By  Investment Master Class

“Because my mother isn’t here tonight, I’ll even confess to you that I have been an arbitrageur”  Warren Buffett

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Arbitrage can be defined as 'the simultaneous or near simultaneous purchase and sale of the same securities or commodities in different markets to make a profit on the (often small) differences in price'.

This essay will take a brief look at 'classic arbitrage' and 'risk arbitrage'. Part two of the series will cover 'merger arbitrage', part three will cover 'time arbitrage' and part four will address 'spin-offs'.

'Classic Arbitrage' refers to, for example, a trader noting a price differential between New York and London gold prices and then buying gold in the cheaper market to quickly on sell in the more expensive market to capture the 'spread' [ie profit] with almost no risk.  Gold prices in London were kept in line with New York, as arbitrageurs like this trader exploited any pricing anomalies.

"A century ago, when you bought the same security in New York and London, there was just a little variation in price from one city to the other.  The professional bought the identical security in one city and sold it in another for a very small, but almost sure, profit." Roy Neuberger

With the advent of high speed communications and computer technology the opportunity for classic arbitrage no longer really exists. Today's example would be the high-frequency trader who arbitrages pricing discrepancies between the different stock exchanges in each market. The high frequency trader of today is a computer system which intercepts trade data at lightning speed and almost instantly sends market orders to other exchanges to arbitrage pricing differentials. In many cases these computers are trying to identify orders likely to be on-route to other exchanges [dirty poker?].  They co-locate computers at the exchanges [and pay premium rents to do so] to obtain quicker market data and low latency order routing, use microwave technology for communications, the latest computer chips for speed and employ complex algorithms. The rise of the machines has meant 'classic arbitrage' is impossible for mere humans.

The key idea in classic arbitrage is taking advantage of a pricing inefficiency with the absence of risk.

'Risk arbitrage' takes advantage of a pricing inefficiency due to some form of trading imbalance or information uncertainty created by a corporate event.  These corporate events include mergers, tender offers, liquidations, spin-offs, stub trades and corporate re-organisations etc.

The arbitrageur is trying to capture the spread between the trading price and the true value of the security.  This spread reflects both the time value of money until the event completes and a risk premium for the chance the deal won't complete, hence the moniker 'risk' arbitrage.

Ultimately the arbitrageur is trying to identify mis-priced risk.  There are a lot of causes of this mis-pricing, for instance, it may result from a stock moving out of an equity index, lack of Wall Street coverage of a spin-off, the stigma of a bankruptcy reorganisation, excessive risk aversion due to the uncertainty regarding a deal's success, a cross border transaction involving securities outside existing shareholder mandates or the complexity/lack of understanding of the nuances of the event etc.

"Since World War 1 the definition of arbitrage - or 'risk arbitrage', as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganisation, liquidation, self-tender etc" Warren Buffett

“Risk arbitrage investments, which offer returns that generally are unrelated to the performance of the overall market, are incompatible with the goals of relative-performance-oriented investors. Since the great majority of investors avoid risk-arbitrage investing, there is a significant likelihood that attractive returns will be attainable for the handful who are able and willing to persevere.” Seth Klarman

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The advantage of 'risk arbitrage' is that these investments tend not to be correlated with the broader stock market as the event has a timetable for completion which is expected to close the pricing anomaly.   This helps protect the portfolio from market sell-offs.  These investments are often referred to as 'special situations' or 'event investing'.

"The risk pertains not primarily to general market behaviour (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialise"  Warren Buffett 1963

“In the first place, with respect to a special situation as it is known in Wall Street.  That is a security which upon study is believed to have a probability of increasing in value for reasons not related to the movement in stock prices in general, but related to some development in the company’s affairs.  That would be particularly a matter such as recapitalization and reorganisation, merger and so forth.” Ben Graham

"The unique aspect of the strategy is its ability to earn attractive returns that are not dependent on the market's direction"  John Paulson

"Our goal is to make money independent of the direction of the market.. We always do this through arbitrage"  Brian Stark

"Risk arbitrage differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments at the underlying company. The principal determinant of investors' return is the spread between the price paid by the investor and the amount to be received if the transaction is successfully completed. The downside risk if the transaction fails to be completed is usually that the security will return to its previous trading level, which is typically well below the takeover price.”  Seth Klarman

Warren Buffett referred to these types of investments as 'work-outs' and employed the strategies at both the Buffett Partnership and then Berkshire Hathaway.

"Starting in 1956, I applied Ben Graham's arbitrage principles, first at Buffett Partnership and then Berkshire.  Though I've not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%" Warren Buffett 1988

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Buffett recognised the benefits risk arbitrage positions would add to the overall portfolio.  In down markets, arbitrage positions tend to outperform. While they are likely to be a drag on performance in strong bull markets, it's outperformance in down markets which is the key to high long term returns.

"I continue to attempt to invest in situations at least partially insulated from the behaviour of the general market." Warren Buffett 1960

"This category produces more steady absolute profits from year to year than the generals [fundamental value investments] do.  In years of market decline, it piles up a big edge for us; during bull markets it is a drag on performance. On a long term basis, I expect to achieve the same sort of margin over the Dow attained by generals"  Warren Buffett 1963

While risk arbitrage returns tend to be uncorrelated with the market, in times of market stress, correlations usually rise. This occurs as mergers and tender offers are more likely to fail as acquirers re-assess the prices they are prepared to pay, or business conditions may mean material adverse change conditions are triggered, or market-out-clauses are triggered, or financing dries up or spin-offs trade poorly. Spreads can also widen as dedicated arbitrage funds may face redemptions.

"The greatest risk in arbitrage is if capital leaves at the

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