The simultaneous purchase in one market and sale in another of a security or commodity in hope of making a profit on price differences in the different markets.
In its simplest form, arbitrage is "buying low and selling high." In this sense, any trader who buys something in one market—whether it is a commodity like grain, financial SECURITIES such as stock in a company, or a currency such as the Japanese yen—and sells it in another market at a higher price is engaged in arbitrage. That trader is called an arbitrageur. In economic theory, arbitrage is a necessary activity in any market, helping to reduce price disparities between different markets and to increase a market's liquidity (ability to buy and sell).
Arbitrage can be divided into the categories of riskless and risk. As an example of riskless arbitrage, imagine that the price of Microsoft Corporation common stock on the Pacific Coast Stock Exchange is less than the price of the same stock on the New York Stock Exchange. A trader who buys Microsoft stock at the lower price on the Pacific Coast exchange and simultaneously sells it for a higher price on the New York exchange is engaging in an essentially riskless transaction. Aided by the speed of modern communications, the buying and selling occur at virtually the same time. This type of exchange occurs daily in the currency market, where a trader may buy French francs at a lower price in London and sell them at a higher price in Singapore.
Much arbitrage falls into the risk category. This type of arbitrage is not always completed with a sale at a higher price; it involves a risk that the price of the item being traded will fall before the trader can sell it. RISK ARBITRAGE came into prominence during the 1980s, when investors began to take advantage of a business atmosphere encompassing a large number of company MERGERS AND ACQUISITIONS. In a merger or acquisition, one company buys or takes over another company. When the management of the targeted company does not want to be acquired by a particular investor or group of investors, the merger is called a hostile takeover. Quite often, the aggressors in such takeovers are smaller in terms of assets than their targets. A hostile takeover is usually initiated when someone believes that the stock of a particular company is lower than its potential value, whether because of poor management or because of a lack of information about the true value of that company.
One way that hostile takeovers are initiated is through a device called the cash tender offer. The party attempting to initiate the takeover announces that it will pay cash for the target company's stock at a price well above the current market value. At this point, risk arbitrageurs become involved in the game. They buy stock from shareholders in the target company, then attempt to sell that stock at the higher price to the party attempting the takeover. If the takeover succeeds and the arbitrageurs receive a higher price for their stock, they profit; if the takeover fails or the arbitrageurs receive a lower price for their stock, they lose. Gauging the risk of a takeover's failure is therefore crucial to an arbitrageur's success.
An arbitrageur who purchases securities on the basis of inside information—that is, information about a pending takeover that is not available to the general public—violates the Securities Exchange Act of 1934 (§ 10[b], as amended, 15 U.S.C.A. § 78j[b]). However, purchasing securities on the basis of rumors about an imminent takeover is not illegal.
Ivan F. Boesky was one example of a risk arbitrageur who was found guilty of engaging in insider trading. Boesky profited enormously from the many corporate takeovers of the mid-1980s. By 1985, he had become famous in financial circles and had published a book, Merger Mania: Arbitrage: Wall Street's Best Kept Money-Making Secret, that extolled the opportunities in risk arbitrage and the benefits the practice gave to the market. In 1986, only one year later, Boesky admitted that he had illegally traded on insider information obtained from Drexel Burnham Lambert, the securities firm that arranged the financing of many of the takeovers of the era. In return for a reduced sentence of three years in prison, Boesky agreed to pay a $100 million penalty and to cooperate with the government's continuing investigation. Boesky named Drexel employee Michael R. Milken as a member of the insider trading network. In 1990, Boesky was released from prison after serving two years.