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Looking for a risk-free return? Arbitrage is the way to go. Its the process of simultaneously buying an asset at a low price and selling essentially the same asset at a higher price, locking up the difference as profit. Warren Buffett, arguably the best investor in the world, has used arbitrage to generate average annualized rate of return of 81.28% from 1980 to 2003 with very low risk.[1]Learn below how you too can get on the action.

Pure arbitrage, generally available only to market makers, is the purchase of securities on one market for immediate resale on another market at a higher price, earning a risk-free profit. Risk arbitrage, available to retail investors, entails some risk and involves purchase of a security and simultaneous sale of a similar security at a higher price in anticipation of convergence of value between the two securities.

While pure arbitrage opportunities are scarce in efficient markets, risk arbitrage opportunities exist all over the world in diverse financial markets, including stocks, bonds, funds, currencies, commodities, and derivatives.

Among the most profitable arbitrage opportunities are mergers and acquisitions, whereby a stock of a company being acquired trades at a discount to the offer price.

Another type of arbitrage is liquidation arbitrage, the purchase of undervalued securities at prices below their estimated liquidation values. Liquidation value is the value owners can receive if they were to give up the business and sell off the assets and pay off the liabilities. Net current asset value (NCAV), the difference between current assets and total liabilities, can be used as a rough approximation of liquidation value.

Pairs trading exploits the difference between two very similar companies in the same industry that have historically been highly correlated, for example, Coke and Pepsi. When the two companys values diverge to a historically high level you can go long on the undervalued company and short on the overvalued one, and profit when their values converge, as history has shown that they eventually will.

Determine the transactions needed to realize your arbitrage profit.

Example 1: If Company A offers to buy Company B for $10 per share of Company B stock, with acquisition to close in 6 months, and Company B stock currently trades at $9, you simply buy Company B stock at $9 and realize a $1 profit (difference between $10 offer and $9 paid) when the acquisition closes. When the deal closes in 6 months, then you will have made an annualized 22% return ($1 profit divided by $9 investment gives 11% in a 1/2 year period, then multiply that by 2, which shows an annualized 22% gain).

Example 2: If Company A offers to buy Company B for $5 and 1 share of Company A stock per share of Company B stock, and Company A stock currently trades at $5 while Company B stock currently trades at $9, you see that $5 and 1 share of Company A stock cost a total of $10, while 1 share of Company B stock costs $9. So you buy low (the Company B stock at $9) and sell high (the Company A stock at $5), locking in $1 arbitrage profit and 22% annualized return when the deal closes after 6 months.

You can use Benjamin Grahams risk arbitrage formula to determine optimal risk/reward: Expected Annual Return= (SG-L(100%-S))/(YP), where

L is the expected loss in the event of a failure (usually difference between current price after announcement of an event and original price before announcement of the event).

Y is the expected holding time in years (usually the time until the merger takes place).

G is the expected gain in the event of a success (usually takeover price less current price).

To use the example above, lets assume the chance of success is 90% (a friendly takeover with no looming regulatory concerns). Current price is $9. Lets assume Company B stock traded at $5 per share prior to merger announcement. The expected loss is the difference between current price of $9 and the original price of $5 before merger announcement, or $4. The holding time in years is 0.5 (6 months). The gain is the difference between the $10 takeover price and the $9 current price, or $1. Plugging these inputs into the equation, the expected annual return = (90%*$1 – $4*(100%-90%))/(0.5*$9) = 11%.

Decide whether the expected annual return is acceptable, by comparing that to your personal discount rate.

Your personal discount rate is the rate of return you can expect by investing your money elsewhere such as the stock market and represents an opportunity cost of capital. Lets suppose your discount rate is 10%, in line with historical market performance. Since the expected annual return of 11% from the merger is greater than your discount rate, you would decide to partake in the merger arbitrage.

Be sure to act quickly. The more efficient the market, the more quickly you must act.

For the brave, use leverage in a margin account to amplify the potential return from an arbitrage. For example, by using 2 to 1 leverage in the example above, you can turn a 22% return assuming merger completion into 44% (or expected annual return from 11% to 22%). Leverage is double edge sword, however, as it could also magnify your losses if prices continue to diverge instead of converging as expected, so use leverage carefully.

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Do an online search for mergers and acquisitions and be alerted when new opportunities arrive.

Diversify to avoid arbitraging deals where the chance of success is all or nothing. Make two or more smaller arbitrage deals to avoid having 100% of the risk in one larger venture.

For mergers and acquisitions, be aware of the risk that the deal may take longer than expected to close or even fall apart, thereby diminishing or even eliminating any potential return.

Watch out for transaction fees. Use low or no-fee brokers to minimize transaction fees. Your arbitrage profit is net of transaction fees, so do not allow transaction fees to eat away your profit.

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