The Compass is always looking for ideas about topics that would resonate with readers and recently, one morning, a murder of crows was ripping into something unattractive on The Compass’s front verge with resounding cries of what sounded like ‘Aaarrrrrbbb…’. Arb is slang for Arbitrage. Quoth the raven…we had our topic!
Arbitrage is where 2+2=4 becomes 2+2=5, but just for an instant, before it slips back to 4 again. It is the opportunistic value created through the simultaneous execution of at least two transactions which locks in a profit by selling and buying an asset (but without adding any value to the asset including retailing or distributing). An example is foreign exchange, where a trader buys USD using CAD for 1.00, CAD using AUD for 0.90 and AUD using USD for 0.80, all at the same time. Once the dust settles, this will make a profit of 12%. Of course, as the market responds quickly to this type of arbitrage (who wouldn’t want a slice of that cake?), the FX values will close almost immediately through market forces until there is no value difference between the three currencies.
Arbitrage traders effectively ensure that markets are ‘efficient’ by taking advantage of inefficiencies in a risk-free manner. (Arbitrage is not taking a position and waiting for prices to fall or rise, as that is speculative and not risk-free.)
Well at least that’s the theory. In agriculture, arbitrage is a tad more practical with three types being the most common:
1. Quality arbitrage
2. Information arbitrage
3. Freight arbitrage.
Quality arbitrage is typically associated with cliff face pricing. For example, if the market for ASW wheat is $310 and APW $350, then buying and blending 10 tonnes of APW with an average protein of 10.8%, and one tonne of ASW with protein of 9.8%, will create eleven tonnes of APW at 10.7% protein, each worth $350 and resulting in $40 of profit.
Information arbitrage comes from buying in one market and selling in another, where there is a distortion in value due to asymmetry of information. An example is a dairy farmer, needing oaten hay quickly, asking his neighbour and offering $300pt. Although the neighbour does not have any hay for sale, he knows his sister in another district has some available, delivered, for $275pt. Because he has the full information picture and his sister and the dairy farmer don’t, he can make an arbitrage profit of $25pt with a quick purchase and sale.
Freight arbitrage is where basis does not accurately reflect the cost of physically moving the product from one location to the other. For example, buying a tonne of lupin in the Kwinana zone for $305, selling it immediately in the Geraldton zone for $340 (delivered in 5 days), and locking in freight for $25 would generate $10pt of arbitrage profit.
All of these forms of arbitrage rely on a market inefficiency that arises through the ever-changing market cycle and all come and go. Farmers and accumulators will blend (or optimise) their wheat up to be just over the highest possible grade’s protein level, marketing consultants uncover and broadcast market information to farmers for a fee and freight providers will price per km to be just under the nearest competitive option. Arbitrage opportunities will still present for those quick and agile enough to seize them, but they are slippery little suckers and by the time you hear about them from somebody else, they will no longer be available.
