Arbitrage Pricing Theory will be this week’s MBA Monday topic (see full list of MBA Monday posts). Probably the most common use of the term “arbitrage” is when associated with Merger Arbitrage. There are other types of arbitrage as well, with entire companies and disciplines dedicated to exploiting arbitrage opportunities. The most common use of the term though involves employing tactics to capture slight differences in pricing. This may involve buying something at a slightly lower price with the expectation of selling it simultaneously or in the near future at a slightly higher price, engaging in a pairs trade where prices are expected to diverge, or purchasing shares in a takeover target where the full acquisition price isn’t yet priced into the current market price (merger arbitrage). In financial markets, this can apply to stocks, bonds, currencies, commodities and all sorts of exotic instruments. Let’s take a look at some common examples and even how I, as a routine retail investor, have utilized arbitrage pricing theory to exploit market opportunities for profit.
- Merger Arbitrage – It’s commonplace for an acquisitor to make a bid for a target company and publicly state the offer price, yet the shares of the target company don’t reach the full offer price. This can be due to a number of reasons. In some cases, merger or acquisition deals fall apart. Sometimes the shareholders or the management reject the bid and don’t feel the offer price adequately reflects the value of the company. In other cases, there are regulatory or anti-trust barriers that can’t be overcome. A relevant recent example of a deal gone awry would be BHP‘s bid for Canada’s Potash (POT). The Canadian government basically shot it down, in what some viewed as a protectionist measure. Meanwhile, if you’re a Canadian and you’re sick of seeing your country’s national resources sold abroad, you might say it’s about time. Regardless, for arbitrageours who looked to exploit the small spread between the price just before the judgment and the offer price, they lost their shirts when the deal fell apart, as they settled back down. A current outstanding acquisition bid example is Avis’s (CAR.O) bid for Dollar Thrifty (DTG.N). The bid currently stands at $53 per share, but Dollar Thrifty is only trading at $50.2 presently. So, let’s say you went out and bought shares on Monday and within a month, the FTC ruled that the deal could go through. That would be a gain of ~$3 per share (6%) in a month, which is well over 70% annualized. Like I said though, these deals sometimes don’t work out and I’d posit that by the looks of this spread with the FTC due to rule soon, investors are actually pricing in some heavy skepticism that this deal will actually be approved.
- Commodities Exchanges – Sometimes an underlying commodity may have different prices on different exchange. Buying a futures month on one exchange and selling the same month on another Exchange by buying both sides involving the same commodity
- Pairs Trades – Occasionally, even as a retail investor, you’ll come across situations where too seemingly similar assets are priced differently or are sure to move differently in the future. You can go long on one and short on the other with an equivalent sum, exploiting the future divergence for a very low-risk gain (i.e. even if you were wrong, you’ll only lose the difference between the gains and losses and won’t lose your full principal). For a real-life example where I exploited this, read more about this gold pairs trade when I basically publicized an incredibly obvious, low-risk, easy money opportunity – and then I executed it. In short, a closed end fund had a runaway premium due to irrational hysteria over the ownership of “physical” gold when conspiracy theorists were purporting that major financial institutions could never meet their claimed gold reserves should they need to. With a couple weeks, I was right, the closed end fund premium crashed, and I captured the difference since I had gone short PHYS and long GLD. Easy!
Situations like this present themselves sporadically and by knowing when you have a decent shot at exploiting market mispricing or market hesitancy, arbitrage pricing theory can help boost your returns.