Questions & Answers

Pure arbitrage refers to the above-mentioned investment strategy in which an investor buys and sells a security simultaneously in different markets in order to exploit price differences. Therefore, the terms "arbitrage" and "pure arbitrage" are often used interchangeably.

Many assets can be bought and sold on multiple markets. When an asset is traded on multiple markets, it is possible that prices are temporarily out of sync. Only when this price difference exists does pure arbitrage become possible.

For example, imagine a large multinational company lists its shares on the New York Stock Exchange (NYSE) and the London Stock Exchange. On the NYSE, the price is $1.05; on the London Stock Exchange, the price is $1.10. If an investor were to buy the stock at $1.05 and sell it at $1.10, he would make a small profit of five cents per share.

Pure arbitrage is also possible in cases where exchange rates lead to price differences, however small.

Ultimately, pure arbitrage is a strategy in which an investor exploits market inefficiencies. With technological progress and the increasing digitalization of trading, it has become more difficult to exploit such scenarios, as pricing errors can now be quickly identified and corrected. This means that the potential for pure arbitrage has become rare.

Merger arbitrage, also known as risk arbitrage, is a type of arbitrage related to the merger of companies, e.g. two listed companies.

Generally, a merger consists of two parties: the acquiring company and its target company. If the target company is a listed company, the acquiring company must acquire the outstanding shares of that company. In most cases, this is done at a premium to the share price at the time of the announcement, resulting in a gain for shareholders. Once the deal is announced, traders looking to profit from the deal buy the shares of the target company, driving them closer to the announced price of the deal.

The price of the target company rarely corresponds to the transaction price, but is often traded at a slight discount. This is due to the risk that the deal will not go through or will fail. Deals can fail for a variety of reasons, including changing market conditions or rejection of the deal by regulators such as the Federal Trade Commission (FTC) or the Department of Justice (DOJ).

In its most basic form, merger arbitrage involves an investor purchasing shares in the target company at its discounted price and then profiting when the deal goes through. However, there are other forms of merger arbitrage. For example, an investor who believes that a deal might fail might choose to sell shares in the target company.

Convertible arbitrage is a form of arbitrage related to convertible bonds, also called convertible notes or convertible debt.

A convertible bond is basically like any other bond: it is a form of corporate debt that earns the bondholder interest payments. The main difference between a convertible bond and a conventional bond is that with a convertible bond, the bondholder has the option to convert the bond into shares of the underlying company at a later date, often at a discounted price. Companies issue convertible bonds because they can offer lower interest payments in this way.

Investors who engage in convertible bond arbitrage seek to profit from the difference between the conversion price of the bond and the current price of the shares of the underlying company. This is usually achieved by taking simultaneous long and short positions in the convertible bond and the underlying shares of the company.

The positions the investor takes and the ratio in which he buys and sells depend on whether the investor considers the bond to be fairly valued. In cases where the bond is considered cheap, the investor usually takes a short position for the stock and a long position for the bond. On the other hand, if the investor considers the bond to be overpriced or expensive, he may take a long position on the stock and a short position on the bond.