Arb 10.10505

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Execution risk[edit]

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.

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