Arbitrage Pricing Theory – MBA Mondays with Darwin

by Darwin on February 7, 2011

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.

Arbitrage Examples

  • 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.

Have You Ever Tried Arbitrage Investing?

{ 8 comments… read them below or add one }

Bret @ Hope to Prosper February 7, 2011 at 9:24 pm

I’m in an arbitrage situation right now with my shares of Frontier Gold (FRG). But, I’m going to sell my shares tomorrow and take the sure profit, instead of waiting to capture the rest of the spread. The big downside of a scuttled deal seems to outweigh the small potential profit from the merger.

BTW, I love Canadian resource stocks and have done well with them. I don’t blame our nothern neighbors for being protective of their industries, but it’s a reality of the global economy.


Darwin February 7, 2011 at 10:15 pm

Congrats on your arb profits! I like those stocks too, but don’t many of them have some wacky tax implications? They often come with nice divvies; have to look into them again.


Evan February 8, 2011 at 10:42 am

Not sure this is what you mean but there is a cool arbitrage that I am involved in sometimes.

You purchase a SPIA (Single Premium Life Insurance Annuity) for $X Amount…you then buy a life insurance product which replaces $X…and you keep the difference to use (the arbitrage).

It works because insurers rate the life insurance (so you can get REALLY SELECT AMAZING perferred) while getting issues the SPIA at the same as everyone else because they don’t rate it.


Darwin February 8, 2011 at 10:10 pm

Now that sounds interesting; understanding insurance products is a shortfall of mine!


Hank February 8, 2011 at 4:33 pm

While this is not exactly the investments your were looking for from you readers, I have done some eBay arbitrage over the years. There have been times when I will run across a deal for an item that I know is selling for a higher price on eBay, and I will buy multiples of that item and them sell them off slowly on eBay. For example, when the Enron scandal broke, I knew of a website selling old Enron stock certificates fairly cheap, and I then resold them on eBay where everyday buyers were going crazy for them. While not an investments in the traditional sense, it is still using the arbitrage pricing theory nevertheless.


Darwin February 8, 2011 at 10:11 pm

Perhaps not in the classical sense, but ingenious nonetheless. What a great idea!


101 Centavos February 8, 2011 at 8:14 pm

@ Hank
Professional “pickers” do this every weekend in the spring. They buy furniture and odds and ends at yard sales, and re-sell them within a short time at auctions, eBay or CraigsList.


Darwin February 8, 2011 at 10:12 pm

Oh yes, I call them evil douche-bags when they hover at our garage sale before it starts, picking through stuff until I shoo them away.


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