Arbitrage – How does it Work?
The financial markets are experiencing the engagement of thousands of traders and investors on a regular basis, wherein each participant’s primary goal is to make a profit. There are a number of trading methods and strategies in the financial markets. However, a trading strategy can only be implemented if the price of the asset indicates a favorable movement. Arbitrage is an unconventional but simple method for acquiring capital markets.
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What is Arbitrage?
Arbitrage is a practice of selling particular security in one market and simultaneously buying the same security in some other market, to take advantage of the price gap in both markets. A question arises of why someone would trade in two different markets as there is a cost associated with every transaction. When particular security is mispriced an investor purchases the security at a low price and sells it at a high price. Although arbitrage opportunity can occur in any asset class that is traded in a standardized form on different markets, it is more common in the currency and stock markets. This opportunity is often short-lived with just a few seconds or minutes. The price of the asset is the result of market demand and supply. The price discrepancy is due to a difference between the supply and demand of an asset in various markets.
How does Arbitrage work?
Arbitrage relies on the ability of the trader to capitalize in various markets on the price difference of the same commodity. The volume of the underlying asset purchased and sold should be the same when entering into this type of trade. Just the price differential is captured from the transaction as the net pay-off. Let us understand how this strategy works in the stock market. Suppose ABC Ltd. stock is traded on both NSE as well as BSE, and there is a mispricing in the value of the security. The price of the security listed on NSE is 200.10/share and the price quoted at BSE is @ 200.05/share. To exploit the arbitrage opportunity, the trader would buy the stock from BSE INR 200.05/share and sell it on NSE @ 200.10/share and make a profit of @ 0.05/share.
Types of Arbitrage:
Although arbitration generally relates to trade opportunities in financial markets, there are also other forms of opportunities in other tradable markets.
Risk Arbitrage: This is also referred to as merger arbitration, as it includes the purchase of shares in the merger and acquisition process. Risk arbitration is a popular strategy among hedge funds that purchase the target’s stock and short-sell the acquirer’s stock.
Retail Arbitrage: This can be conducted with ordinary retail items from your favorite store, as in financial markets.
Negative Arbitrage: This refers to the opportunity lost when the interest rate paid by the borrower on the debt (e.g. the bond issuer) is higher than the interest rate at which the investment is made.
Convertible Arbitrage: This strategy includes the purchasing of a convertible security and the short-selling of its underlying stock.
Statistical Arbitrage: Also known as stat arb, this is an arbitration strategy that includes complex statistical models for the discovery of trading opportunities between financial instruments at distinct market prices. These models are usually based on medium-reverse strategies and require substantial computational power.
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Arbitrage in the Futures market:
- Cash and carry arbitrage
- Reverse Cash and carry arbitrage
Cash and carry arbitrage: This exploits the mispricing between the underlying asset and the futures contract. As the name suggests cash, an investor purchase the underlying security from the market and carry it forward till the expiry of the futures contract and sells the underlying security in the future market at the expiry of the contract. An investor would enter into such an arbitrage when the future price in the derivative market is greater than the spot price of the underlying security. It is generally expressed as Fo > So. The investor buys the at So and sells at Fo.
Reverse cash and carry arbitrage: This is the reverse of cash and carry arbitrage as the future price of the underlying security in the futures market is less than the spot price of the underlying security. An investor will sell the security to invest the money at a risk-free rate of interest and go long on a future contract to buy the same underlying at the maturity of the contract at a lower price. It is generally expressed as Fo < So. The investor sells the at So and buys at Fo.
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The transaction cost associated with trading is generally higher than the profits and hence retail individual investors would not prefer such trades. However large financial institutes benefit from such arbitrage opportunities.
Arbitrage opportunities in the real-world are only available for short periods as algorithm-based trading in the developed markets takes over most of the arbitrage trading. These algorithms automatically identify and catch arbitrage opportunities, which makes monitoring simple for traders. While they are easy to detect, it is difficult to take advantage of them manually.
Author: Divya Sankhla
About the Author: Divya has completed her graduation in Bachelors of Accounting and Finance. She has worked in Deloitte Touche Tohmatsu Services, Inc. as a Research Analyst for 1 year and at JM financial as a Credit Risk Analyst for 1.3 years. She has a keen interest in learning about Financial Market. Well versed with Bloomberg, Capital Line, and Excel.