Saturday, March 1, 2008

Arbitrage Themed Business Models

“Well it takes too much money and risk to make money on your own…” Ever heard of that? Why did you ever assume it true? Classical arbitrage proves it completely false; it puts forth an operation that is both “self financing” and risk free. Seasoned businessmen and traders of financial instruments understand the concept and they apply it all the time.

So how do you pull it off? Why does nobody discuss it openly?

When it comes down to it, core business models of many SUCCESSFUL enterprises rely on arbitrage themed strategies. These guys play the game to win, and they do it by lowering risk dramatically compared to competitors and keeping it undisclosed.

For example:

Decades ago when China first opened its doors to the west, the first western importers made fortunes with the labor and material value discrepancies. They bought in bulk from China, then sold it to buyers in the west immediately at discounts and still made incredible profit margins. They would time the transactions so the revenues arrived before they paid off the Chinese vendors, hence never risking their own wealth. There lies the concept of self financing.

However, as more businesses learned to purchase at these Chinese bargain prices, the original low-price edge has lost its value as competition reigned. This explains partly why industrial secrets hold so much value.

Another example:

Corporate merger arbitrage. Warren Buffet disclosed this strategy as something utilized in his early days of fund management. He has unveiled it mostly because he believes this opportunity does not exist anymore as too many people have become aware of it.

A few weeks ago Microsoft offered to buy Yahoo in the form of stocks at $30 per share. On the day of announcement, Yahoo shares opened at roughly $25 and Microsoft at $34. As soon as the news hit, a truck load of traders initiated buy orders on YHOO, and short orders for MSFT.

The arbitrage strategy would go something like this:

  1. Shorting selling 1,000 shares of MSFT, which credits the trader of $34,000, this serves the self-financing part.
  2. Using that money one can now afford to buy 1,000 shares of YHOO at $25,000.
  3. As soon as prices of both stocks converge, the difference of $9,000 becomes a risk free profit. The prices WILL converge if the merger goes through or in this case via price impact of the arbitrageurs.

Within minutes both stocks jumped toward $30. The ones who got in first made a self financing, risk free profit of roughly $9 per share. However, with the strategy a common knowledge, it has become very difficult to pull it off amongst the competing orders.

“Conventional wisdom” offers nothing useful, it pushes the idea that any business model requires “too much” risk. No law of man or nature forces one to risk bankruptcy to pursue one’s ambitions. From my experience, business owners have a higher probability of devastating failure only if they do not do their homework, i.e. no research, no planning, or flawless execution thereof.

Brainstorm. I had read that Google requires its R&D to come up with at least 100 new ideas each week, and they end with perhaps 5-10 good ones. But those good ones could end up bringing in a whole lot of revenue. Creativity counts.

Find ways to carry out your business with monetary risks as low as possible without compromising income. Become more creative, just slightly more than your competitors, and you will likely end up more successful than the rest.

As Featured On Ezine Articles

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