Finance Creature Number 3

For those of you who, like I, assumed speculators, hedgers, and arbitrageurs were all the same critter with different species names, I’ve now considered two of three creatures of finance who make their living by risk assessment and the balancing of probabilities, speculators and hedgers.  The difference between they work is this: speculators accept a certain level of risk in return for a certain probability of payoff; hedgers accept a certain level of risk in one market but try to balance that risk by making in investment with probabilities of an opposite payoff in another market.  So far, so good.  I’ve left the hardest for last: the arbitrageur.

The arbitrageur–who is often not a person but a bank or a brokerage–makes matching deals in an asset–usually a financial instrument–that trades in two different markets at two different prices.  So the arbitrageur buys an asset (or borrows money) in one market and sells it in another market.  In a perfect world the value of the asset would be the same in both markets.  But the arbitrageur is banking on a less than perfect world, because there is profit to be made in the difference between the two different prices. 

Ideally, to avoid the change of either price over time, the buying and selling in the two markets take place simultaneously.  But the arbitrageur knows it is not a perfect world and therefore has to accept some level of price risk.   Successful arbitrage relies on risk analysis, an understanding of option valuation and VAR, value-at-risk, and, especially, on nearly simultaneous electronic trading.  Balancing values and risks clearly calls for Monte Carlo software and genetic algorithm optimization.  But even with the most sophisticated software and the most favorable odds, the timing of these complicated deals is everything.  Profit depends on a cool hand a the computer.   

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