protect anarbitrageur's competitive advantage for long, it is natural to ask if itcan be based on superior information. If, for example, dividend estimates are diverging between two ®rmsÐeven if their tax treatment issimilarÐtheir respective index fair values will diverge, in turn affectingtheir trading strategies on index arbitrage. From there one ®rm couldpossibly realize a higher return because it is consistently right about itsdividends expectations. However, although theoretically possible, thisphenomenon is short-lived because it is mean reverting. Assuming, forexample, one index arbitrageur adopts an extreme stance and setsdividend expectations to zero, he or she will compute a future fairvalue much higher than that of the market. As a result, he or shewill see the future's price being much too low in the market comparedto his or her model, and he or she will be liquidating his or her positionas fast as possible.9 In front of such an apparent mispricing, anyrational person would spot an anomaly and review the underlyingtrading assumptions, with the probable result of questioning dividendassumptions and revising them upward. In the reverse case wheredividends would have been too high, the exact opposite effect wouldhave been triggered, and the same trader would not have been able tobuy stocks fast enough.The result of this short discussion is to complete our pro®le oftypical arbitrageurs. Not only is this group small and highly specialized, it is also somewhat undifferentiated with regard to marketopportunities and critical parameters. For example, if a large institution9
Index arbitrageurs buy futures and sell stocks when the index future is priced too lowin the market compared to its theoretical value. More details on that in the last part ofthis chapter. The future's fair value is the difference between the future's theoreticalprice and the price of its underlying index.
10
THEORY AND TOOLS
decided to start an arbitrage activity in Japan, one of its ®rst stepswould probably be to open a local subsidiary to circumvent the taxation issue, and it would engage rapidly in peripheral activities to guarantee its arbitrage desk an adequate support. At this point it wouldplace itself only on equal footing with other players. Therefore, differentiationÐand competitive advantageÐon an arbitrage desk residesprimarily in execution skills, at least when the convergence is fairlycertain.10 This does not mean that arbitrageurs always intervene at thesame time and for the same typical pro®t. For example, position limits,by placing constraints unrelated to the market, may have the effect ofrestraining a particular trader when all the others are as aggressive asever. Nevertheless, in general, arbitrageurs tend to intervene at thesame time, and for probably the same expected pro®t, reinforcing theneed for better execution.
Arbitrageurs versus Investors
There is one more important piece that needs to be incorporated in thispreliminary discussion. Arbitrageurs have their own agenda, and inmany cases their incentives are not aligned to those of the investorcommunity at large. We will argue later that the presence of arbitrageurs is usually a good sign for investors because it indicates thatmarket institutionsÐin terms of execution, settlement, and liquidityÐare functioning properly. However, this does not mean that investors necessarily consider it a blessing in and of itself.It is true that arbitrageurs bring prices closer to ef®ciency, but that isa byproduct of their activity, not an overt goal. Consider, for example,the case of risk arbitrage in which the divergence of interest is unambiguous. Arbitrageurs do not care about shareholder value created by aproposed transaction. Indeed, were a given transaction to destroyvalue, they could not care less. Their only concern is to see the transaction effected, if and only if they carry a position.11 In addition, their riskis limited to the effective date of the merger, meaning that if its implementation turns out to be a disaster, they are not affected in any way.10
Execution skills have to be considered from a broad perspective. For example, theability to carry more riskÐbecause of better systemsÐor to borrow or lend stocksmore aggressivelyÐbecause of better relationships throughout the marketplaceÐalso translates into improved execution capabilities because the arbitrageur willtrade more often compared to his or her peers.11The case of reverse arbitrage, in which a trader bets on a deal being called off, happensas well, albeit very infrequently.
