Arbitrage

Arbitrage is the method of making profits from different a price of same asset in different markets. The basic idea is that people should buy underestimated assets and sell overestimated assets, so they make profits when the over or underestimated prices go back to their right prices. People easily can find in a currency exchange market. When you buy U.S dollar in London, Seoul, and Beijing, the price of U.S dollar would be the different. Thus, if people buy U.S dollar in London relatively cheaper than Korea and they can re-sell the U.S dollar in Korea, they can make profits from the difference price between the two countries. Many people use statistical arbitrage, and that is people perform arbitrage by using a statistic on the certain events. People estimate the expected value of certain events, and then when the events are underestimated they invest into those events. For example, people flip a coin and the probability of having tail and head are 50% and 50%. If 70 people bet $100 on having tail in next flip and only 30 people bet $100 on having head in next flip. However, important thing is if the 70 people win they will be get only make $42 (30 people (loser) x $100 / 70 people (winner)) of profits. If the 30 people who bet on having head in next flip win they will be get $233 (70 people (loser) x $1000 / 30 people (winner)) of profits. Thus, if people know how to get expected value from there, they bet on having head in the next flip. Arbitrage is a one of the safe ways to invest, so it is used by hedge funds. However, arbitrage also has a weak point that is if an investor forecasts future poorly, the investor will lose on his or her investment. For example, company A tries to take over company B, and the stock price of company B is $30. Let’s assume if company A takes over company B successfully, investors expect the stock price of B will go up to $40. If the Company B’s early trades of stocks are priced at $35, there is $5 difference between early trades and expect stock price. That is we call risk arbitrage. If company A takes over company B successfully, the investors would make $5 profits. Nevertheless, if the company A could not take over company B, the stock price of company B probably goes below $30, and the investors would lose on their investments. Many investors think arbitrage is considered as risk free investment, but investors should consider those unexpected event in the future.



http://www.investopedia.com/articles/trading/07/statistical-arbitrage.asp

http://en.wikipedia.org/wiki/Risk_arbitrage

http://cafe.daum.net/hedgemanagement/6d8t/2?docid=1GKJ2%7C6d8t%7C2%7C20081223163550&q=statistical%20arbitrage&srchid=CCB1GKJ2%7C6d8t%7C2%7C20081223163550