Friday, May 10, 2013

Arbitrage 101 explained...with Marijuana

Ok, so as a recent MBA grad I certainly learned a LOT of new concepts over the past two years. Some of them made me financially smarter, some made me "look" smarter when I actually talk to smart people, and at a lesser degree, some made me a bit annoying (ask my wife when I go on and on explaining how I would fix the markets in 5 minutes).

Anyways, among the hundreds of new and exciting (NOT) things I learned, there is this one concept that for some reason stuck with me.  Arbitrage.

I have always enjoyed learning new things, but very few concepts have for some reason the impact this particular one had. For the first time I realized what Arbitrage (in Financial terms) was, and I realized what a powerful situation to be in. Finding a "legal" Arbitrage situation in today's financial interconnected world is almost impossible, but there is an industry where Arbitrage is there, open, exposed. And although not legal, the legality of it is what is dictating this situation that some dealers are taking advantage of. Economics 101

Let's get to the concept first. The idea is as simple as logic can imagine, Arbitrage is when a situation arises that someone can take advantage of the price difference between two markets. Not necessarily the same as finding a price difference between two identical products at your two local supermarkets. But think about the Canadian Dollar, US Dollar and Mexican Peso.

Imagine that 1 CAD buys you 10 Mexican Pesos or 1 USD in Canada, but in the United States, 1 USD buys you 1 CAD or 11 Mexican Pesos.  Exchanging CAD for USD is the same regardless the country, but if we are planning a trip to Mexico and we have 1 CAD or 1 USD (which is the same), exchanging that in the US will give us 1 extra Mexican Peso:

1 USD = 1 CAD = 10 MXN  (if the transaction is done on Canadian soil)
1 USD = 1 CAD = 11 MXN  (if the transaction is done on US soil).

By driving to the border and exchanging the money at the first US bank, we got a profit of $1 Mexican Peso. That is called arbitrage. Lets say we do it, and we post it on twitter and we tell our friends, not long after that becomes public & obvious, the markets will correct and the price will be the same, the Arbitrage is gone.

Now that we all understand the basic concept of Arbitrage, I just recently heard a podcast of an Arbitrage situation happening in the US today. With 18 states having legalized marijuana and having created a legal market for it, a pound of Marijuana goes for $45 or less on dispensaries in California according to NPR. The exact same bag of marijuana retails for $60 on the ilegal market in NY.  That creates an arbitrage situation that drug dealers are taking advantage of. Buy in the west coast, sell in the East Coast.

Of course, the main challenge for these dealers is how to move the merchandise. We all now that possessing and moving marijuana for selling purposes is ilegal across the land and the end result is jail. Not an easy task eh?

To fully understand this complicated but yet interesting story, take 25 mins of your busy day and listen to this great NPR's Planet Money Podcast...

Until next time!!

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