Arbitrage refers to the practice of the purchase and sale of securities in different markets with differences in the price of the same security. Arbitrage is based on the concept of inefficiency in the market.
It makes use of the short-lived variation and generates profits by purchasing security from the market quoting security at a lower price and selling in the market at higher selling prices. The investors carrying out the arbitrage activities are called arbitragers.
The arbitrage trade is usually carried in stocks, currencies, and commodities. That’s an example of making profits without presuming the risk of a trade.
Following are the requirements for carrying out the arbitrage,
- Perfect information is required to carry out successful arbitrage activity.
- The sale and purchase of the securities need to be made instantly.
- The transaction cost should be lower for the purchase of an asset or at least lower than the profit made by the arbitrage activity.
- The transaction cost should be lower for the purchase of the exchange of the currency.
Equilibrium and purchasing power parity theory
If the markets are in equilibrium there is no difference in the prices of the security, this means the markets do not provide the opportunity to make profits and is said to be in equilibrium. So, arbitrage can only be exercised in times the market faces inefficiency.
Similarly, the purchasing power parity theory states that the prices of the products in one country are probably equivalent to the price of the commodity in another country.
If the markets are under equilibrium as the price of the commodities are similar in line with purchasing power parity there is no opportunity for arbitrage.
Arbitrage execution and risk
The execution of the arbitrage is considered to be risk-free activity. However, in practice, it’s not possible to remain 100% risk-free and earn profits. So, there may be the following risks arising in the execution of the arbitrage activity.
- The sale and purchase transactions might not be at the same time and there may be some gap in the time. The prices might fluctuate in the gap and leading to loss rather than profit.
- The transaction price might be higher than the profits earned from the process of arbitrage leading to a loss on the transaction.
Why arbitrage is important?
Arbitrage is important to encourage liquidity in the market. This activity increases the volume of sales and purchases within the market.
In addition to this, when arbitragers buy the high price security from the market it’s sold and the lower price security bids up. Hence, the overall efficiency of the market increases, and the difference between identical assets narrows.
Types of arbitrage
The arbitrage strategy surrounds around following forms.
Locational arbitrage is when an investor makes use of a minor difference in the exchange rate of two financial institutions.
It’s based on the idea of buying from one bank and selling to other banks in a way that creates profitability for the investors.
The difference can be between the two banks, locations, the market, etc. The opportunities for this type of arbitrage are lower as it’s a straight difference in the prices and there must be some cost of exchange charged by the banks to get currency exchange.
However, these types of arbitrage are rare in the real world and very difficult to find.
Triangular based arbitrage
The triangular arbitrage is a little complex and involves the sale and purchase of the three different currencies. The concept of the arbitrage is same as it takes into account the little discrepancies in the rate of exchange.
For instance, the investor may sell and purchase currencies including US dollars, CAD dollars, and GBP. There may be little discrepancies in the exchange rate of these currencies leading to risk-free profit for the investors.
Interest coverage arbitrage
The interest coverage arbitrage complex mode of earning risk-free profit. It involves investing in the currency with a higher rate of interest and hedging for the adverse fluctuation/devaluation of the currency.
For instance, if the interest is higher in the GBP than in USD. The funds in USD can be converted into GBP for earning a higher rate of interest. The risk of adverse movement by exchange rate can be hedged by a forward contract.
Advanatges of arbitrage
The following are some of the advantages affiliated with the arbitrages.
- The activity of the arbitrage is free from the risk, the only thing required to make a profit is information about the markets. However, the information needs to be reliable and actions need to be taken instantly.
- The arbitrage activity does not require the capital for a longer time and frees up the capital instantly. So, there is no greater risk for the capital tied up for a greater time.
Disadvantage of arbitrage
The following are some of the disadvantages related to the arbitrages.
- The cost of the transaction may be higher enough to turn the profit in the loss.
- The profit arising from arbitrage is not expected to be higher.
- The arbitrage funds may not produce sufficient profits in the stable market.
- If the investor does not act quickly on the available information to sell the security it may have to face loss.
- If the investor is not able to find sufficient arbitrage opportunities, the available funds might be turned into bond funds which may not produce sufficient profit in comparison with the long-term managed funds.
Overall, arbitrage opportunities are limited in the modern world today as it is very difficult to exploit the opportunity created by the mispricing in the market.
The market has a computerized trading system with the capability to monitor the price of the commodity in similar financial markets around the world.
Even if there is some slight difference in the pricing of the commodity it’s immediately identified by the system and eliminated.
Further, extensive market research is required to ensure profitability by arbitrage and it might be less risk but it’s full of sensitivity requiring active monitoring of the financial markets.