1911 Encyclopædia Britannica/Arbitrage

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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 converse, are mainly confined to stocks and shares, foreign exchanges and bullion; and are for the most part carried on between London and other European capitals and largely with New York. When prices in London are affected by financial or political causes, all other markets are sooner or later influenced, as London is the banking and financial centre for the commerce of the world. It may, however, also occur that some local event of importance initiates a rise or fall in a particular market which must ultimately affect other countries. 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.

In ordinary times those engaged in arbitrage operate with a very small margin of profit. The great improvement in postal, telegraphic and telephonic communication enables operators to close transactions with amazing rapidity, while competition reduces the margin of profit to a minimum. Operations in American stocks and shares are carried on between London and New York on a vast scale, while transactions in African mining shares are undertaken to a considerable extent between London and Paris. The frequent fluctuations in the prices of the latter securities offer a large and fruitful field to bold operators possessed of large resources, while those who have small means often succumb in a commercial crisis. As regards foreign exchange and bullion, arbitrage operators stand on a fairly safe foundation, the fluctuations being slight and involving little or no risk, although they yield a very small margin of profit. Arbitrage operations are for these reasons resorted to frequently by one country in supplying the requirements of another. The slightest advantage in any market is put to profit, and as the margin in ordinary exchange transactions is minute, the ability to operate in this cross fashion renders business possible, which would otherwise be impracticable. To give concrete instances of the working of arbitrage the following may be cited:—

On the 21st of May 1906 the exchange on London in Vienna was telegraphed from that city 24 kronen 43/4 cents; London, requiring to purchase remittances, found that Antwerp had some Vienna to sell, and arranged to buy there. The transactions worked out as follows:—The direct exchange in Antwerp on London being 25·251/2, and Antwerp’s selling price of Vienna being 105 francs for 100 kronen, on dividing 25·251/2 by 105 an exchange of 24·051/4 was obtained or 1/2 cent cheaper than the direct exchange between Vienna and London.

Again a portion of the proceeds of the Russian loan of 1906 had to be remitted to Berlin from Paris. Having exhausted local balances in Berlin, Paris on one side, and Berlin on the other, sought to prevent gold shipments from Berlin, and thus cause stringency in that money market. On the 21st of May 1906 Berlin was therefore seeking to sell Paris in London at 81·35 marks for 100 francs, and draw on London for the proceeds at 20·50. This transaction produced a parity between the exchanges of 25·20, which left a small margin in London.

Two instances of arbitrage of stocks are the following:—On the 24th of March 1906, Japanese exchequer bonds, series 2 and 3, were bought in Tokio at 931/4 and were paid for by telegraphic transfer at 243/8 pence per yen, and were sold in London the same day at 94 for payment on arrival of bonds. It took five weeks for the transmission of the bonds to London, where they were dealt in on the fixed basis of exchange, namely 241/2 pence per yen. The London price works out thus:

93·25 × 24·375/24·50=92·77,

to which must be added the loss of interest, as the firm in London paid cash on the 24th of March for the telegraphic transfer, and did not recover payment until the arrival of the bonds from Tokio five weeks later. The following is a computation of the transaction:—

London price 92·77
Five weeks at 5 % ·45
English stamp 1/2 % on nominal amount  ·50
Insurance 1/8 % ·12
This sum represents the net cost to the arbitrage house in London, and the money paid on the 28th of April left a profit of about 3/16%. The bonds being “to bearer” insurance was necessary for the safety in this, as in all similar transactions.

In the next example, however, this expense was unnecessary, the bonds being “inscribed.” On the 21st of May 1906 American Steel common shares were sold for cash in New York at 413/16 dollars per share, and were bought in London at 427/32 for the account day, May 31st. These figures are explained by the fact that transactions in the United States stocks and shares are on the fixed basis of five dollars per pound sterling, while as regards payments in New York the exchange varies daily. Railway shares are generally 100 dollars each. In the London market, however, five shares of 100 dollars would be £100 nominal. These shares, therefore, cost in London, at the purchase price of 427/32, £42 : 4: 5. The money realized in New York for five shares at 413/16 was 205·93 dollars. A cheque on London was bought at 4 dollars 851/4 cents, realizing £42 : 8 : 9. It should be noted that the shares in these cases are generally lent by the New York correspondent, thus saving loss of interest. The resulting profit in this particular instance was 4s. 4d. for each five shares, divided between the London and New York arbitrage firms. Arbitrage operations with distant countries such as India are large and mainly profitable. Arbitrage with India consists chiefly in buying bills of exchange in London, such as India Council rupee bills amounting to about 16 millions sterling annually, and commercial bills drawn against goods exported to India. The counter-operation consists in purchasing in India, for short or long delivery, sterling bills drawn against exports to Great Britain of Indian produce, such as cotton, tea, indigo, jute and wheat. These operations greatly facilitate trade and the moving of produce from the interior of India to the seaports. Without this assistance Great Britain’s enormous trade could not be carried on, and she would have to revert to the primitive system of barter. The same advantages are afforded to her vast trade with China and Japan, with the material difference that the supply of government council bills is confined to the Indian trade. The balance of trade with all countries is generally settled by specie shipments; hence, with the Far East, silver and gold play an important part in arbitrage.

It will thus be seen that arbitrage fills a useful place in commerce; the profits are small because the competition is great; nevertheless huge transactions employing thousands of clerks result from this system.

The literature of the subject is extremely meagre. Lord Goschen’s Theory of Foreign Exchanges (London, 1866) is general and theoretical, but throws great light upon particular aspects of the philosophy of arbitrage, without touching specially on the details of the subject itself. The principal other works are: Kelly’s Cambist (1811, 1835); Otto Swoboda, Die kaufmännische Arbitrage (Berlin, 1873), and Börse und Actien (Cologne, 1869); Coquelin et Guillaumin, Dictionnaire de l’économie politique (Paris, 1851–1853); Ottomar Haupt, London Arbitrageur (London, 1870); Charles le Touzé, Traité théorique et pratique du change (Paris, 1868); Tate, Modern Cambist (London, 1868); Simon Spitzer, Ueber Münz- und Arbitragenrechnung (Vienna, 1872); J. W. Gilbart, Principles and Practice of Banking (London, 1871); G. Clare, The A B C of Foreign Exchanges (2nd ed., 1895); Money Market Primer and Key to the Exchanges (2nd ed., 1900); J. Pallain, Les Changes étrangers et les prix (Paris, 1905).  (Sw.)