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BY NOREEN JOHNSTON

COMMENTARY

You may have come across the term “arbitrage,” a somewhat exotic-sounding investment strategy, in the newspapers or perhaps from popular Hollywood movies about Wall Street and the financial markets. Traditionally employed by hedge funds, arbitrage is an investment technique that has been used for decades. Its objective? To realize a gain by simultaneously buying and selling two related investments, thereby capturing the return spread as their prices move closer together.

In today’s market, arbitrage strategies are used by institutional investors to exploit the spreads between many different types of securities. Individual investors have access to these alternative strategies through mutual funds that employ specific kinds of arbitrage strategies. Three types of arbitrage are described here—merger, convertible, and fixed income.

Merger Arbitrage

A merger arbitrage strategy enables investors to profit from changes in stock price related to a corporate merger or acquisition. Typically the stock price of a company that is the target of a merger is less than what its value will be when the deal is closed. This spread reflects the risk that the deal may not go through as well as other factors. The portfolio manager simultaneously goes “long” the stock of the target company (meaning that the stock is purchased) and goes “short” the acquiring company (meaning that borrowed stock is sold with the expectation that it will fall in value) or a related equity investment that is designed to hedge exposure to the equity market. If the merger or acquisition is completed, a profit is made. The risk is, however, that if the deal unravels, you may lose money on the transaction, depending on what happens to the stock price of the target company and the equity market hedge.

Convertible Arbitrage

Convertible arbitrage, another kind of strategy, is based on the simultaneous buying and selling of a company’s convertible securities and its common stock. Convertible securities are a kind of hybrid instrument; they are bonds that give the owner the option to convert to stock and so contain traits of both stocks and bonds. If analysis reveals that the convertible securities of a company are undervalued relative to the stock of a company, it will be advantageous to short the stock and take a long position in the convertibles. A profit is made if the two types of securities move closer in value. This type of arbitrage takes advantage of the fact the convertible debt market is not as liquid as the stock market, and therefore difficult to price accurately.

Fixed-Income Arbitrage

Fixed-income arbitrage enables investors to leverage mispricings between related fixed-income securities. This kind of arbitrage is used with highly liquid debt securities including government and corporate bonds as well as swaps and futures that are linked to interest rates or credit quality. The portfolio manager simultaneously takes a position in an undervalued fixed income investment that is expected to rise in price and an overvalued investment that is expected to fall in price. Fixed income arbitrage strategies are designed to limit exposure to changes in interest rates.

One of the benefits of arbitrage is that is has low correlation to the stock and bond markets and can help diversify, and thereby lower, a portfolio’s volatility. But it does take skill to do it right, namely keen analysis and foresight, and it is not without its risks. Your financial advisor can provide you with additional information about this investment technique and its place in your particular individual portfolio.

Noreen Johnston is an investment analyst at Brinton Eaton, an SEC-registered investment advisory firm in Madison, N.J. She can be reached at 973-984-3352 or This e-mail address is being protected from spambots. You need JavaScript enabled to view it .