Chapter 1
Introduction to Merger Arbitrage
Arbitrage is one of the oldest forms of commercial activity. One of the earliest published definitions of the term arbitrage can be found in Wyndham Beaves's seminal Lex Mercatoria,1 first published in 1685, which trained several generations of European merchants until its last edition of 1803. One will be hard pressed to find a finance book today that has been in print for over a century. In the 1734 edition, Beaves writes about arbitrage:
ARBITRATION (a Construction of the French Word Arbitrage) in Exchanges has been variously defined by the several Authors who have treated of it.
One says it is a Combination or Conjunction made of many Exchanges, to find Out what Place is the most advantageous to remit or draw on.
Another describes it, by saying it is only the Foresight of a considerable Advantage which a Merchant shall receive from a Remis or Draught, made on one Place preferably to another.
A third construes it to be a Truck which two Bankers mutually make of their Bills upon different Parts, at a conditional Price and Course of Exchange.
According to a fourth, it is the Negociation of a Sum in Exchange, once or oftener repeated, on which a Person does not determine till after having examined by several Rules which Method will turn best to Account.
Lex Mercatoria, 1734, p. 387
Around that time also appeared in Basel the first book dedicated to arbitrage, J. Wiertz's 1725 oeuvre Traite des Arbitrages de Change,2 which discusses various calculation methods to convert one currency into another. All of these early forms of arbitrage involved currency arbitrage. Patrick Kelly describes a typical nineteenth-century arbitrage in his 1811 book The Universal Cambist, and Commercial Instructor: Being a General Treatise on Exchange, Including the Monies, Coins, Weights and Measures of All Trading Nations and Their Colonies: with an Account of Their Banks and Paper Currencies,3 which took over from Beaves's Lex Mercatoria as the obligatory text book for merchants in the nineteenth century:
Arbitration of Exchange
Arbitration of Exchange is a comparison between the course of exchange of several places, in order to ascertain the most advantageous method of drawing or remitting Bills. It is distinguished into simple and compound arbitration: the former comprehends the exchanges of three places only, and the latter of more than three places.
Simple Arbitration
Is a comparison between the exchanges of two places with respect to a third—that is to say, it is a method of finding such a rate of exchange between two places as shall be in proportion with the rates quoted between each of them and a third place. The exchange thus determined is called the Arbitrated Price, and also Proportional Exchange.
If, for example, the course between London and Paris be 24 Francs for £1 sterling, and between Paris and Amsterdam 54d. Flemish for 3 Francs, (that is, 36s. Flemish for 24 Francs,) the arbitrated price between London and Amsterdam through Paris, is evidently 36s. Flemish for £1 sterling: for as 3 Fr. : 54d. Flem. :: 24 Fr. : 36s. Flem.
Now, when the actual or direct price (as seen by a quotation of otherwise advised) is found to differ from the arbitrated price, advantage may be made by drawing or remitting indirectly; that is, by drawing on one place through another, as on Amsterdam through Paris; […]
To exemplify this by familiar illustrations, suppose the arbitrated price between London and Amsterdam to be, as before stated, 36s. Flemish for £1 sterling; and suppose the direct course, as given in Lloyd's list, to be 37s. Flemish, then London, by drawing directly on Amsterdam, must give 37s. Flemish for £1 sterling; whereas, by drawing through Paris he will give only 36s. Flemish for £1 sterling; it is, therefore, the interest of London to draw indirectly on Amsterdam through Paris.
As securities markets began to develop and expand globally during the nineteenth century, arbitrage began to expand beyond simple currency exchanges. This is reflected in how Otto Swoboda expands the definition of arbitrage in his book Börse und Actien, first published in Cologne in the year 1869:4
Under arbitrage, that is decision, we understand the comparison of notations of any one place with those of another in order to use any arising difference, relative to exchange rates as well as security quotes, and thereby those who enter into such arbitrages (bring together) differences in prices between to places in their favor. […] Ear...
