The Tricky Art Of Arbitrage

What is arbitrage, and how can it lead to ruination, as it did in Nick Leeson's case? Basically it is trying to exploit the differences in the prices of a particular scrip in various stock exchanges. For instance, at 11 in the morning, the Telco share opens at Rs 200 on the Bombay Stock Exchange (BSE), while at the Calcutta Stock Exchange (CSE), the scrip opens at Rs 210. At Madras (MSE), it opens at Rs 208 while on the Ahmedabad Stock Exchange (ASE) the scrip is priced at Rs 215.A broker from a Bombay-based firm decides to buy 10,000 Telco shares at the BSE and 5,000 Telco shares at the MSE. By 12.30 pm, he is able to acquire 15,000 Telco shares at an average price Rs 202.66, though he hasn't made any payments for the shares as yet.

Nor does he have any intention of shelling out hard cash. He now calls up Calcutta and Ahmedabad, where he knows the prices are higher, and wants to sell his Telco stock. By that time, however, the Telco scrip at the CSE and MSE has come down to Rs 205 and Rs 206, respectively, while that at the ASE has gone up to Rs 221. The broker manages to sell 6,000 shares at CSE at Rs 205 while he offloads 3,000 at MSE at Rs 206. In Ahmedabad, he can find buyers for only 4,000 shares at Rs 220. By the end of the day he is stuck with 2,000 Telco shares. These he finally decides to sell off at the best price he can get in Bombay: Rs 200.

At the end of the day, our broker has made a profit of Rs 88,000 in one day without actually bringing any money to the table. But the flip side of the coin is that if the Telco price in Bombay and Ahmedabad had fallen by even Rs 10 at each centre, he could have lost some thousands in a day.

Leeson was arbitraging between three stock exchanges: Singapore, Tokyo and Osaka. The settlement of any such deal has a deadline by when a margin money has to be paid to the stock exchange in proportion to the size of the deal. As Leeson's deals got bigger and bigger, the margin money requirements too shot up. It was this heavy funds requirement that exposed Leeson's skulduggery.