A Third Type of Arbitrage - Arbitrage on Financial Markets

There are all kinds of arbitrage opporunities in financial markets. Most of these opportunities come from the fact that there are many ways to trade esstentially the same asset, and many different assets are influenced by the same factors. A few examples:

• Options. A call option is the right (but not the obligation) to buy a stock at a price given in the option. Suppose Microsoft is selling for $200 a share, and an option which allows me to buy 1 share of Microsoft stock at a price of $120 is selling for $50. I buy the option for $50, then exercise the option and pay $120 for one share of Microsoft stock. I now own one share of Microsoft stock, and have paid $170 for it. I can then turn around and sell the stock for $200, so I'm now up $30. Most arbitrage involving options are more complicated than this, but they all have the same underlying logic. This type of arbitrage is commonly known as "relative value arbitrage".

• Convertible Bonds. Instead of using options, you can also perform a similar type of arbitrage by using convertible bonds. A convertible bond is a bond issued by a corporation which can be converted into the stock of the bond issuer. This type of arbitrage is known as convertible arbitrage.
• Stocks and Stock Indicies. There is a class of assets known as Index Funds which are basically stocks which are designed to emulate the performance of a stock market index. An example of such an index is a Diamond (AMEX: DIA) which mimics the performance of the Dow Jones Industrial Average. Occasionally the price of the diamond will not be the same as the 30 stocks which make up the Dow Jones Industrial Average. If this is the case, then an arbitrageur can make a profit buy buying those 30 stocks in the right ratio and selling the diamonds (or vice-versa). This kind of arbitrage is quite complex, as it requires you to buy a lot of different assets. This type of opportunity generally does not last very long as there are millions of investors who are looking to beat the market any way they can.

The possibilities for arbitrage are everywhere, from financial wizards selling complicated stock derivatives, to video game collectors selling cartridges on eBay they found at yard sales. Arbritrage opporunities are often hard to come by, due to transaction costs, the costs involved with finding an arbitrage opportunity, and the number of people who are also looking for that opportunity. Arbitrage profits are generally short-lived, as the buying and selling of assets will change the price of those assets in such a way as to eliminate that arbitrage opportunity. None of this has seemed to deter the thousands upon thousands of people who look for arbitrage opportunities every day.
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