Following up on this morning's "Meet The Dumbest Insurance Company In The World And the 68.6% Annual Return".
From Bloomberg:
Arbitrage Discovered
Webster's New World College Dictionary defines "arbitrage" as "a simultaneous purchase and sale in two separate financial markets in order to profit from a price difference existing between them," but who reads dictionaries, come on. The practical definition of "arbitrage," at least in the marketing of financial products, is "a thing we think we can make money doing, keep your fingers crossed." So when someone comes to you and offers you a thing called a "Fixed Price Arbitrage Life Insurance Contract," he's not actually offering you the ability to buy and sell the same thing at different prices, locking in a risk-free profit. It's not actually an arbitrage.*I've been known to go off on this issue myself:
EXCEPT NO HOLY GOD IT IS THIS IS AMAZING:
Life insurance is a popular savings product in France, and typically the customer allocates their money among different investment funds offered by the insurer. But this contract was not typical: prices for the funds were published each Friday, and clients were allowed to switch funds at those prices anytime before the next price was published, even if markets moved in the meantime.That's from Dan McCrum at FT Alphaville, and while I suspect that most of my readers who enjoy a good derivatives-mispricing yarn also read Alphaville, I figured I'd point it out here because it is the best of all derivatives-mispricing yarns, and I would hate for anyone to miss it. So go read him, and/or the French magazine -- aptly named "Challenges" -- that first reported this....MUCH MORE, including four footnotes:
L’Abeille Vie called this an arbitrage, but really it was a gift. Is the stock market up this week? Just call your broker to buy it at last week’s price and pocket the difference.
- Webster's is a little weird on this point. I quoted definition 1 in the text, but definition 2 is "a buying of a large number of shares in a corporation in anticipation of, and with the expectation of making a profit from, a merger or takeover." That normally goes by the name "merger arbitrage," or the delightfully paradoxical "risk arbitrage"; in my idiolect you can't just call it "arbitrage." But you see why Webster's would put it there, because otherwise "merger arbitrage" becomes incomprehensible.
1. 2013's "My Second-to-Last Comment on Izabella Kaminska at Tyler Cowen's Marginal Revolution":
.... May 3, 2013 at 12:28 pm
- I was taking the article half seriously when I read the “end of arbitrage”. All I can say is this marks it as quackery. Oh sure, arbitrage may end up being primarily the domain of computers working at lightning speeds. But, the end? Hogwash, there will never be perfect markets.
I guessing the two commenters didn't have the definition: "The simultaneous purchase and sale of the same instrument in different markets at different prices" pounded into their head so often their ears bled.
I did.
How many arbitrages do they think present themselves each year?
Spotting and acting on an arb is pure alpha and here is a dirty little secret:
The entire amount of alpha available to the entire hedge fund industry is only $30 billion per year.
As reported by a hedge fund maven via Investment News back in 2006:
...PHILADELPHIA - Everyone in the crowd assembled for the CFA Institute's hedge fund conference took notice when David S. Hsieh said that the amount of alpha available in the hedge fund industry each year is $30 billion.Got that? All alpha not just arbitrage but all alpha was just $30 bil. in '06.
Mr. Hsieh, a professor of finance at the Fuqua School of Business at Duke University in Durham, N.C., presented a synopsis of his ongoing research, which focuses on the style, risk and performance evaluation of hedge funds, at the Feb. 16 conference here. As part of his work, Mr. Hsieh questioned whether flows into hedge funds are causing a decline in hedge fund returns and what might happen if the high rate of inflow continues.
Because of difficulties in obtaining reliable hedge fund data, Mr. Hsieh used fund-of-hedge-funds data and broke down returns into alpha and beta sources. He said the research led him to "feel comfortable" determining that there is a finite amount of alpha - conservatively, $30 billion - managed by the approximately $1 trillion hedge fund industry. And even if capital invested in hedge funds were to rise, the amount of alpha would remain the same....
Here's CBS MoneyWatch in March 2013:
Hedge funds are too big to beat the marketThis is probably just a definitional problem so let's say it plainly:
In so called risk (merger) arbitrage the emphasis is on the first word.
Cash-and-carry, buying physical and shorting a derivative is not arbitrage.
When people use the term "arbed away" when talking about market anomalies the are not talking about an arbitrage.
Shorting an ETF and buying the component equities is not an arb, it's just a hedged trade.
Same for Index Arbitrage.
The total pool of arb opportunities may be as small as $1 billion.
Even the old Royal Dutch and Shell Transport trade was not an arb, just a fairly good pair trade.....MORE
2. 2012's "Arbitrage: Historical Perspectives"
3. 2014's "Gold and Backwardation or: Why to Hate Izabella de Alphaville"
The faux-eastern-European sounding sub-head is to honor one of her commenters at Dizzynomics who thought that, because of her last name (technically feminine adjectival surname, I looked it up), she was an English-as-a-second-language émigré from points east.*4. 2014 again: "As John Paulson Discovers Once Again: Risk-arbitrage Is Pronounced with the Accent On the First Syllable"
That's pretty funny.
The hate terminology comes from the fact that I was dithering whether to link to the piece that is the basis for her post "The time value of gold and anything" while she was using it as a take-off for some fancy commodities-and-more writing. From Dizzynomics.....
5. 2011 "Glencore: The Perfect Arbitrageur"
6. 2011 "Mispricing of Dual-Class Shares: Profit Opportunities, Arbitrage, and Trading"
7. 2007 "How Buffett Made a Killing in Chocolate, And Warren's Letters to Shareholders":
Warren on arbitrage:
And many more.Some offbeat opportunities occasionally arise in the
arbitrage field. I participated in one of these when I was
24 and working in New York for Graham-Newman Corp.
Rockwood & Co., a Brooklyn based chocolate products
company of limited profitability, had adopted LIFO
inventory valuation in 1941 when cocoa was selling for
50 cents per pound.In 1954 a temporary shortage of cocoa caused the price to
soar to over 60 cents. Consequently Rockwood wished to
unload its valuable inventory - quickly, before the price
dropped. But if the cocoa had simply been sold off, the
company would have owed close to a 50% tax on the proceeds.
The 1954 Tax Code came to the rescue. It contained
an arcane provision that eliminated the tax otherwise due
on LIFO profits if inventory was distributed to shareholders
as part of a plan reducing the scope of a corporation’s business.
Rockwood decided to terminate one of its businesses, the sale
of cocoa butter, and said 13 million pounds of its cocoa bean
inventory was attributable to that activity. Accordingly, the
company offered to repurchase its stock in exchange for the
cocoa beans it no longer needed, paying 80 pounds of beans
for each share.
For several weeks I busily bought shares, sold beans, and
made periodic stops at Schroeder Trust to exchange stock
certificates for warehouse receipts. The profits were good
and my only expense was subway tokens....
And apparently, for some reason the FT Alphaville journalist Izabella Kaminska makes me think of arbitrage.
All together now: "The only perfect hedge is at Sissinghurst":