CHAPTER 1 INTRODUCTION
11
Other examples of such con¯icts of interest include the replacementof a constituent of an index.12 Arbitrageurs want, above all, predictability in execution, even if that implies a relative loss of liquidity. This, inturn, translates into a need for an all-electronic marketplace wherereporting is instantaneous and screen prices accurate, which effectivelymakes dealer markets undesirable. On the other side, investors interested in small- or micro-capitalization companies have a stronger interest in dealer markets because market makers are usually required toquote continuously, even for small sizes, effectively providing liquidityof last resort.These important differences should not be overlooked. Combinedwith the fact that arbitrageurs in general are a smallÐbut ®nanciallyactiveÐcommunity partly explains why arbitrage has been undermore and more scrutiny over the years and as a result, has becomemore and more regulated in some countries.13
DIFFERENT TYPES OF CONVERGENCEAbsolute (Index Arbitrage)
Index arbitrage provides the perfect example of an absolute convergence. By de®nition, a futures expires on a price set to equal that of itsunderlying cash. The only possible reason that this would not occurwould be the exchange's closure or failure. The probability of thishappening is fairly low considering all the precautions taken on margindeposits by futures exchanges worldwide. However, it should not beconsidered impossible, as was sadly shown by the unexpected failureof the Russian Exchange in 1998. Consider also the collapse of Baringsin 1995 that turned out to be fairly innocuous but sent shock wavesthroughout the world ®nancial markets and was dangerously close to ageneral debacle. Again safety nets in place at all levels of modern
12
If the effective date for a change is after the announcement date, the stock ``comingin'' tends to be bid up before it enters the index, while the one being replaced isusually performing poorly while it is still included. The index return does notbene®t from the ``spike up'' and re¯ects the ``spike down.'' In that case indexarbitrageurs are naturally hedged, and investors in index funds are forced to takean opportunity loss.13See, for example, Craig W. Holden, ``Current Issues: Index Arbitrage,'' FinancialAnalysts Journal, 1991, pp. 8±9, for a brief examination of the bad press resultingfrom the October 1989 minicrash.
12
THEORY AND TOOLS
®nancial markets reduce this risk to a comfortable level, but it shouldnot be ignored entirely.An absolute convergence has two types of attributes: economic andtemporal. The common price is unknown but realizable; that is, allmarket participants have access to its de®nition and can theoreticallyexecute on it if necessary. The timing of this convergence is also knownwith certainty.In practice, the fact that futures settlement values are realizabledoes not eliminate execution risks. For example, on exchanges wherethe ®nal value is an average over a period of timeÐtypically EuropeanexchangesÐthe chances of trading at the exact expiry price are virtually nil. On the other hand, the of®cial de®nition is crystal clear,and under normal circumstances market participants can get fairlyclose to the ®nal settlement price. The question of labeling this difference is somewhat arti®cial: If we know we will not be able to execute atthis price, we could fairly say that the whole convergence hypothesisfails. It is clearer, in fact, to segregate the issues and to consider that theconvergence still occurs and the risk gets translated to executing on it.As a general rule, absolute convergence is a comfortable situationin which we can be con®dent that the difference in price captured now,if properly managed, is secured once and for all.14 These are in fact theonly positions that can be labeled ``arbitrage'' because for the mostpart, once the convergence is established, all other risks can be dealtwith and kept under control. This is as close as it gets to risk-freetrading.Opportunities are pro®table if transaction costs and hedging costsare lower than price discrepancies in the market. In the case of indexarbitrage, surprisingly enough, all the markets we consider satisfy thiscondition and support pro®table arbitrageurs. Still, opportunities ofthat nature do not abound. An absolute convergence in the way wede®ne it is not accidental; it must be written in stone, which means thatthe only situations in which it develops recurrently are between derivative products and their underlying reference.Note, however, that derivative product here is used in a very broadsense. The Nikkei 225 future contract listed on the Chicago MercantileExchange (CME), for example, can be considered a derivative of theNikkei 225 future listed on the Osaka Stock Exchange (OSE). The samecharacterization applies also to the Singapore Monetary Exchange14
Note, however, that the realization of this pro®t comes with the convergence. Unlesswe ®nd some opportunity to reverse a position before expiry, only at that time willwe explicitly realize the pro®t traded today.
