The document discusses execution risk in arbitrage transactions, where it may not be possible to close multiple transactions simultaneously due to quick price shifts, leaving the arbitrageur in an unhedged risk position. It also discusses risk arbitrage in the 1980s, where traders would speculate on securities that were clearly under or overvalued when a correction was imminent, such as a takeover bid where the purchase price better reflected the company's value. However, arbitrage transactions involving delays of weeks or months using leverage entailed considerable risk if prices changed during the delay.
The document discusses execution risk in arbitrage transactions, where it may not be possible to close multiple transactions simultaneously due to quick price shifts, leaving the arbitrageur in an unhedged risk position. It also discusses risk arbitrage in the 1980s, where traders would speculate on securities that were clearly under or overvalued when a correction was imminent, such as a takeover bid where the purchase price better reflected the company's value. However, arbitrage transactions involving delays of weeks or months using leverage entailed considerable risk if prices changed during the delay.
The document discusses execution risk in arbitrage transactions, where it may not be possible to close multiple transactions simultaneously due to quick price shifts, leaving the arbitrageur in an unhedged risk position. It also discusses risk arbitrage in the 1980s, where traders would speculate on securities that were clearly under or overvalued when a correction was imminent, such as a takeover bid where the purchase price better reflected the company's value. However, arbitrage transactions involving delays of weeks or months using leverage entailed considerable risk if prices changed during the delay.
The document discusses execution risk in arbitrage transactions, where it may not be possible to close multiple transactions simultaneously due to quick price shifts, leaving the arbitrageur in an unhedged risk position. It also discusses risk arbitrage in the 1980s, where traders would speculate on securities that were clearly under or overvalued when a correction was imminent, such as a takeover bid where the purchase price better reflected the company's value. However, arbitrage transactions involving delays of weeks or months using leverage entailed considerable risk if prices changed during the delay.
Generally, it is impossible to close two or three transactions at the same instant;
therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. However, this is not necessarily the case. Many exchanges and inter-dealer brokers allow multi legged trades (e.g. basis block trades on LIFFE). Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur in an unhedged risk position. In the 1980s, risk arbitrage was common. In this form of speculation, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current price, if the merger goes through as predicted. Traditionally, arbitrage transactions in the securities markets involve high speed, high volume, and low risk. At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act). When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing this risk is through the illegal use of inside information, and risk arbitrage in leveraged buyouts was associated with some of the famous financial scandals of the 1980s, such as those involving Michael Milken and Ivan Boesky.