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Investment Strategies of Hedge Funds by Filippo Stefanini

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2
Arbitrage
There is no free lunch. Old Stock Exchange adage
Arbitrage strategies are very popular in the hedge fund world, but before turning to their description, it is necessary to clarify the specific meaning of the term “arbitrage” in this context.
From an academic point of view, an arbitrage stands for a risk-free transaction that generates an instant profit: a theoretical example of arbitrage is the concurrent purchase and sale of the same security on different markets at different prices. By buying the same security at a lower price and selling it right away at a higher price, an arbitrageur earns an immediate profit at no risk, saving the settlement and delivery risks.
But in the hedge fund business the term arbitrage has developed a different sense, in that it does not refer to risk-free positions, but rather to positions involving risks other than the market risk. Hedge fund arbitrages in practice are directional positions on spreads: if the spread widens or narrows as anticipated, the manager makes a profit; otherwise he suffers a loss. Therefore we must not be misled by the word arbitrage: a hedge fund may well suffer a loss even when it has constructed an arbitrage position - what it takes, is for the spread to widen or narrow contrary to predictions.
An arbitrage opportunity may appear when given technical, geographical, legal or administrative barriers interfere with the correct interaction between two markets trading the same security, thus preventing the security ...

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