There is no free lunch.
Old Stock Exchange adage

Arbitrage strategies are very popular in the hedge fund world, but before turning to their description, it is necessary to clarify the specific meaning of the term “arbitrage” in this context.

From an academic point of view, an arbitrage stands for a risk-free transaction that generates an instant profit: a theoretical example of arbitrage is the concurrent purchase and sale of the same security on different markets at different prices. By buying the same security at a lower price and selling it right away at a higher price, an arbitrageur earns an immediate profit at no risk, saving the settlement and delivery risks.

But in the hedge fund business the term arbitrage has developed a different sense, in that it does not refer to risk-free positions, but rather to positions involving risks other than the market risk. Hedge fund arbitrages in practice are directional positions on spreads: if the spread widens or narrows as anticipated, the manager makes a profit; otherwise he suffers a loss. Therefore we must not be misled by the word arbitrage: a hedge fund may well suffer a loss even when it has constructed an arbitrage position – what it takes, is for the spread to widen or narrow contrary to predictions.

An arbitrage opportunity may appear when given technical, geographical, legal or administrative barriers interfere with the correct interaction between two markets trading the same security, thus preventing the security from having the same price on both markets.

In a perfect world, there would be no arbitrage opportunities, and in the real world most arbitrage opportunities tend to disappear quickly, unless there are high transaction costs that hamper frequent arbitrages. Over time, inevitably, other arbitrageurs will get organized to take advantage of arbitrage opportunities, narrowing down the price difference until it disappears. Arbitrage opportunities draw various arbitrageurs to the market, and they will erode each other’s profits by competing against one another. Once again, to make a return it is necessary to take on risks!

It is important to note that arbitrageurs are not asked to forecast the absolute movement of two securities, but rather the relative movement of one over the other, irrespective of market direction.

Any arbitrage opportunity faces so-called steamroller risks. Through a colorful analogy, an arbitrageur is seen as somebody who picks up a few coins from the ground in front of a moving steamroller: the man runs no risk provided he never forgets that the steamroller is forging ahead towards him. In order to earn a few coins the man runs the risk of being steamrolled.

Risks can also come from regulatory or tax changes, which may force the arbitrageur to close a position while losing money. Or, as illustrated below in the ADR arbitrage example, sometimes conditions regulating the short sale of a security may change suddenly, and the security may be called in by the owner; or sometimes the borrowed security may pay out a dividend, which is going to represent an unexpected cost for the arbitrageur.

The greater the number of arbitrageurs operating on a given market, the higher the competition, which means that the returns realized by the arbitrageurs will be lower. The current trend in the hedge fund business is that the massive money flow towards arbitrage strategies makes it more and more difficult for managers to generate interesting returns.

Most of the low-hanging fruits have already been picked!

This article is a part of “Investment Strategies of Hedge Funds” ebooks by Filippo Stefanini for closed private educations only. You should buy his books for the best completely informations.