Understanding Arbitrage

Part 1 and Part 2 here. I’d recommend you read those before you start this one.

Now, what if at the end of the academic year, you find yourself without a job offer? We all hope and pray that this doesn’t happen to anybody, but the sad reality is that there will always be such cases.

What could be done?

What I am about to describe doesn’t actually happen in any college that I know of, but it helps me build my story, so let’s go with it for the moment:

What a university could do is that it could hire the services of a placement agency. Said placement agency would take on the responsibility of getting these students placed in one firm or the other. These wouldn’t be glamorous jobs, of course, and they wouldn’t be high-paying ones. But hey, at that stage, any job offer is a good offer – and you could always try and shift as soon as possible into a better job, no?

The placement agency wouldn’t do this for free, of course. The college would have to pay the placement agency for each student placed.

Here’s the interesting part, though. It is quite likely that the placement agency would be taking a fee from the firm in which this student got placed. That is, the placement agency gets a fee from the college, but it also gets a fee from the firm.

(There are variants, of course. But we’re talking Zomato, Uber, Dunzo and old school real estate agents and all that. Middlemen, essentially. The equilibrium of who pays, and how much, and why are all excellent questions for an intermediate micro class.)

So what is the placement agency doing? In the language of the financial markets, it is engaging in arbitrage. Arbitrageurs make markets more efficient, by connecting supply and demand. The type of supply and demand that wouldn’t have been able to connect otherwise.

The student that didn’t get placed, and the firm that wanted a new employee hadn’t been able to meet so far, and the placement agency facilitated this deal. We’re talking economics, of course, and the placement agency therefore deserves a fee for providing this service.

This fee can be collected in two ways. First, the way that I just described above: take a flat fee from both sides of the transaction. Or, think of a bank. What does a bank do? It connects people who are willing to loan money to people, with people who are looking for a loan. The bank acts as the middleman, and offers a lower rate of interest to depositors. It also charges a higher rate of interest to people who want to take a loan.

This is known as the bid-ask spread. The middleman bids a lower rate while buying, and asks for a higher rate while selling.

An efficient market is one in which there are no arbitrage opportunities. Or in the language of the economist, an efficient market is one in which there are no search costs. It’s mostly the same thing. I have fixed deposits in the bank that pay me a painfully low rate of interest. In my neighbourhood is a person who has taken a loan from the same bank in which I have my fixed deposit. She is being charged an eye-wateringly high rate of interest.

In effect, I am loaning my money to her. Because I do not know of her existence (nor she of mine), we both use the bank to “complete” the transaction. The difference between the rate of interest I get and she is charged is what pays for the rent of the bank, its employees salaries and so on.

(By the way, what if the bank gives out a new loan to another person before my neighbor has repaid hers? Leverage!)

Real estate agents made the real estate market more efficient than it would have been otherwise, but their margins were so high, that Magic Bricks, and Housing.com and their ilk had a reason to enter and promise lower commissions. So also Uber, so also Airbnb, so also (think about it) Amazon.

Perfect competition, which we learn about in microeconomics, is best thought of as an always ongoing process, not as a static equilibrium. One aspect of which is better, more efficient arbitrage. That’s not how the textbooks do it, and more’s the pity.

Anyways, arbitrage is a good thing, because it makes markets more efficient in two ways:

  1. It makes trades happen that wouldn’t have taken place otherwise
  2. Competition between arbitrageurs drives the “market-making” fee downwards, making more trades happen at cheaper rates.

A truly efficient market is one in which there are no further arbitrage opportunities, and market-maker fees can’t possibly be any lower. No, as it were, dollar bills lying in the streets. See if the joke now makes sense.

So, over the past three days, we’ve learnt about the following:

  1. Forwards markets
  2. Hedgers
  3. Speculators
  4. Arbitrageurs
  5. Efficient markets

Next week (for there is only so much finance we can take at a time) we’ll get back to trying to understand finance, beginning Monday.

Optional homework: watch (and try to make sense of) Arbitrage. And if you want an example of how to write well, read this review of the movie – whether you watch it or not.

What is leveraging?

You may want to give this a read (if you haven’t already) before starting in on today’s post.

In my fourth semester while I was a Masters student at Gokhale Institute, I took this paper called Econometrics-II.

Let’s just say that it wasn’t the best decision ever. The paper was theoretical, abstruse and full of jargon, even by the standards of academia. And because it was my fourth semester, we weren’t exactly a motivated bunch. Placements had happened a little while earlier, you see, and the fourth semester was essentially us killing time until we joined whichever company we had been placed in.

And the combination of a difficult paper and a lack of motivation is a dangerous thing. By the time I and the rest of my batch trooped in to the examination hall for writing this particular paper, we knew it wasn’t going to be a pleasant experience.

And as it turned out, even adjusting for our expectations, it was a truly difficult paper. By the time we left the examination hall, all of us felt that there was a very real chance we wouldn’t pass this particular paper.

The trouble was, I had already entered into a forward contract with a firm to sell my services to them, five hours a day, eight hours a week. My services, that is, as a Masters student.

I had promised, in other words, to sell them something I didn’t possess: the services of a person with a Masters degree.

I was, in other words, leveraged.

What is leverage? The technical term is slightly different than the context in which I am using it over here, but I was in effect betting on the fact that I would be a Masters student by June 2006, in the month of January 2006. And I had promised (in January 2006) to deliver to the firm a service I didn’t have in my possession at that point of time.

To use the language we learnt about yesterday: I had shorted my services, when I didn’t actually have what they wanted.

The firm that had decided to hire me had also used leverage. It had promised to deliver (had sold) to its client a team of analysts. These analysts (one of them being me) would be ready to start work in 2006. So if you think about it:

  • the client was going to pay money to a firm…
  • …assuming that the firm would have a team ready to go in June 2006.
  • The firm, in turn, had assumed that the person they had hired in January 2006 would actually be a Masters student come June 2006.
  • And the student had blithely assumed that Trix-II (which is how all students at my college referred to that horrible paper) would be dealt with one way or the other.

When this last assumption breaks down, so do all the others, causing a chain reaction of sorts. In financial markets, this chain reaction can grow monstrously large, with extremely unpleasant consequences.

<Cough> Subprime <Cough> Crisis <Cough>

When a bank assumes:

  • that a loan that it has made will be repaid, with interest…
  • …and uses those presumed profits to buy an asset…
  • …and uses that asset as collateral to buy something else,
  • exactly the same thing is happening!

When the first loan ain’t repaid, bad things happen.

So is leveraging bad?

As I said yesterday, it depends on whom you’re asking. The student in question is unlikely to view leveraging as a very bad thing. That’s what got the student the job!

The firm will have a rather more bleak view of the affair, but so long as they can find a replacement easily enough, this won’t be an out and out disaster.

In the case of financial markets, leveraging is a (really big) problem when the losses are systemic. That is if all graduates from all colleges suddenly flunked in one year, they’d all be in trouble. As would the firms that had decided to hire them. As would the firms who had hired these firms. And so on.

But as today’s post hopefully makes clear, leveraging itself isn’t bad, so long as it isn’t overused, and that too systemically.

This is a rule that gets broken in a rather prominent fashion every now and then in financial markets the world over, with the attendant mess gaining a lot of attention.

But leveraging itself? It’s used all the time, and by all of us, one way or the other.