Saturday, November 19, 2016

Arbitrage and ethics - food for thought



I don't think many finance professionals would link arbitrage and ethics together. There is an ethical link between being a fiduciary and handling money for clients. Trade organizations and MBA schools will tie business practices, ethics, and being a fiduciary, but you would not expect discussion of ethics matched with talks on arbitrage, but Maureen O'Hara, a esteemed professor of finance at Cornell University has done just that with her new book Something for Nothing: Arbitrage and Ethics on Wall Street.


This is a short read, but it is a book that should cause many to think differently on some of the activities on Wall Street. There are ethics with arbitrage. Many of the stories used in the book we have heard about before, but thinking about them in the context of arbitrage through the lens of ethics is somewhat unusual. 

Professor O'Hara starts with some broad concept of finance that play into a wide definition of arbitrage. Finance is about discounting cash flows and a broader definition of arbitrage looks at these in the context of violations of one price and the restructuring of cash flows. Arbitrage is all about exploiting the violations of one price and structuring cash flows for profit. 

This broad definition means that arbitrage can be used to create deception for those that don't understand the law of one price or the impact of slicing cash flows. Risk shifting does not destroy risk. It just moves it from one party to another. Financial transactions may change cash flows for accounting but not change the value of the firm. Arbitrage can take advantage of regulatory or market structures, or it can be used to exploit market complexity through finding opportunities that others do not see.

Understanding of cash flows and pricing allows for these arbitrages to be made profitably, but that does not mean that all arbitrage activities are ethical. Exploiting arbitrage can be legal, but may border on what could be called weasily behavior. Just because the rules may allow certain financial behavior to be exploited for profit in the name of market efficiency does not mean that it should be undertaken. This ethical consideration is relevant even in the face of arguments that if you don't do it someone else may make the markets "efficient". There are boundaries even in a world that celebrates the law of one price. 

This book is a nice mix of basic ethics with some interesting tales of arbitrage to explain the ways that these activities could fall into gray areas of behavior. These discussions are useful and often not held by those in finance.

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