CHAPTER 1 INTRODUCTION
13
(SIMEX) Nikkei 225. The three of them do not have the same tradingcharacteristics, but they expire on the same day, at the same price.Because the OSE contract carries the largest liquidity, it is fair to saythat it constitutes the underlying reference. The other two are pricedaccording to their speci®cs,15 but it is possible to build an arbitrageposition between the three because of the fundamental convergence.16Index arbitrage is the best example of an absolute convergencebecause it involves numerous execution dif®culties and a wide rangeof risk management techniques. We will use it extensively throughoutthis book and give a detailed presentation of it in the last chapter.
Explicit (Risk Arbitrage)
In a risk arbitrage situation a position is taken on the announcement ofa merger or acquisition (MOE) between two corporate entities.Schematically, if company A decides to merge with company B, itoffers to buy or exchange B stocks against cash or its own shares.For example, in the case of Citibank and Travelers, Travelers offeredto exchange each Citibank share for 2.5 of its own shares.There may be numerous variations of this situation. The offer maybe a combination of both equity and cash, and there may be provisions to alter the exchange ratio if one of the stocksÐtypically theacquirer'sÐexits from a preset price range. The reasoning is thatbelow a certain price, shareholders of B do not get a fair deal anymore and the ratio should be revised upward. At the other extreme, ifthe price of A is high, shareholders may consider the transaction tooexpensive and the ratio should go down. In general, revisions areinfrequent because preset price ranges are fairly wide.We term this type of convergence explicit.17 In general, mergers andacquisitions involve high-level negotiations between all parties, whichresult in strong commitments. Even if the industrial logic or the strategic value is questioned by market participants and analysts, whichcan lead to a fall in share prices after the announcement, such decisionsare meant to be ®nal. Therefore, there is more than pure speculation inthe relationship between the two share prices once the merge decision15
Notably, the CME contract is settled in U.S. dollars, not Japanese yen.In practice, the CME contract trades on Chicago time, when both the SIMEX and OSEare closed, which effectively forbids such positions. However, arbitrage betweenSIMEX and OSE is possible.17The term explicit is not market practice, and it refers to the fact that in a risk arbitragesituation, for example, the convergence has been explicitly de®ned by the terms of thetransaction.16
14
THEORY AND TOOLS
has been made public. Problems do occur regularly, however, fordiverse reasons. Antitrust issues are getting more and more commonas a result of a decade of M&A activity, culminating in a $115 billionbid from MCI WorldCom for Sprint in October 1999. Beyond legalconcerns there may be more pragmatic reasons that these deals failfrom time to time, related to the so-called agency problem. All proposed transactions do not necessarily target shareholder value as aparamount goal, and managers often tend to have their own agenda.18Numerous hostile takeover attempts fail, and even friendly weddingsmay turn sour before the ceremony. The tentative merger of MCI withBritish Telecom in 1997 is a perfect example, and it will serve as anumerical example of what losses amount to when convergence failsto materialize despite a strong conviction as to the contrary. Therefore,our de®nition of explicit convergence may look like this: ``fairlycertain, but not quite.''In these situations, judgment is the ultimate risk management tool.A sound analysis of the industrial project and a careful assessment ofthe shareholders' respective positions and of the regulatory environment certainly help, but they are not suf®cient. The vast majority ofrisk arbitrageurs still lost a great deal of money on British Telecom (BT)versus MCI Communications (MCI).Just as we proposed earlier that there are natural consequencesto draw from a situation of absolute convergence, there are alsostraightforward implications of the intrinsic uncertainty of riskarbitrage. In fact, the actual market prices reveal much more abouttrue market expectations and effectively price the risk of nonconvergence. Therefore, they cannot and should not be ignored.Exposure on dividends or interest rates, while still critical to assesspro®tability, has little impact on the overall level of risk of aparticular transaction.BT/MCI is a good case study of the risks, and we will extensivelyreview this case, as well as that of Staples (SPLS) and Of®ce Depot(ODP), another example of a failed transaction. More generally, however, mergers and acquisitions deals tend to proceed smoothly whenthe underlying strategy is sound and when regulatory issues are not athreat. To get a sense of a typical deal, we will look at Citibank (CCI)
18
See, for example, Randall Morck, Andrei Shleifer, and Robert W. Vishny, ``DoManagerial Objectives Drive Bad Acquisition?'' Journal of Finance, 45, 1990, pp.31±48.
