What are the Benefits of Arbitrage?
To understand arbitrage in right earnest, one must understand the arbitrage benefits and the arbitrage advantages. What exactly are the arbitrage benefits to the trader or the arbitrageur? You can talk about arbitrage benefits for the market or the arbitrage advantages for the financial system as a whole. But, how do the arbitrage benefits work for the trader in question?
We dwell at length on the various advantages of arbitrage; both from the perspective of the trader or arbitrageur as well as from the perspective of the market mechanism as a whole. For many large institutions that are starved for returns, arbitrage is a golden opportunity. Consider a typical foreign portfolio investor or FPI. For them, the cost of funds in most Western markets is lower than 2%. These funds can typically earn close to 8-10% annually on arbitrage in India. That is a huge spread even if you consider the currency risk, which can anyways be hedged for a small cost. These are the rather unknown advantages of arbitrage in the Indian markets.
Advantages of Arbitrage
Before getting down to understanding the advantages of arbitrage, let us spend a moment understanding arbitrage at a conceptual level. Arbitrage is a very popular strategy in finance with the help of which an individual or a trader or an arbitrageur can make a risk-less profit. What is important is that this risk-less profit can be made merely by taking advantage of the price difference between the two markets of the same security. Some even call this price inefficiency but it means the same thing. In short, it happens when the law of one price gets violated. Now let us move to the advantages of arbitrage for the investors in particular and the markets in general.
How arbitrage can add value to traders and markets?
Let us enumerate 5 very important advantages of arbitrage, which will clarify the importance of the concept in no uncertain terms.
- The biggest benefit of arbitrage is that the risk element is next to nil or at least close to zero. You can grasp this with the help of an example. Let us take the case of a company with multiple listings of its stock. If the company is listed in New York and London and prices are different, here is how the arbitrage come about.
- Assume that in the NYSE market it trades at $100 and in the London market it trades at €160 and the exchange rate is assumed to be $1 = €2. Ideally, you can figure out that the stock should be trading in London at €200. Now a person thinking of doing arbitrage would sell stock in the New York market and buy the same stock in the London market. Here the gap of Rs.40 becomes riskless profit or arbitrage profit. Currency risk persists.
- Arbitrage helps in keeping prices of securities across different markets and different market segments more or less in sync with gaps just explained by differential transaction costs. Therefore, you can say that arbitrage helps in better price discovery of an asset and also virtually eliminates price variances across different markets.
- Arbitrage helps in making the financial markets more efficient and robust. Now for example, if there were no arbitrageurs in the markets then stocks would have kept trading at different prices in different markets. This would put a handful of traders at an unfair advantage. In other words, arbitrage ensures that the confidence of investors in the integrity of the stock market is not damaged.
- Lastly, arbitrage makes markets more liquid as it invites institutional participation and the use of sophisticated technology.
What is Arbitrage?
Arbitrage can be defined as the simultaneous purchase and sale of the same asset in different markets. The idea of an arbitrage trade is to profit from tiny differences in the asset's price. In a nutshell, arbitrage exploits short-lived variations in the price of identical or similar financial instruments across different markets, different maturities, different strokes, different related assets, etc. Not all arbitrage is risk-free, but it does contribute in a big way to making markets efficient. Arbitrage exists as a result of market inefficiencies and it both exploits those inefficiencies and resolves them.
In short, there are some key takeaways from arbitrage. Firstly, arbitrage is the simultaneous and synchronized purchase and sale of an asset in different markets to exploit differences in prices using technology-driven execution. Secondly, arbitrage trades are made in stocks, commodities, and currencies. In short, arbitrage is asset agnostic. Lastly, arbitrage takes advantage of the inefficiencies in markets and makes small profits on large volume trades
Different Types of Arbitrage
Some of the popular types of arbitrage can be summarized as under:
- Cash-futures arbitrage
- Statistical arbitrage
- Convertible arbitrage
- Fixed-income arbitrage
- Political arbitrage
- News based arbitrage
- Triangular arbitrage
- Risk-based arbitrage
- Macro arbitrage
- Volatility arbitrage
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Frequently Asked Questions
In order to take advantage of an arbitrage opportunity, you need to go beyond predicting trends. In other words, in order to make arbitrage trading decisions, you must be able to see and act on the interplay of market demand, capacity, product availability. It is very important to understand pricing and relationships to be a good arbitrageur.
Arbitrage is not only good but also essential as it makes the market more efficient, smoother and safer. It also adds to liquidity in cash and futures market.
Of course, arbitrage is ethical. It is just about capitalizing on pricing inefficiencies using algorithms and low latency trading. There is nothing unethical about it.