Arbitrage : Meaning, Work, Examples, Types, Benefits & Drawbacks

What is Arbitrage?

Arbitrage is a strategy that investors use while trading where they purchase an asset in one market and sell the same in a different market or stock exchange. This investing strategy helps the investors generate profit through an asset’s varying prices in different markets. Big institutions, hedge funds, and professional traders take advantage of this investing strategy to generate profit in large volume. Arbitrage is a practice where traders take benefit of market inefficiency. The person exercising this strategy is called an “Arbitrageur”.

Geeky Takeaways:

• Arbitrage is an investing strategy practiced by investors to generate high profits out of market inefficiency.
• It is one of the oldest approaches used in trading to take advantage of the price variation of an asset in different markets.
• It suggests purchasing an asset in one market and selling it in another at a high price.
• The difference between the purchasing and selling price of an asset is known as the “Spread”.
• There are various types of arbitrage which include pure, merger, and convertible arbitrage.

How Does Arbitrage Work?

1. Arbitrage trading exploits price inefficiencies in various markets. An investor can make a good amount of profit with no or very little risk by taking advantage of price differences between the two markets for the same asset.

2. To secure success in arbitrage trading, it is essential to have knowledge about the market and have the ability to adapt to the dynamic conditions of the market.

3. Risk management and proper execution are also essential for efficiently navigating the complexities of arbitrage trading. Traders must consider transaction costs and other expenses, as they can erode potential profits

4. The steps in arbitraging are as follows,

• Identification of Market Discrepancy: It is the foremost step where the trader scans various markets and identifies price differences between the markets. Traders identify the opportunity and grab it as early as possible with the motive of generating profit.
• Buying of Assets: After identifying the opportunity, arbitrageurs buy assets. In the financial market, assets are in the form of securities such as shares, bonds, etc. Arbitrageurs buy these assets on the market where these assets are undervalued. In simple terms, traders buy these assets at a lower price.
• Selling the Asset: As soon as the arbitrageur buys the asset, he sells the same asset in a different market at a higher price. By selling the asset at a higher price, he generates the profit which is equal to the difference between the buying and selling price of the asset.

Example of Arbitrage

1. For instance, shares of ABC company are listed on the National Stock Exchange (NSE) and New York Stock Exchange (NYSE). The share price on NSE is ₹350 and on NYSE it is listed at $40 per share. Assuming the USD/INR exchange is ₹80 per dollar then the share price of XYZ will be equal to ₹320. Now, the trader practising arbitrage would purchase shares of XYZ at ₹320 on NYSE and sell them at ₹350 on NSE. He will generate a profit of ₹30 per share. This was an example involving the stock exchanges of two different countries.

2. Arbitrage is prominent in the security market but it also happens in daily life. Suppose Mr A purchases 100 tickets of an event in bulk at ₹50 per ticket and then sells them at ₹60. With this, he earns ₹10 on each ticket which gives a total of ₹1000.

Types of Arbitrage

1. Pure Arbitrage: It is what is commonly known as ‘arbitrage’. Pure arbitrage is an investment strategy with minimum or no risk in which the investor takes advantage of market inefficiency. Here, the trader purchases the asset on one stock exchange where the price is lower and sells it on different exchanges where the price is higher. This occurs when an asset is being traded on different markets. The opportunities for pure arbitrage exist because market participants take time to gain and adapt to new information.

2. Convertible Arbitrage: Convertible arbitrage involves trading of convertible securities such as convertible shares and bonds. Arbitrageurs may buy convertible bonds and short-sell the underlying stock, creating a hedge. Profits are made from the price discrepancy between the convertible security and the stock.

3. Merger Arbitrage: Arbitrageur makes a profit through the difference in price of shares of a company during the process of merger or acquisition. It is considered that usually, the price of the shares of the company increases due to a merger of two or more companies or a takeover. A trader buys the company’s shares before the completion of a merger or acquisition and sells them after the completion of the process. It is also known as risk arbitrage.

4. Spatial Arbitrage: In spatial arbitrage, a trader uses geographical locations to exploit price inefficiency. An arbitrageur buys an asset from one location at a lower price and sells that asset at another location where the price of that asset is higher. With this, he gets the benefit of the amount equal to the difference between the buying and selling price.

5. Retail Arbitrage: Investors in retail arbitrage take benefit of price differences for products between different retail channels. This involves buying products from one retail source and reselling them at a higher price through another retail channel to make a profit.

Benefits of Arbitrage

1. Low Risk: It is an investing strategy using which an investor can make a good amount of profit with no or very little risk by taking advantage of price differences between the two markets for the same asset.

