Financial Education

Arbitrageurs seek to exploit temporary market inefficiencies by buying a security they believe is underpriced and shorting a similar security they believe is overpriced. If the securities are not perfectly matched, the trade faces fundamental risks. But even if the securities are perfectly matched, the trade runs the risk that the inefficiency that produced it in the first place will continue or get worse.

For example, when Palm, Inc. shares were first spun out from 3Com investors were far more enthusiastic about Palm’s future than about 3Com’s. So much so, that Palm rose in value to the point that it was valued higher than 3Com – even though 3Com still owned most of the shares. Arbitrageurs sold Palm and bought 3Com knowing that when the remaining Palm shares were spun out they could replace the shares they had shorted and end up owning “free” 3Com shares.

However, the arbitrageurs (information traders) ran the risk that the investors who created the opportunity (noise traders) would continue to misprice the securities. If they continue to force Palm shares higher relative to 3Com, the arbitrageurs could be forced to cover their short positions early at a loss.

For more information, see all articles on: Active Management, Behavioral Finance, Investing in Stocks, Investment Returns, Portfolio Management, Valuation

See also:

Risk and Return in Fixed Income Arbitrage

Fundamental Risk and Arbitrage Strategies

Hedge Fund Strategies: Risk Arbitrage

The Statistics of Statistical Arbitrage

The Relative Value Arbitrage Style