Arbitrage in finance means simultaneous purchase and sale of a security in different markets or within one market on different exchanges to generate risk-free profit from the difference in the price of the security. It involves the exploitation of market inefficiency to generate profits which results in different prices to the point where there are no arbitrage opportunities are left. It can be inferred as long as market inefficiencies are present there is always room for Arbitrage.
Example of Arbitrage
ABC stock is trading on two different stock exchangesStock ExchangesStock 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. and quoting at the following prices:
- Exchange 1: $17.80
- Exchange 2: $18.00
Assuming no taxes and transaction costs and no restriction on the simultaneous purchase and sale of ABC stock, an arbitrage opportunity exists. Under this, an arbitrageur can buy ABC stock on Exchange 1 @17.80 per unit and sell on Exchange 2 @18.00 per unit, thereby making a risk free profit of $0.20 per unit.
A classic area where a lot of arbitrage opportunity exists is in Cross currency trades where a trade can happen in different currency pairs (GBP/USD) and (USD/INR) to get a better price than outrightly trading in a GBP/INR.
Let’s understand this concept with hypothetical numbers:
Below is the quoted price of three currency pairs on 01.01.2020:
In the above case derived price of GBP/INR is 96.39, obtained by multiplying with the cross-currency rate of GBP/USD and USD/INR
The above case provides an arbitrage opportunity to make risk free gain and involves the following steps:
- Converting Pound (GBP) into dollars at the conversion rate of 1.29$;
- Converting dollars into INR at the conversion rate of 74.72 per dollar;
- Thus converting one GBP into 96.39 INR and then selling the same for the quoted 95.83 INR to convert back into GBP thereby making an arbitrage profit of INR 0.56 per unit of a pound (GBP)
Types of Arbitrage
- Dividend: Under this type, traders purchase stocks just before the ex-dividend date and also buy put options on the underlying stock. As the stock goes ex-dividend, the price of a stock falls to adjust for the dividend increasing in price of put optionsPut OptionsPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated., thereby benefiting the trader. Also, the fall in stock price is adjusted by way of dividend receipt.
- Futures: Under this strategy, the stock is purchased in cash and sold in the futures segment. Usually, the futures price is higher than the cash price to account for the future premium; however, on expiry, both prices converge, resulting in arbitrage profit for the trader.
How Traders Use Arbitrage Opportunities?
Traders generate risk-free profits in two ways:
- Selling at higher prices in one stock exchange and buying the same security from another stock exchange at lower prices on a real-time basis to benefit from the price difference.
- Similarly buying of security at lower prices from one stock Exchange and selling the same security at higher prices on another stock exchange on a real-time basis to benefit from the price difference.
Risks of Arbitrage
Although it is considered as a Risk-free profit trade; however, it also suffers from certain risks which are enumerated below:
- Counterparty credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. default is one of the significant risks faced in Arbitrage under which one of the activities either buyer or seller defaults leading to losses in arbitrage trade.
- Another risk relates to liquidityRisk Relates To LiquidityLiquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases., at times due to less liquidity both buying and selling at the different prices don’t happen to result in a reduction in spread (the difference between buy price and sell price) or at times negative spread.
- In the real world price inefficiency continues despite arbitrage as there is a concept of transaction cost, which at times costs more than the spread a trader can earn across different exchanges.
- It is a costly affair and requires a lot of margins to undertake arbitrage trades which limits retail investors to benefit from it.
- They despise being called risk-free suffer from counterparty credit risk in technical parlance.
- Arbitrage is confined to only highly liquid securities as thinly traded securities suffer from the high bid-ask spreadBid-ask SpreadThe asking price is the lowest price at which a prospective seller will sell the security. The bid price, on the other hand, is the highest price a prospective buyer is willing to pay for a security, and the bid-ask spread is the difference between them..
This article has been a guide to the meaning of arbitrage and its definition. Here we discuss how traders use arbitrage opportunities along with examples and types. You may learn more about financing from the following articles –