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The Little Book of Alternative Investments: Reaping Rewards by Daring to be Different by Phil DeMuth, Ben Stein

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Chapter Ten

A Field Guide to Hedge Funds, Part Deux

Arbitrage, et al.

Arbitrage sounds hard, but there’s less to it than meets the eye.

Let’s say Nintendo releases a new game station just before Christmas, and it sells at a huge premium on eBay. However, you notice that Amazon suddenly has inventory at sticker price. You could sell the game boxes on eBay and fill the orders from Amazon, pocketing the difference in price.

A sweet deal, but don’t quit your day job. Opportunities for riskless profits are rare and fleeting, since other market participants discover them and attack like piranhas until there’s nothing left. That is life under efficient markets. An example in finance might be noticing a difference between the price of gold in London and New York. Or a difference between Berkshire Hathaway’s class B and A shares of stock that is more or less than the 1500:1 ratio at which they are supposed to exchange. Arbitrage refers to a transaction involving two similar or fungible items that are priced differently in different markets. An arbitrageur is someone who practices arbitrage. Not to be confused with saboteur, an agent who blows up bridges behind enemy lines.

As time has passed, the term arbitrage has been watered down to mean taking a long and a short position on similar assets, often with an eye toward locking in a profit from any price discrepancy between the two. Since even this usage is too strenuous, today arbitrage means any nifty trade: the simultaneous buying and ...

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