When Arbitrage Breaks

In the second half of Chapter 17, Larry Harris explains why being an arbitrageur isn’t just about finding a “money machine.” It’s a risky business that requires massive capital and perfect timing.

The Four Arbitrage Killers

Even if you identify a perfect arbitrage opportunity, four things can go wrong:

1. Implementation Risk: You buy one leg of the trade, but before you can sell the other, the price moves against you. You’re stuck “straddling two ice floes,” and you’re about to get soaked.
2. Basis Risk: You bet the gap between two prices will close, but instead, it gets wider. This is where most arbitrageurs lose their shirts.
3. Model Risk: Your math is wrong. You think two things are related, but they aren’t. Or you missed a key variable (like taxes or dividends).
4. Carrying Cost Risk: It costs money to hold these positions (interest on loans, storage fees for commodities). If the prices take too long to converge, the costs eat all your profit.

Staying Power: The LTCM Lesson

Harris mentions the legendary hedge fund Long-Term Capital Management (LTCM). They were the smartest guys in the room (Nobel prize winners!), and they were doing “pure” arbitrage that was almost guaranteed to work in the long run.

The Problem: They used too much leverage. When the market moved against them in the short run, they didn’t have the “staying power” to wait for the prices to converge. Their creditors forced them to liquidate at the worst possible time.

The Lesson: Never leverage yourself to the max. You need enough margin to survive the “random walk” of the market.

Repackaging Risk (Financial Engineering)

Arbitrageurs are the world’s “risk manufacturers.”

• They buy a basket of stocks and sell a futures contract.
• They buy an option and sell the underlying stock.

By doing this, they allow other traders to hold risk in the form they want (like an option) while the arbitrageur holds the hedge. They are effectively “repackaging” common factor risks into new financial products.

Arbitrageurs vs. Dealers

Dealers and arbitrageurs are like two different types of bridge builders:

• Dealers bridge Time: They buy from a seller at 10:00 AM and sell to a buyer at 10:05 AM.
• Arbitrageurs bridge Space: They buy from a seller in New York and sell to a buyer in London at the exact same time.

Both provide liquidity, and they often compete for the same trades. Dealers generally dislike arbitrageurs because arbitrageurs are usually better informed and can “pick off” a dealer who is too slow to update their prices.

Summary: The Economic Benefit

Arbitrageurs might be greedy, but they provide a vital service. They make sure that news in one market (like a drop in oil prices in London) quickly reflects in all other related markets. They are the reason you can trust that the price on your screen is “real.”

Next time, we look at the Buy-Side Traders—the people who actually own the money—and how they decide which orders to send to the market.

Next Post: Buy-Side Traders and Their Strategies