Arbitrage is the process where there is simultaneous purchase and sale of an asset in order to profit from a difference in the price of the similar financial instruments, on different markets or in different forms. A person who engages in this type of trading is called an arbitrageur. The term is applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and also currencies.
Just an act of buying a product in one market and selling it in another for a higher price at some later time is not arbitrage. Arbitrage is when the transactions occur simultaneously to avoid exposure to market risk, or the risk assumed that prices may change in one market before both transactions are complete. In practical terms, this is only possible with securities and financial products which can be traded electronically.
For example; this type of price arbitrage is very common, but it ignores the cost of transport, storage, risk, and other factors. "True" arbitrage is when there is no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one exchange and selling on the other.
Arbitrage is possible when any one of the below three conditions is met :
- The same asset should trade at the different price on all markets
- Two assets with identical cash flows should not trade at the same price.
- An asset having a known price in the future does not trade today at its future price discounted at the risk-free interest rate.
Arbitrage Trading Program (ATP) is a program used to place simultaneous orders for stock index futures and the underlying stocks. Outward Arbitrage is a form of arbitrage which involves the rearrangement of a bank's cash by taking its local currency and depositing it into euro banks. The interest rate will be higher in the interbank market that will enable the bank to earn more on the interest it would receive for the use of its cash.
Types of arbitrage
Following are the major types of arbitrage;
- Merger arbitrage
- Convertible bond arbitrage
- Statistical arbitrage
- Covered interest arbitrage
- Uncovered interest arbitrage
- Regulatory arbitrage
- Triangle arbitrage
- Telecom arbitrage
- Political arbitrage
- Fixed income arbitrage
- Volatility arbitrage
Merger arbitrage generally consists of buying the stock of a company which is the target of a takeover while shorting the stock of the acquiring company. Usually the market price of the target company is less than the market price of the acquiring company. The spread between these two prices depends mainly on the probability and the timing of the takeover being completed and also the prevailing level of interest rates. It is also known as risk arbitrage.
Convertible bond arbitrage
An investor holding a bond can return it to the issuing company in exchange for a predetermined number of shares in the company, and this is called as convertible bonds. The price of a convertible bond is sensitive to certain major factors as below,
When prices rise, the bond part of a convertible bond tends to move lower, but the call option part of a convertible bond moves higher.
When the price of the stock the bond is convertible into rises, the price of the bond tends to rise.
If the creditworthiness of the issuer deteriorates while widening its credit spread, the bond price tends to move lower, but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility).
An arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value because of complexity of the calculations involved and the convoluted structure that a convertible bond.
In this kind of arbitrage, the arbitrageurs take the advantage of the differences in anticipated values by capitalizing on the relationship between price and liquidity.
Covered interest arbitrage
When a financial instrument or security is bought by an investor in the denomination of a foreign exchange or foreign currency, and the foreign exchange risk is hedged through the sale of a forward contract in the sales proceeds of the financial instrument again in the home currency, then it is said to be covered interest arbitrage.
Uncovered interest arbitrage
In this case funds or money are sent to another country for availing the benefit of increased interest rates in forex agencies.
A regulated organization which avails the benefit of the deviation between the regulatory positioning and the economic or real risk is known as a Regulatory arbitrage.
The process of converting one currency to another with a view of converting it again to a third currency and, finally, converting it back to the original currency within a short time span. This opportunity for riskless profit arises when the currency's exchange rates do not match. Triangular arbitrage opportunities happen seldom and when they do, they only last for a matter of seconds. Traders who take advantage of this type of arbitrage opportunity usually have advanced computer equipment and/or program to automate this process.
It is an arbitrage strategy utilized by Telecom arbitrage organizations, such as Action Telecom UK.
The approach where political knowledge or calculations about the future are implemented for discounting and forecasting values of securities is known as Political arbitrage
Fixed income arbitrage
It is a kind of arbitrage which is primarily related to hedge funds.
It is also known as vol arb and is a kind of statistical arbitrage. It is used with the help of buying or selling of a delta neutral option portfolio and the underlie of the portfolio.