CHAPTER 1 INTRODUCTION
15
and Travelers (TRV), and Credit Commercial de France (CCF) andHong Kong and Shangai Bank (HSBC), which happened to be mergersof substantial size.
Hypothetical (Pair Trading)
Pair trading is a popular strategy that appeared initially in the 1980s,and it consists of matching stocks with similar behaviorÐthat is, highcorrelationÐand trading on their divergence.19 It has been re®ned overthe years and nowadays typically involves stocks with somewhat identical business models from identical industry groups.Because these positions involve a divergence-convergence process, they are abusively labeled ``arbitrage'' although there is nofundamental reason in general that a convergence should materializeafter a divergence has occurred. Indeed, these positions are drivenby statistical analyses and can be characterized as small regulargainers and big one-time losers. For some time an arbitrageur willcapture small recurrent pro®ts, but at the ®rst blowup the loss maybe such as to engulf those pro®ts and more. The reason is thatexceptional events or announcementsÐearnings related, for exampleÐtend to widen the spread instantaneously, even if the companies have similar pro®les. By contrast, except for a mergerannouncement, it is dif®cult to conceive of new information thatwould induce the two prices to converge that fast. Only in themedium to long term does the market adjust prices to account forunderlying similarities. This strategy therefore is generally quite fragile and exposed to price shocks.We term this type of position speculative arbitrage, which isÐintentionallyÐsomewhat of a contradiction. Even more than risk arbitrage,convergence is here the most risky side of the strategy, and success isusually subordinated to a rigorous discipline in cutting losses for failedbets. The opportunities of that type tend to live longer than othersbecause the broader market does not recognize the price differenceas an anomaly. In essence, the convergence is ``proprietary'' in naturebecause only a small number of players truly believe it is justi®ed.Now we do not mean that these strategies are doomed to fail.Indeed, there has been some evidence that they can be quite pro®table19
For a complete description and study of pairs trading, see Evan G. Gatev, William N.Goetzmann, and K. Geert Rouwenhorst, ``Pairs Trading: Performance of a RelativeValue Arbitrage Rule,'' National Bureau of Economic Research, Working Paper 7032,www.nber.org.
16
THEORY AND TOOLS
when executed properly. Also, it is possible to identify pairs that havestructural characteristics, ensuring that convergence is not left entirelyto chance. Therefore, discrepancies of that sort may be pro®tablyexploited, but there must be rigorous analysis, tight management,and diversi®cationÐthat is, a large number of pairsÐto offset inherentweaknesses in the underlying model.To study further this type of position, we will perform a simplestatistical exercise with the stocks of the Dow Jones index.Extracting pairs from simple regression techniques, we will examineif these pairs exhibit a pro®table pattern. We will also considerRoyal Dutch Petroleum (RD) and Shell Transport and Trading(SC). These companies have shares listed in the United States andin Europe, and they are two faces of the same coin: RD holds 60percent of the group Royal Dutch/Shell, and SC holds the remaining 40 percent. In both cases the companies are ``shells'' derivingtheir income from their participation only. Therefore, they haveequity claims on the same asset base, and their market pricesshould follow a predictable relationship based on the 40/60 partition of these assets.
