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3 Risks
Arbitrage transactions in modern securities markets involve fairly low risks. 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. These risks become magnified when leverageLeverage is related to torque; leverage is a factor by which lever multiplies a force. The useful work done is the energy applied, which is force times distance. Therefore a small force applied over a long distance is the same amount of work as a large fo or borrowed money is used.
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. 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.
In the 1980sMillennia: 1st millennium 2nd millennium 3rd millennium Centuries: 19th century 20th century 21st century Decades: 1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s 2010s 2020s 2030s Years: 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 Events and trends a practice with the oxymoronicAn oxymoron (plural "oxymorons" or "oxymora") is a short phrase that appears self-contradictory. Oxymoron is a Greek term which can be translated literally as "sharp-witted absurdity". The oxymorons are a proper subset of the expressions called contradict name of "risk arbitrage" became 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.
Long-Term Capital Management (LTCM) lost $100 billion mis-managing this concept in September 1998. LTCM had attempted to make money on the difference between different bond instruments. For example, it would buy U.S treasury bonds and sell 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, 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. Since the markets were already nervous due to the Asian crisis, investors began selling non-U.S. treasury debt and buying U.S. treasuries, which were considered a safe investment. As a result the return on U.S. treasuries 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 returns of U.S. treasuries and other bonds to increase, rather than to decrease as LTCM was expecting. Eventually this caused LTCM to fold, and a bailout had to be arranged to prevent a collapse in confidence in the economic system.
An ironic footnote is that they were right long-term (the LT in LTCM), and a few months after they folded their portfolio became very profitable. However the long-term does not matter if you cannot survive the short-term, and that they failed to do.
Economics
