Arbitrage and International Trade and Finance

By Kinjal Doshi

So there’s an arbitrage. So what? This desk has a lot of money on arbitrages. Arbitrages aren’t particularly great trades.

                           -Treasury bond treasurer at a major Wall Street investment bank.

A stockbroker comes into the office in morning, and sees two different price quotas for the same stock. Naturally, he puts in buy orders on the lower quota and sells them at a higher one. This is the base for arbitrage of opportunities.

The concept of arbitrage is one of the cornerstones of financial economics and is widely believed not to exist in financial markets. There is a growing body of literature that is studying the potential arbitrage opportunities that cross listed shares create. If prices between local shares and their cross listed shares differ considerably, arbitrage opportunities are tend to occur. Large price deviations form arbitrage-price parity does not necessarily imply arbitrage profits are possible. Transaction costs, capital control restrictions, conversion laws, and lack of liquidity may make the practice of arbitrage very difficult. One of the foundation principles of financial economics is that arbitrage cannot exist in securities market. Since, if they did, investors would make inestimable wealth by holding unlimited positions. Economic theory implies that an arbitrage is an investment opportunity that is literally too good to be true.

In textbook terms, arbitrage is the practice of taking advantage of a price difference between two or more markets, striking a combination of matching deals that capitalise on imbalance, the profit being the difference in market prices. A general expectation is that nations will invoke both on the ground, that all income will be subject to taxation and the basic motto of international tax will be to provide relief for any double taxation. International tax arbitrage refers to the taxpayer’s practise of taking advantage of gaps in the domestic laws of countries relating to cross-border transactions. When non-taxation in the home country meets non-taxation in the source country these taxpayers derive perfectly legal benefits in both countries. Regulatory gamesmanship is dependent on a technique of regulatory arbitrage, which occurs when parties take advantage of a gap between the economics of a deal and its treatment. Regulatory arbitrage can be easily shrugged off as the inevitable by-product of high price lawyering. And for all those who are concerned with the benefit of arbitrage, moral suasion is not enough. As already said, in the financial market, an arbitrage opportunity is the possibility of making gains at no cost, or by taking no risks. Since trading does not cease until all arbitrage opportunities are quenched, at the market clearing equilibrium there is no arbitrage. No arbitrage at the initial endowments means that no trade can increase the traders utility are zero cost- gains form trade must thus be zero.

Though arbitrage doesn’t require costs nor has no risks. When an arbitrageur buys a cheaper security and sells a more expensive one, his future cash flows are zero, and thus enjoys profit. Arbitrage plays a major role in analysis of security markets, since its effect is to bring prices to fundamental values thereby keeping markets efficient. To state how arbitrage can lead to trade among nations, it is quite simple. When firms in the same industry located at different areas or nations experience shocks to production costs ( shortage of supply, power outages, exchange rate changes, commodity tax rates change, etc.)  in their industries that are imperfectly related, arbitrage opportunities would tend to arise.

Of all arbitrages, global labour arbitrage is of growing concern. The labour arbitrage is due to barriers of international trade, that  jobs move from nations where labour and cost of working is low/inexpensive to higher paying nations. This phenomenon has itself widened the gap between consuming and producing economies. If a glitch occurs in any of the producing economies then the consuming nations will see a high demand in low supply which would in turn lead to high inflation in consuming countries. What recent studies and research on this topic shows is that there is no simple solution to such a phenomena. Fighting the labour arbitrage will slow down the process but it would bring back the outsourced jobs. Hoping that currency arbitrage will result in new employment in countries that have lost their production capacity in support of cheap labour is optimistic. Steven Roach, chief economist at Morgan Stanley, gives reasons for the arbitrage process:

(a)   The maturation of global offshore outsourcing platforms. This comes from heavy capital investment in emerging markets and a low cost workforce ready to use new tools.

(b)  The new imperatives of cost control. With a world economic landscape comprised of nations- each with its comparative advantage (low cost labour) will see labour intensive work migrate to them from higher labour cost markets.

(c)   E-based connectivity: digitalisation in general.

Though in theory it is said arbitrage involves no risk, in a diverse world we live in, risks are unavoidable, though of small scale. In a renowned book by John Paulson, The “risk” in risk arbitrage, the shortcoming of arbitrage is well depicted.

In sum, international arbitrage as it is seen to be emerging in recent years mostly involves taking advantage of differences in basic components of the domestic system. Rome was not built in a day, and our economic model would take time to complete. The importance of arbitrage conditions in financial economics has been recognized since Modigliani ad Miller’s classic work on the financial structure of a firm. Keeping in view the ambiguities present in the theory and practise of arbitrages, proper research and improvements should be made.

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