What is Difference Between Arbitrage and Hedging
Arbitrage is about capitalizing on price differentials between markets while hedging is about reducing risk through offsetting positions. This arbitrage vs hedging debate has often come and there has been no resolution to this arbitrage vs hedging debate as both are meant to be used in different circumstances. Today, we will understand the basics of this arbitrage vs hedging discussion and apply it to regular trading.
Have you ever wondered about the difference between arbitrage and hedging? One is meant to capitalize on price differentials or pricing inefficiencies and that is arbitrage. However, hedging is meant to reduce risk by taking a counter or offsetting position in the market. Here is how the two activities work.
Difference Between Arbitrage and Hedging
At the outset, it must be remembered that both hedging and arbitrage play important roles in capital markets in discovering prices, reducing risk, and making profits. But what is the difference between arbitrage and hedging? Hedging involves the use of more than one concurrent and simultaneous bet in opposite directions in different markets or the same markets with different segments. It is an attempt to limit the risk of serious investment loss by agreeing to take huge positions for limited risk and limited return.
To understand the difference between arbitrage and hedging, let us consider an example. Tata Steel is quoting in the cash market at Rs.1250 and in the futures market at Rs.1260. So, you can effectively buy in the cash market and Rs.1250 and sell in the futures market at Rs.1,260. The difference of Rs.10 is your assured profit. You earn 0.79% in a month, which if annualized would be closer to 9.7%, which is a good rate of return on a risk-free approach like arbitrage.
Let us now focus a bit more on the hedging side of the story
To understand the difference between arbitrage and hedging, you must also understand how hedging is positioned. In reality, hedging is not the pursuit of risk-free trades. Instead, it is an attempt to reduce known risks while trading. Classic examples of hedges are contrary options contracts, contrary forward contracts, swaps, etc. These are hedging products that do not add to your reduction but make your trade more palatable by reducing the known risk. In hedging, the trader does not make big profits but she can better define worst-case losses and best-case returns and create a trade-off between the two.
What is Brokerage is Charged On Arbitrage?
Normally, brokerage on arbitrage is charged at concessional terms and that is normally part of the agreement itself. That is because arbitrage is a high volume and low margin business and if the brokerage rates are very high then the trade would not be profitable. Hence the brokerage is normally kept at a very low level like a typical futures or options trade so that the trade can be profitable. A typical cash futures arbitrage trade gives an annualized return of around 8-9% with monthly rollovers. Hence, the brokerage has to be very low.
Normally, the round-tripping brokerage on an arbitrage initiation and the arbitrage unwind put together must not be more than 0.25% of the trade to be profitable. This includes the statutory charges payable on both sides of the trade. Most of the trades of arbitrage are algorithmic trades and are charged brokerage like a typical low latency trade. The focus of arbitrage trades has to be low latency trades with a low brokerage.
Use of Speculation
One of the major questions to be answered is whether speculation is necessary for a market and does it contribute to the market mechanism or the market liquidity. The reality is that speculators are prevalent in the markets where price movements of securities are highly frequent and volatile. However, the important role that they play is that they often double up as market makers or liquidity creators. How exactly does this work?
For example, when you keep speculating in the markets with small spreads, the order book gets filled up with a plethora of trades and encourages the more serious players to also participate in the market with the additional liquidity created with their two-way quotes. These speculators play a very important role in the markets by absorbing excess risk and providing much-needed liquidity in the market. That is because the speculators are generally direction agnostic and are indulging in the market by buying and selling even when other investors don't participate.
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Frequently Asked Questions
Hedge funds do a variety of routine arbitrage like cash-futures and inter-market arbitrage. However, they are also into some very advanced macro arbitrage strategies. Here is an example of how hedge funds leverage on such macro arbitrage strategies. This is quite popular among higher risk players like hedge funds. Here are is a look at types of macro arbitrage strategies. Here is a look at 3 such strategies.
- Risk arbitrage or Merger Arbitrage is one of the common trades in capital markets. This strategy entails buying stocks that are in the process of a merger or acquisition or amalgamation. Merger arbitrage is popular among hedge funds with a higher risk appetite. They buy the target company’s stocks and short-sell stocks of the acquirer. Such strategies are normally leveraged using futures.
- Convertible arbitrage is another extremely popular arbitrage strategy. The convertible arbitrage involves buying a convertible security like a partially convertible debentures or a full convertible debenture and short-selling the underlying stock, when there is mispricing visible.
- One of the most popular forms of arbitrage in the modern world is what is popularly referred to as statistical arbitrage. This is an arbitrage technique that entails complex statistical models to decipher trading opportunities across different market prices. Those models are popularly called mean reversion strategies where you bet on prices and trends coming back to normal after significant deviations
It is the other way round. Hedging is not risky but it is meant to control or reduce the risk in a transaction. Hedging is a risk management strategy employed to offset losses in investments by taking an opposite or a contrary position in a related asset or a similar asset of a different maturity or strike. The reduction in risk provided by hedging also typically results in a reduction in potential profits as a trade-off but it makes the strategy more valuable to the trader by reducing the risk component. However, there are some cases wherein traders create hedges and then close and book profits on one leg of the hedge. Such strategies can be fairly risk because you convert a hedged transaction into an unhedged transaction.
Neither arbitrage nor hedging is meant to be extremely profitable. Of the two, normally, arbitrage is meant for small profits on large volumes. However, hedging is purely meant to reduce your risk of an open position in the market. It is not meant to be return enhancing but only risk reducing.