This week I was encouraged to read “arbitraging Japan” – an ethnography of a group of arbitrage traders working in a Japanese securities firm in the late 80’s when Japan experienced something loosely equivalent to the UK’s big bang, through to the early 2000’s. I wouldn’t unhesitatingly recommend it to all – but it raised a few topics that I wanted to reflect on briefly because I’ve also wondered about them professionally and personally – if you have too you should read it.
The key concept of the book is arbitrage. In financial markets, this generally refers to the practice of going long and short very closely related instruments which are fundamentally economically related. One aims to buy a cheap version and sell a rich version of the same thing. The main example covered by the traders in the book is the practice of buying and selling stock index futures against the component stocks of the index in the expectation that the prices of the two will converge. As a fixed income market guy by trade the main similar activity I see in this vein is trading the government bond futures basis (see footnote). However whilst the instruments that are subject to arbitrage are normally related fundamentally – they can diverge in price (hence the possibility of arbitrage) – and the extent to which they diverge is arguably simply a matter of speculation. It’s hence my belief that so called arbitrage traders are engaged in a form of meta speculation – effectively selling options on structural breaks.
By this I mean, if there’s some event that perturbs prices such as it can be argued there’s an arbitrage opportunity – there’s no guarantee the phenomenon that displaced them won’t carry on. A classic recent example in markets has been the persistent richness of German government bonds relative to interest rate swaps, and government bond futures. The cause is simple enough – the EcB has pre announced that it will buy bonds regardless of price. Even though other instruments exist that do the same thing (ie, get euros in the future rather than now via interest rate swaps or futures) – they aren’t buying those – so the relative value of these bonds has become a thing that rv funds use to hedge their macro exposures, and macro funds use to take outright speculative, not arbitrage positions.
The point generalises – any difference between comparable securities that can be effected by ‘macro’ factors can go from an arbitrage trade to a macro trade. This phenomenon can of course become self fulfilling as markets are forward looking by nature. Some but not all of this is addressed in the book – which presents the tension between arbitrage (rv) and speculation (macro) as a kind of existential question that the traders involved grapple with. I think both the author and the participants interviewed come across as naiive when discussing this – it’s much more a practical distinction than an abstract one – but it is well worth a skim read to decide for oneself. I am a self declared arbitrage/rv sceptic – so i am biased. This book is an interesting perspective.
The other interesting part for me was the perpetual discussion of exit strategies by the subjects of the book, derivative traders who looked at their work as an engineering problem. As they could see that theirs was an engineering problem that didn’t solve any identifiable real world one, they were all anxious to make an impact on the real world by quitting and doing something proper. This is well worth reading for any of who who wonder what city folks sit and think about when they, as all of us, ponder there place in the world and the meaning of their work. These Japanese securities traders worry about exactly the same mix of existential angst about the usefulness of their work combined with the visceral fear that others are being paid more for the same work that pervades dealing floors across the world to this day. I encourage you to sift the book for these sentiments.