You may have heard the term arbitrageur – it is a type of trader who tries to benefit from price inefficiencies in the market. An arbitrage trade requires executing two trades simultaneously that off-set each other. This allows the trader to capture the “risk-free” profits. For example, an arbitrageur may look at a stock that is listed on more than one exchange. If on one exchange the stock is cheaper then an arbitrageur would buy that stock while simultaneously selling the more expensive stock listed on the other exchange. An arbitrage trading strategy can be risky and recently some arbitrageurs who traded on the relationship between US Treasuries and interest rate swap yields have had their fingers burned. Earlier this week the yield on 10-year US Treasuries rose above that of the 10-year swap rate. An arbitrage trade using swaps is very costly if it goes against you, since margin payments are required once the swaps trade starts to lose money.
When a security or a whole portfolio of assets makes returns that are unexpected over a period of time this is known as an abnormal return. The calculation for the expected rate of return is the sum of each possible rate of return multiplied by the probability of it happening. An abnormal rate is a measure of how much an actual rate of return differs from the expected return for that asset. An abnormal return can be positive or negative. If the expected return of an asset is 10 per cent, yet the asset returns 20 per cent, then the abnormal return is 10 per cent.