Arbitrage Meaning Examples Trading Types Opportunities

Arbitrage Meaning

Arbitrage is an act of generating income from trading a certain currency, security, or commodity in two different markets. The arbitrageurs reap a margin from the varying price of the same commodity in two different exchanges or markets.

It is a practice that takes advantage of market inefficiency. The same commodity, currency, or asset is priced differently in two or more distinct markets. It indirectly improves the markets by highlighting loopholes. But as soon as the market makes those improvements, the profitability for the arbitrageurs terminates.

Key Takeaways

Arbitrageurs procure commodities, security, or currency at a low price from one market. They then sell it in a market where the same commodity is priced higher. The difference between the prices yields profits. In the US, arbitrage is not prohibited by law. Instead, it is stimulated as it exposes market inefficiencies, facilitates market corrections, and establishes price uniformity. The associated risks are low, but so are the profits. Most such opportunities are already exhausted; market is rapidly becoming more competent.

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Arbitrage Explained

Arbitrage refers to the process of making meager profits by concurrent buying and selling of securities in different markets or exchanges. A spread is a variation in the prices of a single security, currency, or commodity in two different markets or exchanges; it is also considered the arbitrageur’s profit.

While the arbitrageurs try to take advantage of market incompetency, they end up pinpointing pricing errors for a particular stock. As a result, markets actually end up improving. But consequently, as soon as the market makes those improvements, the profitability for the arbitrageurs terminates.

Usually, arbitrageurs are huge financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more that invest hefty funds into the buying and selling of commodities, assets, or currencies. They operate in two different markets. Also, the arbitrageur has to make several trades to generate a decent profit because prices do not vary substantially when the markets are efficient. As a result, arbitrageurs have to discover new opportunities continuously.

Arbitrage Examples

To understand the arbitrage process, let us look at some examples. Assume that a stock XYZ is listed in both markets A and B. The price of XYZ in market A is $17, but in market B, the price is 16.69 Sterling Pounds ($20). Therefore, Peterson, the arbitrageur, buys 100 XYZ stocks in market A. He spent $1700 and then sold the stocks in market B for $2000. Deducting $50 for the transactions fee, Peterson earns $250 from this trade.

Now let us discuss another example. Cross currency trade is a classic opportunity. Transactions take place in different currency pairs (GBP/USD) and then (USD/INR), instead of trading GBP/INR straight away. This is done to get a better price.

Let’s understand this concept with hypothetical numbers:

For example, below is the quoted priceQuoted PriceA quoted price refers to the latest trading (bid and ask) value agreed upon by traders for security. It usually appears as a notification on the online trading platforms, signifying prices of in-demand stocks, bonds, derivatives, or commodities. Exchanges express it in cents or dollars.read more of three currency pairs on 1 January 2020:

In the above case derived price of GBP/INR is 96.39, obtained by multiplying with the cross-currency rate of GBP/USD and USD/INR

The above case provides an arbitrage opportunity to make risk free gain and involves the following steps:

Converting Pound (GBP) into dollars at the conversion rate of 1.29$;Converting dollars into INR at the conversion rate of 74.72 per dollar;

Here, one GBP is converted to 96.39 INR, and then the same is sold for the quoted price of 95.83 INR to convert back into GBP. All in all, an arbitrage profit of INR 0.56 is made per pound (GBP).

Types of Arbitrage

The different kinds of arbitrage practices are as follows:

Pure Arbitrage: Here, the arbitrageur takes an immediate buy and sell decision without blocking the funds.Risk Arbitrage: Often, investors estimate a price rise of the stock and thus block the money by buying and then holding it. Basically, the investors expect a price hike in another market.Retail Arbitrage: This is a common practice in e-commerce. Arbitrageurs buy a certain product at a discounted price from the local retailer and then sell it on an e-commerce website for a high price.
Merger Arbitrage: This is a strategic activity. Arbitrageurs procure the stocks of a target company when they suspect an imminent takeoverTakeoverA takeover is a transaction where the bidder company acquires the target company with or without the management’s mutual agreement. Typically, a larger company expresses an interest to acquire a smaller company. Takeovers are frequent events in the current competitive business world disguised as friendly mergers.read more or mergerMergerMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm.read more. When the prices accelerate after the merger, they sell the shares. Convertible Arbitrage: Arbitrageurs benefit from holding a long position in convertible security and by grabbing a short position in the underlying stock.
Dividend Arbitrage: Under this type, traders purchase stocks just before the ex-dividend dateEx-dividend DateAn ex-dividend date is one of the four important dividend dates, usually set one business day before the record date. It is a deadline; shareholders need to buy the stocks before this date to become eligible for the upcoming dividend payout. It is also called the ex-date.read more. The ex-dividend date is the date by which the investor has to complete his purchase of the underlying stock. Only then is he eligible for the dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more on the the listed date.

Also, the traders buy put options on the underlying stock. A Put Option is a contract that gives the buyer the right to sell the option at any point in time on or before the contract expires.

As the stock goes ex-dividend, the stock price falls to adjust for the dividend increase in the price of put options, thereby benefiting the trader. Also, the fall in stock price is adjusted by dividend receipt.

Futures Arbitrage: The stock is purchased in cash and sold in the futures segment. Usually, futures are priced higher than the cash price to account for the future premium. However, on expiry, both prices converge, resulting in an arbitrage profit for the trader.

Arbitrage Opportunities

Traders generate risk-free profits in two ways. First, they sell at higher prices in one stock exchange. Then, they buy the same security from another stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.read more at lower prices—in real-time. This way, they benefit from the price difference.

Similarly, the traders purchase an asset at a lower price from one stock exchange. Then they sell the same asset at a higher price in another stock exchange. Again, all this is done in real-time to benefit from the price difference.

Arbitrageurs use the following options to generate profits:

Security or asset – buying and selling of equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company’s balance sheet.read more, bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more, and other financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more over two or more stock exchanges or stock markets;Commodity – procuring goods from one nation or market at a reasonable price and then selling it in another nation or market where its market price is high;Currency – acquiring a currency pair from one broker at a nominal price and selling it to another at a higher value.

Risks

Although it is considered a risk-free trade, it is prone to various shortcomings discussed below:

Market Uncertainty: Markets are unstable and therefore can respond opposite to expectations. Buying and selling given security in different markets can reduce spread to such an extent that arbitrageurs end up in losses instead of profits.Counterparty Credit Risk Delinquency: When activities, buyers, or sellers default, arbitrageurs encounter losses.Limited Opportunities: It cannot be taken as a full-time career. With the increase in such flares, the regulators start checking market inefficiency. Ultimately, loopholes are eliminated, leaving little room for arbitrage.High Transaction Costs: Different markets have varying transactions fees—taxation and brokerage charges. Overlooking these costs while determining the spread impacts the profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more.Requires Lumpsum Funds: Arbitrageurs have to invest a huge sum to generate even a minute income.