Friday, 5 May 2017

Time Arbitrage

Example to illustrate "time arbitrage":

Company ABC's stock is trading at $8 a share.

Company XYZ offers to buy company ABC for $14 a share in four months.

In response to the offer, Company ABC's stock goes to $12 a share.

How can you arbitrage on this situation?

The simple arbitrage play here would be to buy Company ABC's stock today at $12 a share and then sell to Company XYZ in four months for $14 a share, which would give a $2 a share profit.

Unlike the normal everyday stock investment, this is a solid offer of $14 a share in four months.

Unless something screws it up, you will be able to sell the stock you paid $12 a share for today for $14 a share in four months.

It is this CERTAINTY of its going up $2 a share in four months that separates it from other investments.

Once Company XYZ's offer is accepted by Company ABC, it becomes a binding contract between Company ABC and Company XYZ with certain contingencies.

What is the risk of this arbitrage?

The reason that the stock does not immediately jump from $8 a share to $14 a share is that there is a risk that the deal might fall apart  

In this case, we won't be able to sell the stock for $14 a share and Company ABC's share price will probably drop back into the neighbourhood of $8 a share.

Understanding Time Arbitrage

We are arbitraging two different prices for the company's shares that occur between two points in time, on two very specific dates.  This kind of arbitrage is thought of as "time arbitrage".

This kind of arbitrage is very difficult to model for computer trading. 

It favours the investors who are capable of weighing and processing a dozen or more variables, some repetitive, some unique, that can pop up over the period of time the position is held.

In Summary

1.  The arbitrage opportunity arises because of a positive price spread that develops between the current market price of the stock and the offering price to buy it in the future.

2.  The positive price spread between the two develops because

  • of the risk of the deal falling apart and 
  • the time value of money.

No comments: