stock traders' term, combining garbage and arbitrage, for activity in stocks swept upward by the psychology surrounding a major takeover. For example, when two leading entertainment stocks, Time, Inc., and Warner Communications, Inc., were in play in 1989, stocks with insignificant involvement in the entertainment sector became active. Garbatrage would not apply to activity in bona fide entertainment stocks moving on speculation that other mergers would follow in the wake of Time-Warner.

arbitrage involving risk, as in the simultaneous purchase of stock in a company being acquired and sale of stock in its proposed acquirer. Also called takeover arbitrage. Traders called arbitrageurs attempt to profit from takeovers by cashing in on the expected rise in the price of the target company's shares and drop in the price of the acquirer's shares. If the takeover plans fall through, the traders may be left with enormous losses. Risk arbitrage differs from riskless arbitrage, which entails locking in or profiting from the differences in the prices of two securities or commodities trading on different exchanges.

strategy used to offset investment risk. A perfect hedge is one eliminating the possibility of future gain or loss.

A stockholder worried about declining stock prices, for instance, can hedge his or her holdings by buying a put option on the stock or selling a call option. Someone owning 100 shares of XYZ stock, selling at $70 per share, can hedge his position by buying a put option giving him the right to sell 100 shares at $70 at any time over the next few months. This investor must pay a certain amount of money, called a premium, for these rights. If XYZ stock falls during that time, the investor can exercise his option-that is, sell the stock at $70-thereby preserving the $70 value of the XYZ holdings. The same XYZ stockholder can also hedge his position by selling a call option. In such a transaction, he sells the right to buy XYZ stock at $70 per share for the next few months. In return, he receives a premium. If XYZ stock falls in price, that premium income will offset to some extent the drop in value of the stock.

selling short is another widely used hedging technique.

Investors often try to hedge against inflation by purchasing assets that will rise in value faster than inflation, such as gold, real estate, or other tangible assets.

Large commercial firms that want to be assured of the price they will receive or pay for a commodity will hedge their position by buying and selling simultaneously in the futures market. For example, Hershey's, the chocolate company, will hedge its supplies of cocoa in the futures market to limit the risk of a rise in cocoa prices.Managers of large pools of money such as pension and mutual funds frequently hedge their exposure to currency or interest rate risk by buying or selling futures or options contracts. For example, a global mutual fund manager with a large position in Japanese stocks who thinks the Japanese yen is about to fall in value against the U.S. dollar may buy futures or options on the Japanese yen to offset the projected loss on the currency.

arbitrage that exploits and thereby eliminates differences between spot exchange rates, forward exchange rates, and interest rates on deposits, thus creating interest rate parity.

contract in which two counter-parties agree to exchange interest payments of differing character based on an underlying notional principal amount that is never exchanged. There are three types of interest swaps: coupon swaps or exchange of fixed rate for floating rate instruments in the same currency; basis swaps or the exchange of floating rate for floating rate instruments in the same currency; and cross currency interest rate swaps involving the exchange of fixed rate instruments in one currency for floating rate in another.

Typically, a swap contract exchanges fixed rate obligations for a floating rate instrument in the same currency. In its simplest form, the two parties to an interest rate swap exchange their interest payment obligations (no principal changes hands) on two different kinds of debt instruments, one being a fixed interest rate, the other being a floating rate.

For example, the Student Loan Marketing Association (Sallie Mae) may want to swap rates with a mutual savings bank-a mutually beneficial transaction, as Sallie Mae, a highly rated institution because of its status as a federal agency, prefers floating rate to match short-term loans in its student loan portfolio. Sallie Mae can sell fixed rate debt at a relatively low cost, whereas the mutual savings bank prefers to match its long-term fixed rate mortgages with fixed rate funds.