Arbitrage is a financial transaction that makes an immediate profit without any risk. Arbitragers take advantage of different rates, prices or conditions between different markets. Arbitragers make profit by exploiting price differences of identical or similar financial instruments. Trading foreign exchange is a kind of arbitrage where no risk involve where arbitragers buy at lower price and sell it at higher. However, the term has expanded the meaning now any activity to buy underprized item and sell at higher price to earn profit. These days futures index by the BSE and NSE are instrument used for arbitrage. Arbitrage opportunity exist whenever the future price goes up from the fair value. Fair value is current price plus holding cost where holding cost could be cost of financing plus storage, Insurance etc. For example, suppose a futures contract is traded on two different exchanges.
F = S + C where F = Futures price, S = Spot price and C = Holding
However if fair price is more than spot price plus holding cost or fair price is less than spot price plus holding cost, then arbitrage opportunity exists.
F > (S + C) or F < (S + C)
This means once the position is created, it becomes a hedged position and so it is not relevant whether the market moves up or down, one needs to only look at the difference in price when this position is created and the profitability when it is reversed.
[Image credit : flickr]
Types Of Arbitrage
Risk arbitrage is also known as merger arbitrage. A form of arbitrage which involves the simultaneous purchase of stock of a company which is expected to be taken over and selling shares to the acquiring company with the anticipation that market value will decrease, an investor hopes to gain from both sides of the trade. Or we can say buying the stock of the acquiree and selling to the acquirer to earn profit.
Conversion arbitrage an investment strategy in which an investor buys a put and writes a call for shares of stock already held. The put and call should have identical exercise prices and expiration dates. The execution of this type of arbitrage approach is understood to be relatively risk free for the investors.
Fixed Income Arbitrage
In fixed income arbitrage strategy, one seeks to profit from small differences in interest rates between two bonds or other fixed-income securities that are otherwise essentially the same. Fixed-income arbitrage rarely results in a large profit and can be quite risky.
Index arbitrage is a strategy designed to take profit from temporary discrepancies between the prices of the stocks comprising an index and the price of a futures contract on that index Or you can say an investment trading strategy that exploits divergences between actual and theoretical futures prices.
Market arbitrage is the process of taking advantage of differences in prices for the same commodity in different markets. However, the costs of buying and selling commodities can limit the actual profit made.
The opportunity lost when municipal bond issuers assume proceeds from debt offerings and then invest that money for a period of time (ideally in a safe investment vehicle) until the money is used to fund a project, or to repay investors. The lost opportunity occurs when the money is reinvested and the debt issuer earns a rate or return that is lower than what must actually be paid back to the debt holders.
Statistical arbitrage is a situation where there is a disparity between an asset’s "natural" price, based on its inherent value, and its actual market price. Some traders will attempt to take advantage of this disparity in the belief that they can profit when it is corrected.
Triangular Arbitrage is a process of taking one currency and converting it to another currency only to convert it back to original currency within short time spam. This method of forex trading is done to capitalize on gains in one currency versus another currency. This opportunity for riskless profit arises when the currency’s exchange rates do not exactly match up.