Leap of Faith (Technical Trading)
The ®nal category we explore is technical trading. Technical tradingcan be de®ned as any trading strategy based entirely on statisticalanalysis and/or charting analysis, in which a position is taken on thebelief that an identi®ed ``pattern'' will repeat itself in a predictablemanner. The same causes will bring the same effects, allowing aninvestor to anticipate and take the appropriate position, which isnot even necessarily hedged. Strictly speaking these strategies donot ®t our de®nition of arbitrage, but they constitute an extensionof it because the underlying reasoning is that of a relative valueanalysis, not against another security but against the same onetaken in another time frame.Our interest in these positions is double: On one side it is interesting to investigate what type of strategy may ®t into this category, outof curiosity and to establish a contrast to the three previous categorieswe described. At the same time, the very existence of pro®table technical trading rules has been consistently denied by numerous academics, because like arbitrage, these positions violate an underlyingfundamental principle in that they indicate stock prices may indeed bepredictable. Numerous practitioners, on the other hand, will testify that
CHAPTER 1 INTRODUCTION
17
technical trading can actually be pro®table if only because it has a selfful®lling characteristic.20Therefore, our analysis will be short and focused on these twopoints. We will present two rules and limit the analysis to an explanation of the underlying principle and testing results. These rules aresimilar and derived from the idea that stock prices tend to exhibit amean-reversion property in the very short term. In particular, we willexamine how it is possible to generate pro®ts by taking a positionagainst an unexpected signi®cant move in the market.
Arbitrage and Oscillators
In physics oscillators are phenomena that repeat themselves periodically and vary around an average value. This is intuitively very close tothe idea of a recurring convergence, and we want to explore here towhat extent we can extend the parallel.Consider a random variable XÐa stock price or any other variablerelated to market prices. Without knowing its distribution, we draw avalue Xt at regular intervals and compute an average ET X over alarge period of time T:01 XXtT tt
tt T
ET X 
0
We do not impose any particular condition on X, and intuitively wesay that X is an oscillator if ET X ! 0 when T ! 1. In other words, ifwe wait long enough, X is equal to zero on average.This formalism is very simple and has the advantage of applyingdirectly to many ®nancial concepts. For example, numerous technicalindicators are oscillators, meaning that their expected value over a longperiod of time is known and usually 0, and any signi®cant deviationfrom that value is interpreted in a speci®c way.Clearly, an arbitrage is always based on an oscillator, by nature.Regardless of its value now, the relative mispricing is expected toaverage 0 over time, and that is precisely what we presented as convergence. Therefore it may be interesting to apply tools traditionally20
The moving average crossover rule is a classic example. Supposedly when two moving averages of different periodicity cross over, the underlying security is likely tostart a short-term trend. If a lot of investors believe in this rule, regardless of itstheoretical value, the effect of their aggregate trading will be observable in the market, effectively realizing the original prediction.
18
THEORY AND TOOLS
