${\ displaystyle K = P_ {0}}$ ${\ displaystyle P_ {0}}$ ${\ displaystyle P_ {0} + i> P_ {1}}$ ${\ displaystyle P_ {0} + i}$ ${\ displaystyle t_ {1}}$ ${\ displaystyle P_ {1}}$

Market forces and occurrence of the arbitrage condition

In the market context, however, the permanent existence of such a “money printing machine” is unlikely. It is to be expected that the arbitrage opportunities will be eliminated by market forces after a certain period of time. With reference to the above example, the main reasons for this are the following developments.

If there is an arbitrage opportunity as described in the example, rational individuals will recognize this opportunity and try to take advantage of it. This means that, on the one hand, more cows are being offered at the cattle market in order to redeem the price and invest it in the bond. This results in an increased supply, which in the short or long term leads to falling prices . Hence the right side of (4), will increase. ${\ displaystyle t_ {0}}$ ${\ displaystyle P_ {0}}$ ${\ displaystyle P_ {0}}$ ${\ displaystyle P_ {1} / P_ {0}}$

At the same time, the increased demand for bonds leads to falling interest rates . Thus the left side of (4) decreases, so . ${\ displaystyle i}$ ${\ displaystyle (1 + i)}$

Eventually it will:

(5) and all arbitrage opportunities are eliminated. This thus describes the so-called arbitrage condition .

{\ displaystyle 1 + i = P_ {1} / P_ {0}}

Conditions for the operation of market forces

In order for the market forces described to have a fundamental effect towards the occurrence of the arbitrage condition, i.e. the neutralization of the opportunity to realize a risk-free profit, certain framework conditions must be given. Essentially, these are:

(A) a functioning market; d. H. in particular:

complete information of the market participants (complete market transparency )
Security with regard to market conditions (prices, costs, etc.)
free market access
the non-existence of discriminatory transaction costs (only directed against individual market participants)
homogeneous goods

(B) rational individuals who base their decisions on maximizing their expected utility.

literature

Olivier Blanchard , Gerhard Illing: Macroeconomics. 4th updated and enlarged edition (of the American edition). Pearson Studium, Munich 2007, ISBN 978-3-8273-7209-3 (Wi - Economics) .
Horst Demmler: Introduction to Economics. Main band. 4th improved edition. Oldenbourg Verlag, Munich 1993, ISBN 3-486-22552-9 .
Pankaj Ghemawat : The Forgotten Strategy. In: Harvard Business Review. 81, November 11, 2003, ISSN 0007-6805 , pp. 76-85.
Karl-Heinz Moritz, Georg Stadtmann: Monetary foreign trade. Vahlen Verlag, Munich 1999, ISBN 3-8006-2491-5 ( compact study economics 15).
Hal R. Varian : Fundamentals of Microeconomics. 4th revised and expanded edition. Oldenbourg Verlag, Munich 1999, ISBN 3-486-24505-8 (International standard textbooks in economics and social sciences) .
Elmar Altvater : Geoeconomics and New Arbitrage Capitalism. In: contradiction. 18, 36, 1998, ISSN 1420-0945 , pp. 18–41 online (PDF; 12.4 MB)
Artur Woll : General Economics. 12th revised and expanded edition. Vahlen Verlag, Munich 1996, ISBN 3-8006-2091-X (Vahlen's handbooks of economics and social sciences) .

Web links

Wiktionary: Arbitrage - explanations of meanings, word origins, synonyms, translations

Individual evidence

^ Willi Albers, Anton Zottmann (Ed.): Concise dictionary of economics. Volume 1, 1977, p. 325 f.

^ Helmut Lipfert: National and international payment transactions. 1970, p. 124.

^ Journal for the entire credit system, Volume 11, issues 13–24, 1958, p. 28.

↑ Luis Esteban Chalmovsky: The international payment transactions and the foreign exchange markets in the economic theory and in the banking practice. 1984, p. 154 f.

↑ Susanne Wied-Nebbeling: Market and Price Theory . 1997, p. 46 f.

↑ Gerhart von Schulze-Gaevernitz, Edgar Jaffe: The individual areas of acquisition in the capitalist economy and the domestic economic policy in the modern state , part 2: banking. 1915, p. 86.

^ Raymond Aron, Bert F. Hoselitz: Congrès et colloques , Volume 15, Issues 4–5, 1970, p. 135.

↑ Richard Ehrenberg: Global stock markets and financial crises of the 16th century. 1922, p. 22.

↑ Antoine-Augustin Cournot: Investigations on the mathematical foundations of the theory of wealth. Jena 1924, p. 102 ff.

↑ quoted from: Paul Parey: Reports on Agriculture , Volume 44, 1966, p. 211.

^ Léon Walras: Éléments d'économie politique pure, ou théorie de la richesse sociale. 1874, pp. 113-116.

↑ Erich Schneider : Balance of payments and exchange rate. 1968, p. 90.

↑ John Maynard Keynes: A Tract on Monetary Reform. 1923, p. 77 ff.

↑ John Maynard Keynes: A Tract on Monetary Reform. 1923, p. 129.

^ Paul Einsig: The Theory of Exchange. 1937, p. 169.

^ Willi Albers, Anton Zottmann (Ed.): Concise dictionary of economics. Volume 1, 1977, p. 326.

^ Israel Kirzner: Competition and Entrepreneurship. 1978, p. 32.

^ Siegfried Trautmann: Investments: Assessment, Selection and Risk Management. 2007, p. 8.

↑ Horst Demmler: Introduction to Economics. 4th edition. Oldenbourg Verlag, Munich 1993, p. 61.

↑ Hal R. Varian: Fundamentals of Microeconomics. 4th edition. Oldenbourg Verlag, Munich 1999, pp. 193-194.

[1] Willi Albers, Anton Zottmann (Ed.): Concise dictionary of economics. Volume 1, 1977, p. 325 f.

[2] Helmut Lipfert: National and international payment transactions. 1970, p. 124.

[3] Journal for the entire credit system, Volume 11, issues 13–24, 1958, p. 28.

[4] Luis Esteban Chalmovsky: The international payment transactions and the foreign exchange markets in the economic theory and in the banking practice. 1984, p. 154 f.