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Chapter 11. A Sure Thing: No Risk and Sure Profits

Chapter 11. A Sure Thing: No Risk and Sure Profits

The Search for a Free Lunch

Linda loved getting something for nothing. She shamelessly took advantage of misprinted coupons at grocery stores and freebies at vacation resorts. She wondered whether there was a way she could apply her skills to improving her portfolio performance. Her friend Brian, who was a broker, suggested that there might be a way to take no risk and make high returns in the stock market. Lots of foreign stocks, he argued, had listings in the United States and some of them traded at much higher prices in the U.S. markets than they did in their local markets. Using his connections, he said he could buy shares cheap in the local market while borrowing the more expensive shares listed in the U.S. market and selling them. A profit was guaranteed, he argued, since the two shares were in the same company.

Linda went along with the plan. Brian bought the shares in an Indonesian company on the Jakarta stock exchange and borrowed and sold shares in the same company in the U.S. market at a price that was 20% higher. He told Linda that the borrowed shares would have to be returned in two months but that the price difference would narrow by then, thus giving her a sure profit. Linda watched the share prices in both the Indonesian and the U.S. market in the days after. When the price difference did not narrow initially, she was not worried. When the price difference was still 20% a month after the trade, she sought out Brian but he reassured her that all was well. Doing her own research, she discovered that the U.S. listing was called an ADR and had always traded at a premium on the local listing, and that an ADR could not be exchanged for a local share. When the difference in prices reached 25%, she told Brian to settle the account to limit her losses, and decided that she her odds were much better with her local grocery store than in the stock market.

Moral: If you see easy money to be made in the stock market, you have not looked hard enough.


Despite being told repeatedly that there are no free lunches, investors never stop looking for them. If you can invest without taking risk and earn more than you could make on government bonds, you have the equivalent of a free lunch in investing. There are both institutional and individual investors who search for these elusive opportunities hoping to find them and mine them for certain profits. These riskless investments that earn more than the riskless rate represent arbitrage opportunities. In this chapter, you will look at arbitrage opportunities in their pure form first, and also in the form in which you are most likely to encounter them: where there is some residual risk. You will also examine why arbitrage opportunities, even when they present themselves, are so difficult to exploit for certain profits.


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