How_Money_Works_-_The_Facts_Visually_Explained

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PROFIT-MAKING AND FINANCIAL INSTITUTIONS

Financial markets

How it works

Arbitrage is the practice of buying a tradeable asset

in one market and almost simultaneously selling it at

a higher price in a different market. Conversely, it is

also the practice of selling an asset in one market and

buying it for a cheaper price in another. Arbitrage,

as currently practiced in stock and bond markets,

is only possible due to the computing power now

available, so large volumes of transactions can

exploit small differences in prices within milliseconds.

The automated

program carries out

the transactions within

a fraction of a second

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60 %

of US equity trading

was estimated to

be High-Frequency

Trading at its height

in 2009

LONDON

WHEN ARBITRAGE

GOES WRONG

In 1998, hedge fund Long-Term Capital

Management (LTCM) lost $4.6 billion

as a result of arbitrage trades in bonds

that went wrong.

The price difference between the

bonds being traded was relatively small,

so in order to make a profit LTCM had to

carry out large volumes of trades. These

trades were also highly leveraged using

billions of dollars borrowed from other

financial companies.

This high leverage and the 1998

Russian financial crisis prompted

investors to move their capital to less

risky investments. LTCM sustained huge

losses and was in danger of defaulting

on its loans. The US government had to

intervene in order to prevent a collapse

of the debt markets and damage to the

global economy.

Company A

London Stock Exchange

SELL

2. Sell share at UK
   price to make a small
   profit—in this case,
   $0.023 per share
   exchanged.


3. Receive profit

£2.30

=

$3.013

=

PROFIT OF

$0.02 PER

SHARE

£2.30

US_064-065_Arbitrage.indd 65 13/10/2016 17:08