Saturday, February 24, 2018

"Arbitrage: Historical Perspectives"

A topic of endless fascination (and some misunderstanding)
Three reposts First up, November 2012's headliner:

An interesting survey by Simon Fraser University Professor Geoffrey Poitras

This article discusses the history of arbitrage from ancient times until the beginning of the twentieth century. Opportunities for arbitrage trading in ancient times are related to the movement of goods over distance. The key role of the bill of exchange in arbitrage trading during the Middle Ages is identified and the connection to ‘arbitration of exchange’ discussed. A 17th century arbitrage involving the gold and bill of exchange markets is detailed. As reflected in merchant manuals of that period, the connection between riskless arbitrage trading and the method of conducting arbitration of exchange in the 18th and 19th centuries is detailed. An overview of 19th century arbitrage trading in securities and commodities is also provided. The article concludes with an examination of the etymology and historical usage of the word ‘arbitrage’ and the associated ‘arbitration of exchange’.

...Arbitrage in Ancient Times
Records about business practices in antiquity are scarce and incomplete. Available evidence is primarily from the Middle East and suggests that mercantile trade in ancient markets was extensive and provided a number of avenues for risky arbitrage. Potential opportunities were tempered by: the lack of liquidity in markets; the difficulties of obtaining information and moving goods over distances; and, inherent political and economic risks. Trading institutions and available securities were relatively simple. Circa 1760 BC, the Code of Hammurabi dealt extensively with matters of trade and finance. Sumerian cuneiform tablets from that era indicate a rudimentary form of bill of exchange transaction was in use where a payment (disbursement) would be made in one location in the local unit of account, e.g., barley, in exchange for disbursement (payment) at a later date in another location of an agreed upon amount of that local currency, e.g., lead [20]. The date was typically determined by the accepted transport time between the locations. Two weeks to a month was a commonly observed time between the payment and repayment. The specific payment location was often a temple....MUCH MORE (24 page PDF)
Secondly, February 2015's

In Which Bloomberg's Matt Levine Goes All "Let's Use Words Correctly, Class" On Us
Not that there's anything wrong with that.*
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.

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.
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.
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:
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.
Finally the post the little asterisk was hinting at, May 2013's "My Second-to-Last Comment on Izabella Kaminska at Tyler Cowen's Marginal Revolution" which was an update to "Tyler Cowen on Izabella Kaminska's 'Counterintuitive Model of the Modern World'" wherein Ms Kaminska was quoted—and attacked for—using the Fukuyama-ish term "The end of Arbitrage" (we know something of the evolution of said term)

My Second-to-Last Comment on Izabella Kaminska at Tyler Cowen's Marginal Revolution
Earlier today I mentioned that:
"In the comment section Marginal Revolution's usually perceptive, articulate and good looking commenters don't acquit themselves well on this post."
That was before the following two comments:
Becky Hargrove May 3, 2013 at 12:18 pm
There is plenty to quibble with in Kaminska’s assertions but I’ll just make a note about point seven. One assumes she sees greater efficiency and abundance as a positive gain for people in general. But…the end of arbitrage? That is also the end of greater attributable valuation for human skill, someone please send her a memo.
steve 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.
People, people, people arbitrage opportunities have been disappearing for the past 150 years!

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.

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.... 
Got that? All alpha not just arbitrage but all alpha was just $30 bil. in '06.
Here's CBS MoneyWatch in March 2013:
Hedge funds are too big to beat the market
This 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.

The link the two commenters were referring to happened to go through this little blog: "VIX, The End of Arbitrage and the Death of Volatility (VIX; VXX; VVIX)".

It linked at Alphaville to some thoughts by Christopher Cole, a hedgie who specializes in volatility trades.
I'm not sure what Steve and Becky do at the market but I'm guessing from their comments that it is not esoteric volatility trades. Read the darn post.

Next up, I'll deal with another commenter.

Here's Professor Hsieih's Hedge Fund Research page.
Here's some smart commentary on the $30 Billion figure.
See also Hsieh's "The Search for Alpha—Sources of Future Hedge Fund Returns", 11page PDF via the CFA Institute.

Two tautologies:
Hedges are not arbitrage, that's why they're called hedges and all hedges are dirty (imperfect).

I'll leave you with a thought from January's "Spot Gold Down $21.80 as HSBC, Credit Suisse Lower Forecasts (GLD)":

...How can one look at that and not think "Gold point arbitrage"?
You have to go to the master, Professor Officer (take that Herr Prof. Dr. Dr.) for the whole scoopage:

Cambridge: Cambridge University Press, 1996, 342 pp.

but one of these days I'll get around to posting on this perfect little arb where J.P. Morgan was willing to accept a measly $1000 profit per $1,000,000 traded because it was an honest-to-goodness arbitrage, not some "hedge", for, as we chant each morning, (all together now) "The only perfect hedge is at Sissinghurst":