In the world of alternative investments, there are several strategies and tactics you can employ. These strategies often differ from the typical “buy and hold” tactics leveraged by most long-term stock and bond investors—and are usually more complicated.

Arbitrage is one alternative investment strategy that can prove exceptionally profitable when leveraged by a sophisticated investor. It also carries risks you must consider. To effectively include arbitrage in your alternative investment strategy, it’s critical to understand the nuances and risks involved.

Below is an overview of arbitrage, including a look at three types you should know: pure arbitrage, merger arbitrage, and convertible arbitrage.

What Is Arbitrage?

Arbitrage is an investment strategy in which an investor simultaneously buys and sells an asset in different markets to take advantage of a price difference and generate a profit. While price differences are typically small and short-lived, the returns can be impressive when multiplied by a large volume. Arbitrage is commonly leveraged by hedge funds and other sophisticated investors.

There are several types of arbitrage, including pure arbitrage, merger arbitrage, and convertible arbitrage. Global macro is another investment strategy related to arbitrage, but it’s considered a different approach because it refers to investing in economic changes between countries.

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Types of Arbitrage

1. Pure Arbitrage

Pure arbitrage refers to the investment strategy above, in which an investor simultaneously buys and sells a security in different markets to take advantage of a price difference. As such, the terms “arbitrage” and “pure arbitrage” are often used interchangeably.

Many investments can be bought and sold in several markets. For example, a large multinational company may list its stock on multiple exchanges, such as the New York Stock Exchange (NYSE) and London Stock Exchange. Whenever an asset is traded in multiple markets, it’s possible prices will temporarily fall out of sync. It’s when this price difference exists that pure arbitrage becomes possible.

Pure arbitrage is also possible in instances where foreign exchange rates lead to pricing discrepancies, however small.

Ultimately, pure arbitrage is a strategy in which an investor takes advantage of inefficiencies within the market. As technology has advanced and trading has become increasingly digitized, it’s grown more difficult to take advantage of these scenarios, as pricing errors can now be rapidly identified and resolved. This means the potential for pure arbitrage has become a rare occurrence.

2. Merger Arbitrage

Merger arbitrage is a type of arbitrage related to merging entities, such as two publicly traded businesses.

Generally speaking, a merger consists of two parties: the acquiring company and its target. If the target company is a publicly traded entity, then the acquiring company must purchase the outstanding share of said company. In most cases, this is at a premium to what the stock is trading for at the time of the announcement, leading to a profit for shareholders. As the deal becomes public, traders looking to profit from the deal purchase the target company’s stock—driving it closer to the announced deal price.

The target company’s price rarely matches the deal price, however, it often trades at a slight discount. This is due to the risk that the deal may fall through or fail. Deals can fail for several reasons, including changing market conditions or a refusal of the deal by regulatory bodies, such as the Federal Trade Commission (FTC) or Department of Justice (DOJ).

In its most basic form, merger arbitrage involves an investor purchasing shares of the target company at its discounted price, then profiting once the deal goes through. Yet, there are other forms of merger arbitrage. An investor who believes a deal may fall through or fail, for example, might choose to short shares of the target company’s stock.

3. Convertible Arbitrage

Convertible arbitrage is a form of arbitrage related to convertible bonds, also called convertible notes or convertible debt.

A convertible bond is, at its heart, just like any other bond: It’s a form of corporate debt that yields interest payments to the bondholder. The primary difference between a convertible bond and a traditional bond is that, with a convertible bond, the bondholder has the option to convert it into shares of the underlying company at a later date, often at a discounted rate. Companies issue convertible bonds because doing so allows them to offer lower interest payments.

Investors who engage in convertible arbitrage seek to take advantage of the difference between the bond’s conversion price and the current price of the underlying company’s shares. This is typically achieved by taking simultaneous positions—long and short—in the convertible note and underlying shares of the company.

Which positions the investor takes and the ratio of buys and sells depends on whether the investor believes the bond to be fairly priced. In cases where the bond is considered to be cheap, they usually take a short position on the stock and a long position on the bond. On the other hand, if the investor believes the bond to be overpriced, or rich, they might take a long position on the stock and a short position on the bond.

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One Tool in the Alternative Investment Arsenal

Arbitrage, in its many forms, can be an effective tool for investors seeking low-risk yields. Because yield is often small, it requires high volumes to realize the benefits of arbitrage and generate enough profit to overcome transaction fees. For this reason, arbitrage is generally not a strategy individual investors can leverage for themselves. It is, however, often used by hedge funds and other institutional investors that are capable of high volumes.

While effective, arbitrage is just one tool among many when it comes to alternative investments. If you’re considering a career in alternative investments, it’s important to understand all of the potential strategies you can leverage for your clients. Taking an online course, such as Alternative Investments, is an excellent means of gaining the knowledge you need to be successful.

Are you interested in exploring the role that alternative investments can play in your career? Learn more about our five-week online course Alternative Investments and other Finance & Accounting courses.

Tim Stobierski

About the Author

Tim Stobierski is a marketing specialist and contributing writer for Harvard Business School Online.