Types of arbitrage

Merger arbitrage

Also called risk arbitrage, merger arbitrage generally consists of buying the stock of a company that is the target of a takeover while shorting the stock of the acquiring company.

Usually the market price of the target company is less than the price offered by the acquiring company. The spread between these two prices depends mainly on the probability and the timing of the takeover being completed.

The bet in a merger arbitrage is that such a spread will eventually be zero, if and when the takeover is completed.

Municipal bond arbitrage

Also called municipal bond relative value arbitrage, municipal arbitrage, or just muni arb, this arbitrage strategy generally consists of building a leveraged portfolio of high-quality, tax-exempt municipal bonds and simultaneously hedging the duration risk in that municipal bond portfolio by shorting the equivalent taxable corporate bonds. These corporate equivalents are typically interest rate swaps referencing Libor or BMA (short for Bond Market Association). Muni arb is a relative value strategy that seizes upon an inefficiency that is related to government tax policy; interest on municipal bonds is exempt from federal income tax. Because the source of this arbitrage is artificially imposed by government regulation, it has persisted (i.e., it has not been "arbed away") for decades.

The arbitrage manifests itself in the form of a relatively cheap longer maturity municipal bond, which is a municipal bond that yields significantly more than 65% of a corresponding taxable corporate bond. The steeper slope of the municipal yield curve allows participants to collect more after-tax income from the municipal bond portfolio than is spent on the interest rate swap; the carry is greater than the hedge expense. Positive, tax-free carry from muni arb can reach into the double digits.

The bet in municipal bond arbitrage is that, over a longer period of time, two similar instruments--municipal bonds and interest rate swaps--will correlate with each other; they are both very high quality credits, have the same maturity and are denominated in U.S. dollars. Credit risk and duration risk are largely eliminated in this strategy. However, basis risk arises from use of an imperfect hedge, which results in significant, but range-bound principal volatility. The end goal is to limit this principal volatility, eliminating its relevance over time as the high, consistent, tax-free cash flow accumulates.

Convertible bond arbitrage

A convertible bond is a bond that an investor can return to the issuing company in exchange for a predetermined number of shares in the company.

A convertible bond can be thought of as a corporate bond with a stock call option attached to it.

The price of a convertible bond is sensitive to three major factors:

* Interest rate. When rates move higher, the bond part of a convertible bond tends to move lower, but the call option part of a convertible bond moves higher (and the aggregate tends to move lower).

* Stock price. When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise.

* Credit spread. If the creditworthiness of the issuer deteriorates (e.g. rating downgrade) and its credit spread widens, the bond price tends to move lower, but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility).

Given the complexity of the calculations involved and the convoluted structure that a convertible bond can have, an arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value.

Convertible arbitrage consists of buying a convertible bond and hedging two of the three factors in order to gain exposure to the third factor at a very attractive price.

For instance an arbitrageur would first buy a convertible bond, then sell fixed income securities or interest rate futures (to hedge the interest rate exposure) and buy some credit protection (to hedge the risk of credit deterioration). Eventually what he'd be left with is something similar to a call option on the underlying stock, acquired at a very low price. He could then make money either selling some of the more expensive options that are openly traded in the market or delta hedging his exposure to the underlying shares.

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