If you've been investing for some time, odds are that you've heard about arbitrage. Often, arbitrage comes up in the context of large financial institutions using it to make easy money at the expense of less sophisticated investors. The implication is that small investors can't hope to make money through arbitrage-based strategies.
However, while it's true that some arbitrage-based strategies require a significant amount of capital, there are other ways to use arbitrage even if your available capital limits you to making relatively small transactions.
A simple explanation of arbitrage
In general, arbitrage opportunities can exist whenever there are at least two different markets in which a particular good is offered for trade. Unless the prices in each market remain exactly the same at all times, any discrepancy in price can be exploited by alert investors. For example, shares of Royal Dutch Shell
Historically, the lack of instant communication and reliable shipping made arbitrage opportunities common. In modern times, advances in communication and shipping have reduced the number of pure arbitrage opportunities, which involve little or no risk. These days, index arbitrage opportunities on stock exchanges may involve microscopic differences in price that last a matter of seconds. Futures markets in different areas of the world may have slight disparities in the prices of certain goods, but as long as the disparities are small enough that the transaction costs of taking advantage of them would wipe out any potential profit, then there's no point in attempting an arbitrage strategy.
However, for those investors willing to assume a higher amount of risk, certain arbitrage opportunities that arise from proposed mergers between companies that are publicly traded are frequently available for any investors who want to use them.
Arbitrage opportunities in the context of corporate mergers can be divided into two basic categories: cash buyouts and stock buyouts. In cash buyouts, an acquirer offers to pay a certain amount of money to shareholders of the proposed target company in exchange for their shares. In stock buyouts, the acquiring company offers to trade shares of its stock to the target company's shareholders in exchange for the shares of the target company's stock.
With cash buyouts, the arbitrage strategy is extremely simple. Usually, after a company makes a cash offer to buy the stock of another company, the target company's stock rises sharply but lingers at a level slightly below the offer made. As an example, take the recent buyout offer for Yankee Candle
Stock buyouts are a bit more complicated. For instance, last month, the Chicago Mercantile Exchange
It's important to understand that merger arbitrage is far from risk-free. Before a merger can take place, there are several things that the companies have to do. Regulatory agencies may have to approve mergers involving companies in certain industries, and if the proposed merger raises antitrust concerns, then the Department of Justice may review the terms of the merger and its effect on the market segment in which the companies do business to determine whether the merger will have anti-competitive consequences that run contrary to antitrust laws. For cash mergers, the acquiring company must secure enough financing to pay target shareholders. Overall market conditions can also change, making what originally would have been a profitable combination no longer viable. Last spring, investors in salon operator Regis
The lure of easy money is what draws investors to seek profits from arbitrage opportunities. As long as you understand the risks involved, looking closely at proposed mergers can help you discover ways to make good short-term returns on your investment.
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Fool contributor Dan Caplinger has dabbled in merger arbitrage, with both successes and failures. He doesn't own any shares of companies mentioned in this article. The Fool's disclosure policy is risk-free.