In twelve clear and simple questions, you can learn what financial arbitrage is all about and how ABC arbitrage practices its business in the markets.
12 clear and simple questions
Arbitrage is a combination of several operations generating earnings without risk by simply benefiting from imperfections between different financial markets. Arbitrage ensures equal prices at any given moment in time. It ensures fluidity between different markets and contributes by supplying liquidity. It is a basic operation which guarantees market efficiency.
It is a quantitative investment technique designed to take advantage of price discrepancies between financial instruments (such as two comparable financial assets) or markets. Financial markets offer a wealth of opportunity for this. For example, companies with large market capitalizations may be listed in a number of countries and on several different markets. They often issue large quantities of derivative instruments such as warrants and convertible bonds. Pricing discrepancies between these various market listings and their hedging instruments generate arbitrage opportunities.
Based on common sense, arbitrage uses only mathematically measurable data taken directly from market activity and leaves no room for speculation. It is simply a matter of exploiting inefficiencies in the financial markets through the application of scientifically-grounded analytical methods.
ABC arbitrage applies a strict definition of arbitrage and is only involved in transactions where the price convergence process follows a specific set of rules. The group never speculates on any potential event, nor does it ever try to predict whether a financial asset will go up or down. These transactions are designed to produce results that are independent of movements in the markets, exchange rates or interest rates. ABC arbitrage carries out a wide series of operations designed to draw the benefits of unjustified price differences between convergent financial instruments. The group considers these differences to be effectively “unjustified“ solely on the basis of objectively measurable mathematical or statistical processes. Objectively measurable means that the results are identical over time and are not influenced by the operator involved in the measurement.
This rational approach leaves no room for rumors or speculation. Unlike speculators, who react to all kinds of short-term information, arbitrageurs trade on a rational basis using a very specific model. They never try to predict which way the market will go and always reason in terms of relative value. They buy one product and sell another simultaneously, spreading their risk over a large number of trades. Through their action, arbitrageurs in fact contribute to reducing market volatility because they do not practice “naked short selling“, which means that they do not sell assets in advance and therefore never speculate. Since each sale is backed by the purchase of a correlated product, they supply essential liquidity to the markets.
There are essentially two major types of arbitrage strategy, mainly involving equities and equity derivatives: arbitrage without market risks and arbitrage with market risks.
Arbitrage without market risks involves transactions without any directional or event risk. These operations are fully hedged and subject to a strict convergence protocol within a predefined timeframe.
Exposure is limited to operational risk such as hedging errors, calculation errors or custodian default. A classic example is exchange arbitrage, which exploits pricing discrepancies in a financial instrument traded on several different exchanges, although the margins earned on this business are almost non-existent.
Arbitrage with market risks, unlike arbitrage without market risk, involves certain convergence risks. A typical example is “risk arbitrage“, which involves buying the stock of a company subject to a takeover bid or swap offer and selling the stock of the acquiring company. However, a number of suspensive conditions could cause the deal to fail, for example the requirement for the acquiring company to obtain a minimum percentage of the target for the offer to go ahead. For these strategies, risks are systematically identified and hedged.
The balance between the two arbitrage types or between geographic areas depends mainly on opportunities identified in the market, bearing in mind that the priority is to develop, as much as possible, arbitrage strategies without market risks which in principle are not limited in terms of volume.
The group’s growth is based on taking advantage of the full range of market opportunities. To do so, it deploys the necessary resources to produce sustainable profitability, through the conception of new arbitrage classes. This determination to be a multi-strategy player, focusing on systematic and global development opportunities, has been a cornerstone of the group’s approach from the outset and has allowed ABC arbitrage to benefit from most variations in market conditions.
Some types of arbitrage may be sensitive to changes in the stock market environment. This is particularly true for risk arbitrage, which is influenced by the number and size of takeover deals in the market, and applies as well to volatility-driven arbitrage, which depends on the type and volume of instruments issued and the extent of market ‘turbulence’. The group has therefore chosen not to restrict its activity to any product type or specific geographical area. The group does not try to forecast market trends, but simply develops a range of complementary strategies, applicable to changing conditions.
Arbitrage classes/ Development environments stock
|Arbitrages with market risks||Arbitrages without market risks||ABC arbitrage|
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Given that the environment is constantly changing and given the group’s determination to benefit from any given scenario, ABC arbitrage continues to search methodically for new technical and geographical opportunities to enhance its performance and profitability. The increase in the number of operations and the development of new arbitrage formulas allows the group to compensate for the natural decrease in margins, but allows it to diversify its business to lower risk and increased revenues, as part of an overall industrialization strategy.
ABC arbitrage studies these rules diligently, looking at things such as the convergence mechanisms of derivatives or at the takeover prospectuses of merger and acquisition operations to check and control the principles as they are published and to point out any anomalies objectively. Technically, ABC arbitrage transforms contracts and regulations into equations. Its market regulations expertise is a key part of the group’s know-how and an integral part of all arbitrage operations. The AMF consulted ABC arbitrage during the fourth quarter of 2008 to work on a task force looking at short selling practices, which demonstrates that its expertise is appreciated in this area.
The activities of the group contribute to the interests of both. By encouraging issuing companies to be clear, precise and respectful of their commitments, we contribute to healthier governance and better management. And then, through its precise interventions, the group ultimately defends the interests of all shareholders and in particular smaller investors, by providing the needed liquidity to the purchasing and sales process.
12 : With so many changes going on constantly, how can companies like ABC arbitrage remain consistent in their approach?
From the outset, the company has had a shared philosophy, which has contributed to its continued success: always remaining open and curious in order to develop new formulas that increase efficiency and develops its expertise. Since 1995, the group’s basic values have remained the same: method, precision, simplicity and determination.