Joseph Perry sz Numbers, Shape, Chance, and Change ProererMeay ( un @ The Hunt for Arbitrage Gk a Pea ein tomes oo oaenentee ten concert ceeaeetaat sewing fr the beat ways to cake money. Wher Ibe redvcg expenses o te foe see eet mens pod, stp at akes re one _ © th demand. Same tnt he oy, hoping ad the py ft deans. “Others ook tothe stock market, hoping to beat he markets and make a prof. Overall, thy al ooking fr ona ting a way oma cay money. Inthe fence vot ‘one way to make easy money is through arbitrage. is Arbitrage means the possibilty of making a risk-free profit without investing. Ls S oh nial of altemately, as rskless instantaneous prof For example, if one) could purchase 10 dollars for 9 euros at one bank and then go to another bank and sell the 10, Ti fh Me dolar for 10 euros, he or she would have made a iskless proitof 1 eure pnd arbitrage o.. Pes would have been achieved, One can see the benefits of arbitrage; a i is essentially oe the process of making fee meoney! However, ts reminds one ofthe edage, “There st no free lunch." Alas, arbitrage is no exception because) fundamentally, it does not exis. . “ (On the basic level, nothing of the same value should ever be sold for two ifferent prices, and thus there should be no arbitrage. However, this is not a perfect financial world in which we live. There are discrepancies that allow arbitrage to persis. For instance, arbitrage can be achieved through differing exchange rates in multiple 4 thew 5 og te De AS ernie? Cg et& shod ages gon “ge whats olen fg te gone countries or through differences in stock prices indifferent markets. These are two ‘examples of one ofthe two types of arbitrage, pure arbitrage. Pure arbitrage is rare but highly valued in today’s financial world. On the other hand, relative value arbitrage is much more common and is the basis for many hedge funds and other trading businesses. Pure arbitrage Is defined as, “Generating rskless profit today by statically or dynamically matching current and future obligaions to exacty offset each other, inclusive of incurring known financial costs." (Dubi) The example of differing exchange rates in diferent countries is a good example of pure arbitrage. Ifthe exchange rate in the US is 10 dollars for 10 euros and the exchange rate in France is 10 euros for 700 rupees and the the exchange rate in India is 700 rupees for 9 dollars, one can make a profit by converting dollars to rupees to euros back to dollars. Another example of pure arbitrage can be found in the stock markets. Any discrepancy between @ stock price In two diferent markets is an opportunity for arbitrage, If a stock is seling higher on the New York Exchange than the London Exchange, one could purchase the stock in the London market for a lower price and sel tin the New York Exchange fora profi. Other examples of pure arbitrage are very rare in the current market. This can be attributed to the high speed nature of financial Ueensactions and interactions with the Law of One Price, which states that the same item cannot sell for two different prices at the same time (Dubil). When such a discrepancy ‘occurs, itis instantly taken advantage of to tun a profit, These actions immediately start to enforce the Law of One Price. Therefore, as transactions take advantage of theiscrepancy it begins stabilize, effectively eliminating the opportunity for pure arbitrage. In the example of differing exchange rates, the Law of One Price would cause the values to begin stabilize as more between currencies. arbitrage rests on the substitution of risk. In practice, one must start with a broadly —™ my doting hed with certain known risks. To control these risks, one must find and “pe — mn 2014 te same time a substitute a comparable risk that is, preferably, exactly opposite for both risks. Take US bonds, for example. Suppose one purchases $50 millon in 30 year US bonds while at selng shot 85 mon of 26 year bond. The risks inh instance are the interest rates, The Investor does not know how much prof he or she wil be making Gi Zier of tne bonds. However the investor does know that the pir of vestments has rte test ates. et fone goss down, he ter gee uP ae We versa, Therefore, ac(one ones money, the other wil gain it and none ofthe investment willbe lst. Risk sti prsent asthe interest rates ae not concretely linked and could 3 i slow tr lk Ao since the investor will have some operating costs, the profits made through the difer slighty. However, the differences will be small investments must be greater that the operating costs. Through this elimination of zB primary risk, relative value arbitrage Is achieved. The basis of hedge funds and also the primary tool of many large financial firms is relative value arbitrage. They follow thesame basic patter, balancing risks in stocks and bonds to maximize profit. In order to generate substantial prof, these fms rely on a large numberof diferent investments that must be constantly reevaluated to maximize the profs Bog yielded. Relatve hy ete! value erirags very important n todays fancial markets, ‘Aolrage can also nappen in places much closed nome than Wall Street. One such place is {nonprofit hospitals. As nonprofits, these hospitals are exempt from federal income taxes and are allowed to issue tax-exempt debt. Using these benefits, nonprofit hospitals can achieve another type of arbitrage, tax arbitrage, Tax arbitrage is defined as, “The use of proceeds from lower-cost tax-exempt bonds to finance the s purchase of hlgherol secures” (Coldges) According to the Internal Revenue and Treasury relations, ox abirage is Nighy tga and vey regulated, Despite these 2 } facts, nonprofit hospitals can evade the law (with 2 simple technicality. The definition of fom taesrempt bonds canot be directly used to tax arbitrage states that profits 4 ipt tly Md purchase higher! secures, Th loophole odes in he form ofthe idea of pros) < boing directly used to purchase higher-yield securities.) As long as the hospital does not directly use the profits from a tax exempt bond, they can stil purchase high-yield securities, For example, consider a hospital with plans to build a new research wing. The Hon in two furs: $5 0 hospital has assets worth $20 1 fn Ue builuing and upkeep fund, $5 million in real estate, and $10 milion in the “Just in-case we -get-sued-funt ‘The new wing is projected to cost $5 milion. The hospital could liquidate some of its assets from its building fund to finance the building project. However, they can also use/. ‘s taxcoxompt debt, This tax-exempt debt will have @ small intrest rate, Thris-because “he people who purchsed the debt re wing to accept smalr tums on their money because the profs are taxexerpl end thus ae comparable to the pois rom taxed profs om higher intrest rales. Now the hospital has tox exemet dob wrth $5 ion and is expected to pay $1 million in interest on that debt for a total cost of $6 million for ne new wing. Since the hospital di ulate $5 millon forth bln proec, 1 decides o vest wth und rom ts “us n-case-we-get-sved" fund, They ives $5 millon in highly! secures. Sine the hospital fs nonrfta pofis tom th investment are tax fe. The hosp invests goin iorst in he amount of $1.2 milion dung he te ofthe Bung project. Inthe end, the hosp hs pid $1 mon in nero but earned $1.2 mon in intrest aswel. The hospitals ol assis Gectdng the new $5 milion win) sre row $202 millon $02 milion inthe “skin caso wo et ued" und and $10 miton in he rea estate fund, Tax abitae has been achieved! ecrdng to th federal goverment, in 2002 here were 1.278 nonrtt hocpls with acerempl debt Of tise, apprcsnally 248 were eaing ren tom tx srblzage. W tax rbleage became pa, he federal govemmenteetnatos Leake $504 mil more per yar fram nengoft nesta investent {Nenpoft) Aes 0 fae tue by ot pa lead ba making profits under tax arbitrage. (Colleges) Gueneen Nonprofit hospitals are not the only places where, tax arbitrage is known to exist, ‘ax riage con al eccu in cologes and universes. Such insutons of higher) ae z denedbidige x pacha |ae ol gear by veel ee yy Ok Teaming also enlay the benef of being exempt from federal income toxes and the | soity use tacoxemt debt. The process ofa arbirage or colages and universes is much the seme a5 tis for nonpoft hospi, ring onthe use of exexerpt debt and investment in highield secures. The main ference between inatutons of higher learning and nonprofit Rosales the magnitude of ax arirage. Neary 100% of taxoxempt debt Issued by colages and universes Is beloved to make profts under tax arbitage. In addon to this, colleges and universities goneraly have larger asses to use for tax arblrage, The taxcexempt debt of $15 billon used by nonprofit hospitals pales in comparison to the $290 billion tax-exempt debt used by colleges and isd universities. (Colleges) ‘The federal goverment estimates that it loses $5.5 billon in BA Se i" (profit from allowing colleges and universities to purchase tax exempts bonds (Colleges) get, ve Consider someone who has dedicated their fe to the mastery of arivage, nt arbirageur. Perhaps he or she works fora large fhancial frm or perhaps tis arbitrageur owns his own investment business. Is he'limiless? Are there bounds on what he can eam with arbitrage? ‘Simply put here are a number oflimits on arbitragours. Fist of consider tne oxeise rede es icasslatagu. The buses of attains an intimate knowoge of @ speci ld, One must row pcs, nest aes, tends, fears between tient Ivesiments, ad posible ous Of an kes Consequently, an arbitrageur is limited by his or her knowledge. Additionally, ani arbirageris inte bythe oun of valle funds. One can ony invest what he o ‘she owns, what is loaned to him or her, or what cionts give to him or her to invest. The‘amount of money give to an arbitrageur is an important limit. The amount of money given by a client is directly relates to how successful the arbitrageur is with client's money. The only way to evaluate an arbitrageur is by his or her previous performance. Consequently, an arbitrageur is limited by his or her previous performance. ‘These two paragraphs tumed out to be too tec ‘mathematical understanding: 4. The uses of Arbitrage a. Arbitrage as a "Natural Law" ». Explanation of how arbitrage is used to determine prices of assets 2. Black-Scholes Model. a. Definition/ Explanation of Model Vor b. Explanation of Development ff cen Ih eo yt ©. How does it apply to arbitrage? a oe Ht ae cotin stains aon or abtage, Sogo ot and see rt The way fr making {roe money with litle risk are out there just waiting to be claimed! | know tis paper i shorter than the required amount. 1am looking fr other aspects of arblrage to replace tothe paragraphs on Black-Scholes and asset pricing. The final paper 10 ree ye Thea ite ap | Tent le 46 Bho ebi f4 eben he A kth Piles weld Se frect, expec Tew, bh dh d the TZ hand « ht, a Kase Lite % sre ade Utne hw