dedicated to cyclical phenomena to arbitrage situations and to try toextract a better analytical understanding of the cycle involved, notablyin terms of expected periodicity. Typically, for example, Fourier analysis is frequently used to decompose periodical functions into elementary components, and it has many applications in the world of ®nancialoscillators.However, the most interesting advantage of oscillators lies in theexploration of the opposite relationship: Is every oscillator associatedwith an arbitrage opportunity? The answer to this question is unfortunately no, but clearly every oscillating indicator should neverthelessbe considered as a potential candidate and examined accordingly.The careful design and exploration of ®nancial oscillators probablyconstitutes one of the best ways to systematically come up with newideas and new opportunities. Typically this approach is very usefulfor statistical arbitrage, which tries to establish and test relationshipsbased on perceived recurrent patterns.To illustrate the point, consider a popular trading strategy calledmean reversal. It is based on the assumption that when a stock gets toofar from a short-term moving average, it tends to come back at somepoint, and the strategy is to try to capture this move back. Consider, forexample, the chart in Figure 1-1.It shows the normalized deviation between the General Electric(GE) closing price and its 10-day moving average over a period ofone year.21 The deviation oscillates around zero, and it seems to berelatively symmetrical. This suggests that if we sell GE at a peak orbuy it at a bottom, we can probably lock the move back to the 0.Unfortunately this simple operating procedure does not reallywork because we cannot ``trade'' the moving average. Therefore,we have to take a position exclusively on GE, which may or maynot move in the right direction. Consider the two examples in Tables1-1 and 1-2.In the ®rst case we decide to take a long because the differencebetween GE and its 10-day moving average has crossed the 1:5 standard deviation threshold and we expect it to come back to zero.22 We21
The normalized deviation is obtained by taking the difference between GE and its10-day moving average, minus the average of this difference and divided by thestandard deviation of the difference. This transformation is called a Z transform,and it is used to allow a rapid comparison to a normal distribution.22For a normal distribution, a realization of 1.5 standard deviation corresponds to aprobability of 13 percent. In other words, a deviation of 1.5 standard deviation fromthe moving average has 13 percent chances of occurring. Naturally, the underlying
CHAPTER 1 INTRODUCTION
19
TABLE 1-1DateNov. 27, 1998Nov. 30, 1998Dec. 1, 1998
GE Closing Price
10-Day MA
Norm. Deviation
$925/16$903/ 8$911/ 8
$92.00$92.22$92.29
0:831:851:32
take a long position on November 30 at $903/8, and as early as December1 the position is showing a pro®t of $0.75, that is, 0.83 percent.By contrast in the second situation the outcome is not a pro®t.Based on the same criteria, we would go short on December 18 at$967/8. Unfortunately the price of GE does not come back, and indeed,if we were to cut the next day we would lose $1.50. Assuming we wantto wait for the normalized deviation to come back below 1.51/2, wewould indeed keep the position until December 24, at which timethe total loss is $4.06, that is, 4.2 percent. Clearly the strategy doesnot work in that case.This simple example shows that even in the presence of a clearcut oscillator, pro®table arbitrage is far from assured. We could naturally work further with this model, for example, in trying to hedgeeach position against a future. Overall there is no doubt that theopportunity is worth exploring, but it is far from certain that wewill be able to transform it into a money machine. More generallyTABLE 1-2DateDec. 17, 1998Dec. 18, 1998Dec. 21, 1998Dec. 22, 1998Dec. 23, 1998Dec. 24, 1998
GE Closing Price
10-Day MA
Norm. Deviation
$945/16$967/ 8$983/ 8$991/ 16$1013/ 8$10015/ 16
$90.51$91.19$91.94$92.81$93.94$95.19
1.381.921.941.761.891.28
(Footnote continued)assumption is that the distribution of the deviation is normal, which is a convenientapproximation but an approximation nevertheless. We could have chosen any otherthreshold than 1.5, as long as the resulting probability clearly indicated the event isinfrequent enough to be remarkable. The ®gure 13 percent is as good a number as anyfor the purpose of our discussion. If we were to actually trade this strategy, it would becritical to test different values and choose accordingly.
20THEORY AND TOOLS
Figure 1-1 Normalized Deviation GE(Source: Compiled by author from Datastream data.)
CHAPTER 1 INTRODUCTION
21
the same thing is true of all sorts of oscillators: They are well worthexploring, but success is hypothetical. Still the concept gives an entrypoint in the quest for opportunities.23
ARBITRAGE AND PRICINGMarket Ef®ciency
The ef®cient market hypothesis states that ``prices of securities fully re¯ectavailable information.''24 It basically comes in three ¯avors dependingon the strength of the underlying assumptions about information dissemination. The weak form asserts that stock prices already re¯ect allinformation contained in the history of past prices. The semistrongform asserts that stock prices already re¯ect all publicly available information. The strong form, which has been made illegal in some countries by laws against insider trading, states that stock prices re¯ect allrelevant information including insider information.The most important consequence of an ef®cient market is that mostsecurities are, by de®nition, fairly priced by the market. There may beissues about liquidity to weaken this general statement, but certainlythere cannot be any gross mispricing in an ef®cient market. In otherwords, arbitrage opportunities cannot exist. If they do, they may be theresult of an optical illusionÐtypically nonsimultaneous pricesÐortheir magnitude is such that they do not create pro®table opportunitieswhen transaction costs are includedÐfor example, the put-call parityon listed European options.For the most part all these arguments hold in the marketplace.However, there are still numerous opportunities that support pro®table dedicated traders. For example, the three categories we introducedbeforeÐindex and risk arbitrage and pair tradingÐare actively andpro®tably traded in the world's largest markets. This apparent paradoxhas been studied extensively in the academic sphere.25 The resolutionof the con¯ict comes from two different arguments.23
Note, however, that such opportunities are necessarily speculative in nature becauseif the convergence were absolute or explicit, we would presumably know about itbeforehand.24Cited in Bodie, Kane, and Marcus, Investments, p. 933.25See, for example, Craig W. Holden, ``Index Arbitrage as Cross-Sectional MarketMaking,'' Journal of Futures Markets, 15, 1995, pp. 423±455, for a general discussionof market ef®ciency and index arbitrage.
22
THEORY AND TOOLS
On one side, the theory states that because arbitrageurs usually donot carry any inventory, they should not be able to realize a pro®tÐthis would be a risk-free pro®t.26 However, we can argue that the zeroinventory is not a rigorous assessment because the execution of arbitrage transactions involves two legs, and execution risk exists on each ofthem. Carrying this execution risk, even for a short period of time,justi®es the return earned. In addition, arbitrageurs transfer liquiditybetween markets, which can be considered market making to a certainextent, and also justi®es returns.A second argument, much more practical and quite trivial, is thatmarket ef®ciency is a consequence of arbitrageurs' activity. Marketsbecome ef®cient because a lot of independent players explicitly orimplicitly behave in a way that is consistent with that hypothesis.Nobody is in a position to extract large pro®ts from arbitrage-drivenstrategies, but everyone bene®ts from them. It can be argued that theconvergent forces that bring an ef®cient equilibrium almost alwaysresult in pro®ts being extracted from the market, but in general theseare spread out widely across participants in such a way that everyonesees them as negligible.In essence, the ®rst argument relates to structural characteristicsof different instruments and markets. The second argument, on theother hand, is seemingly in contradiction with an earlier statement,that arbitrageurs were few and highly specialized. The necessarydistinction here is the notion of explicit versus implicit arbitrage.There are relatively few participants involved in explicit arbitrageÐthat is, an aggressive quest of opportunitiesÐbecause of all the reasons exposed earlier. However, virtually everybody is doing passiveor implicit arbitrage. Think about a merger situation: If you need togo long on any of the stocks involved in the merger, you will probably buy the acquired company because target companies tend totrade at a discount compared to their fair value in the proposeddeal. Beyond the case of a merger, if you need to go long of themarket, as a general rule you will probably buy the futures if it isat a discount to its fair value, provided that you are legally in aposition to trade indifferently cash or futures. Therefore, in bothinstances your behavior is consistent with an ef®cient market, andyour trade will push the market toward full ef®ciency. You can26
Inventory in that context refers to a net position at risk. The term is also used todescribe, for example, the residual position that specialists on the NYSE orNASDAQ market makers carry on an ongoing basis as a result of their duties toquote prices and provide liquidity.
CHAPTER 1 INTRODUCTION
23
hardly be described as an arbitrageur, yet you take advantage of adiscount and therefore extract a small pro®t from a situation in whichprices did not re¯ect fair values. As opposed to a professional arbitrageur, you only modi®ed your behavior as a result of a perceivedopportunity but did not initiate a trade following thatperception. Because your intervention is conditional to other parameters, it is clearly less effective in bringing the prices back to theirfair values. Depending on the opportunity, the relative proportion ofexplicit versus implicit arbitrageurs changes considerably, and thepro®ts generated by bringing the market back online acc