ARBITRAGE, the term applied to the system of equalizing prices in different commercial centres by buying in the cheaper market and selling in the dearer. These transactions, or their con verse, are mainly confined to stocks and shares, foreign exchanges and bullion, and are carried on between the various financial cen tres of the world. When prices are affected in any country by some local financial or political event of outstanding importance, all other markets are sooner or later influenced. For instance, a crisis in France would immediately depress all French securities, and by exciting the fears of capitalists, would stimulate transfers of funds and raise all the exchanges against France.
The scale of profit on arbitrage transactions varies with the risks entailed. Take for instance arbitraging in exchange. Dealing in francs between London and Paris in terms of sterling is a simple operation and the risk of loss is very small as such transactions are almost invariably carried on by telephone and can be closed almost immediately. When on the other hand arbitrage dealers in London and Paris operate in guilders, Swiss francs or dollars, there is a double risk and the margins of profit aimed at are somewhat larger. Nevertheless, the slightest advantage in any market is put to profit, and international exchanges are adjusted with extreme rapidity.
For example, a dealer wishes to buy French francs which he can obtain in London at 176.7o and he telephones to his Paris corre spondent asking him how he would buy sterling. If he bids it is clear that Paris offers him an advantage of 1 cent per f ster ling. The dealer may, however, think that a still better rate can be obtained in the international market, and he rings up his agent in Amsterdam and asks him at what price he will sell Paris. The reply is fl. 4.93a for each frs. too. In order to ascertain whether or not this offer is advantageous. the dealer has to learn the rate at which he can obtain the guilders with which to reimburse his Amsterdam agent and he finds that he can get fl. 8.73 per £: on this basis he calculates what will be the net outturn.
Arbitrage in exchanges is usually calculated by chain rule as follows:— Another example. when a purchase of Swiss francs is desired the arbitrageur finds that London sells Zurich at Swiss francs per L, Paris quoted 853.70 French francs for too Swiss francs, and New York offers Swiss francs at $22.57 per too, and he can buy dollars from the "Control" in London at He figures by the chain rule, and as a result buys his Swiss francs in New York, buying dollars with which to do so in London:— Pure arbitrage in foreign exchange has been curtailed by the establishment of Equalization Funds in various countries, the ad ministrators of which funds "peg" the exchanges so that arbitrage profits are eliminated. The Tripartite Agreement between Great Britain, France and the United States is an outstanding example of how the arbitrageur is being squeezed out of the market. By agreement the participants "earmark" the gold for one another to cover the operations in exchange, in that way saving the heavy cost of freight and insurance which the arbitrageur has to pay in moving gold from one country to another.
To give an example, Geduld Proprietary Mines are good de livery in London and also in Paris. The stamp duty in 1939 was 2 per cent in England, and about 3 per cent in France, so that before these shares could be actually transferred to London from Paris, with a profit to the dealers, allowance must be made for cost of insurance, shipping, brokers' commission, and the full stamp duties.
There are other elements of speculation that beset stock and share arbitrageurs, even if on both sides they are members of the Stock Exchanges of their respective countries and so avoid paying brokerages. When the London operator buys abroad, unless his seller elects to keep the result of his sale in sterling, the London buyer has to provide foreign currency and run the risk of any vari ation in the rate of exchange. He may find also that it is more costly to fix his exchange for forward delivery than for actual spot. Again, he is constantly up against Government restrictions of all sorts, both British and foreign, which are formulated whenever a Government desires to counteract any tendency on the part of its subjects to export capital and so depreciate its exchange. So long as these difficulties exist, the volume of business done by arbitra geurs in stocks and shares by no means keeps pace with any in crease in the amount of stocks and shares dealt in in the Stock Exchanges of the world, and the tendency is for investors and speculators to send their Stock Exchange orders abroad to the country where the market is the most free and is the least penal ised by taxes and restrictions.
Examples of arbitrage transactions with Paris and New York :— Dollars sold at 468.32=k i,o16.i.8d., leaving an arbitrage profit of L8. 7. 6d.
It often happens that the margin of profit is not as big as the examples quoted, so it follows that in order to save the expense of shipping, insurance, stamps, etc., the arbitrageur endeavours to turn his position by re-buying abroad and selling in London.
Operations in Gold.—For restoring the equilibrium of inter national balances, recourse is frequently had to gold and again the arbitrageur exercises his ingenuity in finding out where gold can be obtained at the cheapest rate and whether, after he has paid expenses, the net outturn will be better than remittance by tele graphic transfer. The profit is often small, as will be seen by the following example in which the arbitrageur buys 174 bars of gold and sells his exchange a week ahead at 4.671, making a profit of :— If the arbitrageur could only sell his dollars at 4.68, for the $2,452,276.98 he would only obtain £523,842.16s.od., leaving him a loss of 1200.
Sometimes, when exchanges are under such strict control that exchange arbitrage is rendered almost impossible, it occurs that arbitrage in stocks and shares becomes simpler and more active for this reason. In normal times if one contemplated doing busi ness of this nature, it is necessary if one wishes to avoid specula tion as much as possible, to guard not only against fluctuations in the prices of the stocks dealt in, but also against possible adverse movements in exchanges. For instance, if the arbitrageur buys U. S. Steel shares in London and sells them in New York, the estimated profit might vanish, or even turn into a loss, if the value of the pound sterling were to depreciate materially in New York before he covered his exchange. A transaction that would leave a normal profit if the pound were obtainable at $4.68 might result in a loss if the exchange were to move to $4.70 before he had time to purchase his sterling. But when the dollar-sterling exchange is under strict control both in Great Britain and in the United States, the rate of exchange does not play so important a part in the transaction, which can be "cornered" at leisure without undue risk.
Arbitrage in stocks and shares is continuous between the London and the Provincial stock exchanges. Exchange does not enter into these transactions at all. Nor does it to any appre ciable extent in arbitrage between London and Johannesburg. A very large volume of business is done in gold mining shares be tween these two cities.
Before China was forced off the silver standard on Nov. 4, a large and profitable arbitrage business used to be done in that metal between London and Shanghai. The method was a simple one. If the arbitrageur foresaw a profit in shipping silver from China to London he could at all times sell it "forward" in London, as there has been for a very long time an official quota tion on the London market for silver for delivery in two months' time. On the other hand if he visualized a profit in buying silver in London and shipping it to Shanghai, he could buy it either for prompt delivery or for delivery in two months' time. The advantage of the latter would be that, should the Anglo-Chinese exchange veer round during the interval between the purchase of the silver and its delivery, he could reverse his position by reselling his silver in London and, simultaneously, reselling his sterling in Shanghai, thereby saving the cost of freight and insurance twice over and also the loss of interest while the silver was in transition. This, in fact, was very fre quently done. The arbitrageur did not confine himself to direct business between Shanghai and London. Considerable arbitrage transactions took place also with India and the United States. Should China at any future time return to a silver standard there is no doubt but that arbitrage in silver with that country would be resumed.
To be a successful arbitrageur, it is of vital importance to be well informed, to be quick so as to get in before one's competi tors, and to have a reliable and energetic counterparty. Tendencies change very rapidly and demands or supplies of stocks, shares and exchange are rapidly filled up. (S. ; E. L. F.)