Editing Arbitrage (section)

==Risks==
Arbitrage transactions in modern securities markets involve fairly low day-to-day risks, but can face extremely high risk in rare situations,<ref name=DamghaniCointelation /> particularly [[Financial crisis|financial crises]], and can lead to [[bankruptcy]]. Formally, arbitrage transactions have [[negative skew]] – prices can get a small amount closer (but often no closer than 0), while they can get very far apart. The day-to-day risks are generally small because the transactions involve small differences in price, so an execution failure will generally cause a small loss (unless the trade is very big or the price moves rapidly). The rare case risks are extremely high because these small price differences are converted to large profits via [[Leverage (finance)|leverage]] (borrowed money), and in the rare event of a large price move, this may yield a large loss.

The principal risk, which is typically encountered on a routine basis, is classified as execution risk. This transpires when an aspect of the financial transaction does not materialize as anticipated. Infrequent, albeit critical, risks encompass counterparty and liquidity risks. The former, counterparty risk, is characterized by the failure of the other participant in a substantial transaction, or a series of transactions, to fulfill their financial obligations. Liquidity risk, conversely, emerges when an entity is necessitated to allocate additional monetary resources as margin, but encounters a deficit in the required capital.

In the academic literature, the idea that seemingly very low-risk arbitrage trades might not be fully exploited because of these risk factors and other considerations is often referred to as [[limits to arbitrage]].<ref>{{cite journal|last1=Shleifer|first1=Andrei|first2=Robert|last2=Vishny|year=1997|title=The limits of arbitrage|journal=Journal of Finance|volume=52|pages=35–55|doi=10.1111/j.1540-6261.1997.tb03807.x|citeseerx=10.1.1.184.9959|s2cid=16947326}}</ref><ref>{{cite journal|last1=Xiong|first1=Wei|year=2001|title=Convergence trading with wealth effects|journal=Journal of Financial Economics|volume=62|issue=2|pages=247–292|doi=10.1016/s0304-405x(01)00078-2}}</ref><ref>{{cite journal|last1=Kondor|first1=Peter|year=2009|title=Risk in Dynamic Arbitrage: Price Effects of Convergence Trading|journal=Journal of Finance|volume=64|issue=2|pages=638–658|doi=10.1111/j.1540-6261.2009.01445.x|citeseerx=10.1.1.113.688}}</ref>

===Execution risk===
Generally, it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. However, this is not necessarily the case. Many exchanges and inter-dealer brokers allow multi legged trades (e.g. basis block trades on LIFFE).

Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE.  This leaves the arbitrageur in an unhedged risk position.

In the 1980s, [[risk arbitrage]] was common. In this form of [[speculation]], one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current price, if the merger goes through as predicted. Traditionally, arbitrage transactions in the securities markets involve high speed, high volume, and low risk. At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act). When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing this risk is through the [[Insider trading|illegal use of inside information]], and risk arbitrage in [[leveraged buyout]]s was associated with some of the famous financial scandals of the 1980s, such as those involving [[Michael Milken]] and [[Ivan Boesky]].

===Mismatch===
{{details|Convergence trade}}
Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable; this is more narrowly referred to as a [[convergence trade]]. In the extreme case this is merger arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses.

===Counterparty risk===
As arbitrages generally involve ''future'' movements of cash, they are subject to [[counterparty risk]]: the risk that a counterparty fails to fulfill their side of a transaction. This is a serious problem if one has either a single trade or many related trades with a single counterparty, whose failure thus poses a threat, or in the event of a financial crisis when many counterparties fail. This hazard is serious because of the large quantities one must trade in order to make a profit on small price differences.

For example, if one purchases many risky bonds, then hedges them with [[Credit default swap|CDSes]], profiting from the difference between the bond spread and the CDS premium, in a financial crisis, the bonds may default ''and'' the CDS writer/seller may fail, due to the stress of the crisis, causing the arbitrageur to face steep losses.

===Liquidity risk===
Arbitrage trades are necessarily synthetic, ''leveraged'' trades, as they involve a short position. If the assets used are not identical (so a price divergence makes the trade temporarily lose money), or the margin treatment is not identical, and the trader is accordingly required to post [[margin (finance)|margin]] (faces a [[Margin calls|margin call]]), the trader may run out of capital (if they run out of cash and cannot borrow more) and be forced to sell these assets at a loss even though the trades may be expected to ultimately make money. In effect, arbitrage traders synthesise a [[put option]] on their ability to finance themselves.<ref name="bm">{{cite web|url=http://www.purearb.com/purearb/wp-content/uploads/2009/03/desco_market_insights_vol_1_no_1_20090313.pdf |archive-url=https://ghostarchive.org/archive/20221009/http://www.purearb.com/purearb/wp-content/uploads/2009/03/desco_market_insights_vol_1_no_1_20090313.pdf |archive-date=2022-10-09 |url-status=live|title=The Basis Monster That Ate Wall Street|publisher=[[D. E. Shaw & Co.]]|access-date=February 12, 2011}}</ref>

Prices may diverge during a financial crisis, often termed a "[[flight to quality]]"; these are precisely the times when it is hardest for leveraged investors to raise capital (due to overall capital constraints), and thus they will lack capital precisely when they need it most.<ref name="bm" />

=== Gray market ===
[[Grey market]] arbitrage is the sale of goods purchased through informal channels to earn the difference in price.<ref name=":0">Lu, Y; Foropon, Cyril RH  VIAFID ORCID Logo  ; Wang, D; Xu, S ， Journal of Enterprise Information Management; Bradford ，2020 ， Arbitrage in gray markets and its impact on supply chain decisions ， vol.34 , no.1, pp.382-8. </ref> Excessive gray market arbitrage will lead to arbitrage behaviors in formal channels, which will reduce returns due to factors such as price confusion, and may even cause prices to plummet in severe cases.