2. Efficient Markets: Arbitrage helps financial markets become more robust and efficient. It narrows the price gap between two different markets and ensures that prices across markets remain closely aligned.

3. Liquidity: Arbitrage invites institutional investors who play a key role in providing market liquidity. Arbitrageurs increase the trading volume and make it easier for other investors to buy and sell assets.

4. Cross-Border Investment: Generally, investors use international or cross-border markets for practising arbitrage. This helps in the integration of global markets and encourages cross-border investments.

5. Profit Opportunity: The main advantage of arbitrage trading is profit-making by exploiting the price inefficiency of the markets. Traders buy assets at a low cost and sell them in another market at a higher cost.

Drawbacks of Arbitrage

1. Transaction Cost: There is a high transaction cost linked to buying and selling assets that people usually ignore. Further, taxes are also applied to the income generated through the selling of the asset. Both of these elements lower the profit or sometimes result in loss.

2. Less Opportunity: In real life, there are very less opportunities for arbitrating because of the enhanced technology and awareness of the loopholes. To gain arbitrage opportunities, a trader should be highly active and expert in making transactions.

3. Market Risk: The market is never stable, it changes frequently. Arbitrage involves taking positions in different markets simultaneously. Changes in market conditions can expose arbitrageurs to market risk, leading to potential losses.

4. Capital Requirement: To take the benefit of the price difference of the markets, traders require a significant amount of capital. This can limit the accessibility of arbitrage strategies to smaller investors or firms with limited capital.

5. Technology: An arbitrageur should be highly active and must be aware of the current situation of the market. Mostly, arbitrageurs rely on technology for information and quick execution of the trade. Lack of technology or any glitch or system failure can hinder the execution process and the arbitrageur might lose the opportunity.

Conditions for Arbitrage

1. Asset Availability: In trading, the asset must be listed in two stock exchanges, which are to be considered for arbitrage trading. For instance, if a person is planning to purchase a share of ABC company on the National Stock Exchange and sell it on the Singapore Stock Exchange, he must make sure that the shares of ABC company are listed on both stock exchanges.

2. Price Difference: To practice arbitrage, there must be a difference in the price of an asset in two different markets. Without price difference, there would be no profit generation.

3. Simultaneous Transaction: Arbitrageur should carry on trading of shares simultaneously in different markets to capture the price difference. The period for which the price inefficiency occurs is very short, hence, the trader should complete the transaction as early as possible to gain a profit.

Trading with Arbitrage

• Trading with arbitrage is mainly done by large institutions, hedge funds and professional traders, who take advantage of this investing strategy to generate profit in large volume. Arbitrage trading is a great opportunity to make a profit with very low risk.
• With the advancement of technology, traders can quickly buy and sell securities online which ultimately has improved the efficiency of the market. This has reduced the period of price difference of an asset and led to a lack of arbitrage opportunities.
• In India, there are two recognised stock exchanges are National Stock Exchange(NSE) and the Bombay Stock Exchange(BSE). The securities of the companies are listed in these two exchanges.
• However, the Securities Exchange Board of India(SEBI), the regulatory body of the secondary market, does not allow arbitrage trading. It means that traders can not purchase security from one market and sell it on the other on the same day. Hence, it is not easy to get involved in arbitrage trading in the Indian market.

Conclusion

• Arbitrage is a condition where you can buy and sell the same asset simultaneously at different prices, resulting in a risk-free profit. With various advantages, it also has some downfalls.
• Trading with arbitrage is mainly done by large institutions. However, in real life, there are very less opportunities for arbitrating because of the enhanced technology and awareness of the loopholes.
• It is an investing strategy using which an investor can make a good amount of profit with no or very little risk. While practicing arbitrage, the availability of capital is a key aspect to generating more profit and exploiting the price inefficiency in a better way.
• Moreover, efficient utilisation of advanced technology, and ability to adapt to the dynamic conditions of the market. , as well as the use of analytical tools are also some of the essentials for generating high-profit margins.

Frequently Asked Questions(FAQs)

What is arbitrage?

Arbitrage is a strategy that investors use while trading where they purchase an asset in one market and sell the same in a different market or stock exchange.

Why do price discrepancies occur in markets?

Price discrepancies occur due to various factors such as geographical differences, time lags in information dissemination, currency exchange rate variations, market inefficiencies, etc.

What types of Arbitrage are there?

There are various types of arbitrage such as pure arbitrage, merger arbitrage, retail arbitrage, spatial arbitrage and convertible arbitrage.

Is Arbitrage risk-free?

While arbitrage is often considered a low-risk strategy, it is not entirely risk-free. Market conditions, transaction costs, slippage, and other factors can impact potential profits.