Basketball Betting Arbitrage: Swindle Your Friends

Basketball, Arbitrage, and the Beauty of Finance

The University of Virginia Cavaliers just won their first-ever NCAA Division I Men's Basketball Title, defeating the Texas Tech Red Raiders 85-77 in overtime in the championship game.

I, as an avid basketball fan, naturally bet on this game with a friend. Since Virginia was the favorite, we set 1.5:1 odds — if Virginia won, I'd win $15, but if Texas Tech won, he'd win $22.50. After rigorous analysis of the two teams (not really), I bet on Virginia and won $15 at the end of the day.

But my friend was still happy, even having lost $15 to me. Why? Well, this was no ordinary friend. This was a JP Morgan trader. Let's call him J. Doing what he does best, J engineered a situation where he would win no matter what. 

In addition to our bet, J was able to secure a bet of better odds with another guy. J initially gave the other guy $20, and then said that if Virginia won, then the other guy would have to pay J $38; otherwise the other guy could keep the $20.

Let's look at every possible situation (There are only two: Virginia winning and Texas Tech winning). 

1. If Virginia won, then J would lose $15 to me on our bet, but gain $(38-20) = $18 from his other bet. This would net J $(18-15) = $3
2. If Texas Tech won, then J would win $22.5 from me on our bet, and lose $20 on his other bet. This would net J $(22.5-20) = $2.50.

No matter what happens, J makes money. The awesome thing is that there is absolutely no risk involved — J will always make money. J has just benefited from riskless arbitrage. 

Arbitrage is a fancy word, but all it means is "the process of exploiting differences in the price of an asset by simultaneously buying and selling it." Essentially, the price I gave him on the bet (in this case the odds) was different from the price that the other guy gave him. So J simultaneously bet on Virginia and Texas Tech ("simultaneously buying and selling"), and we just saw how he did it.

J has given us a very real world demonstration of arbitrage.

This is similar to what some of his job as a trader at JP Morgan would be (though much of the process I am about to describe has been automated by computers). He would detect inefficiencies in the market (i.e. price differences like we saw with our betting odds), and exploit them to generate profit for the firm. He would buy low and sell high. If someone were to offer a price of $x for some financial product, and at the same time J has a client who wants to buy that financial product for $(x+5), then J can easily buy the product from the seller at $x and then sell it to the buyer for $(x+5), generating $5 of profit. The difference here is that this transaction is much riskier than the sports betting between friends I described and participated in above. In the time between when J buys the product for $x and sells it for $(x+5), the product is held on JP Morgan's books and let's just say a lot of things can happen while it's there (namely, it could depreciate in value or external demand for that product could go down and maybe the highest bidder out there would only want to buy it for $(x-5), which would lead to $5 of loss for the firm). This isn't exactly arbitrage, because the buying and selling are not simultaneous, and it definitely isn't riskless, but the similarities are there. Of course, many of financial products that are traded now are more complicated and have more complex mechanisms used to value them than in this basic example, but you get the idea.

I got caught up in the machinations of a trader. I came out okay, and with an increased respect for J's skills.