The ChoosaBroker Trading Academy
Textbook arbitrage trading requires no capital and carries no risk. But in practice, both of these assumptions are incorrect. Arbitrage as a strategy is not tailor-made for retail investors. But that does not imply that you don’t need to understand the underlying concepts. Arbitrage is one of the fundamental notions of modern finance. Every serious student of the market requires some knowledge of the principles and the people involved. In this lesson, we will learn:
Who is an Arbitrageur?
Arbitrageurs are traders and investors who seek to capitalize on the inefficiencies in price of a financial asset by executing simultaneous trades that offset one another and theoretically result in “risk-free profits.” The term “arbitrageur” is derived from the French word “arbitre,” which usually means umpire or referee. Mathematician Mathieu de la Porte was the first to use it in the financial market context in his 1704 treatise ” La Science des Negocians et Teneurs de Livres.”
Arbitrageurs play an important role in the operation of financial markets, as their efforts to exploit price anomaly forces asset prices to return to their perceived market value. In its simplest form, arbitrage involves the simultaneous purchase and sale of an instrument in different markets. The assets that typically lend themselves to such opportunities include stocks, bonds, commodities and foreign currency pairs. An arbitrageur would, for example, try to profit from the price discrepancies in a stock that is listed on more than one exchange by buying the underpriced shares on one exchange while concurrently shorting the exact same number of overpriced shares on another exchange, thus netting risk-free profits as the stock prices in the two markets converge.
Conditions Necessary for Arbitrage
According to the Efficient Market Hypothesis, during normal market conditions, arbitrage opportunities can’t exist. However, this gave rise to Grossman and Stiglitz’s “arbitrage paradox” that states that if arbitrage is never observed, participants won’t have enough incentives to track the markets, in which case arbitrage opportunities would eventually appear. Conditions for arbitrage arise in practice because of market inefficiencies. During such periods, assets can be mispriced primarily due to asymmetric distribution of information.
Arbitrage is feasible when any one of the below three conditions is met:
- The same instrument does not trade at the same price across two markets.
- Two instruments with equivalent cash flows are not available at the same market price.
- An instrument with a known future price does not currently trade at the future price that discounts the risk-free interest rate.
When the same asset does not sell for the same price in all locations, an arbitrageur will:
- Purchase the asset from the market where it is priced lower, and simultaneously short on the market that offers a higher price, or
- Buy the physical good from the cheaper market and deliver the asset to a buyer in the market tendering a higher price.
Types of Arbitrage Trades
Arbitrage encompasses a large number of strategies. Let us examine six of the most commonly-employed arbitrage techniques.
- Merger Arbitrage Merger arbitrage is a popular event-driven strategy and consists of buying the stock of a company that is the target of a takeover while short selling the stock of the acquiring company. In the presence of uncertainty that a merger might fall through, the target company can trade at a discount to the takeover price being offered. The spread between these two prices is the arbitrageur’s potential profit.
- Geographical Arbitrage When an arbitrageur seeks to profit from price differences in geographically disparate markets, it is referred to as geographical or spatial arbitrage. For example, a bond dealer in Chicago might be offering a bond at 100-10/23, while a dealer in New York is bidding 100-12/23 for the same bond. An arbitrageur spots the discrepancy and simply buys the bond from the Chicago dealer and sells it to the New York dealer.
- Cash-and-Carry Arbitrage In cash-and-carry arbitrage, an arbitrageur attempts to exploit pricing inefficiencies in the spot (or cash) market and the futures markets. It involves the purchase of a long position in a stock or a commodity, and the simultaneous short sale of a futures contract for the same underlying stock or commodity. In theory, the futures contract has to be priced relatively higher than the underlying asset for the arbitrage trade to yield a profit.
- Liquidation Arbitrage The infamous “Gordon Gekko” in Oliver Stone’s 1987 movie “Wall Street” employed this strategy when he purchased and sold off companies on the verge of liquidation. For example, suppose Company X is staring at liquidation. It has a book value of $10 per share but is currently trading at $8 per share. In Gekko’s case, he would buy companies that he reckoned would generate a profit if he broke them in to parts and sold them independently – a practice widely employed in reality by institutional investors.
- Relative Value Arbitrage Also known as “pair trading,” this arbitrage strategy was pioneered by Gerry Bamberger at Morgan Stanley in the 1980s. It is market-neutral and relies on matching a long position with a short position in a pair of highly correlated assets such as two stocks, currencies, exchange-traded funds or commodities. Arbitrageurs wait for correlation between the two instruments to temporarily weaken, and then go short the over-performer, while simultaneously buying the under-performing asset. The position is closed once the correlation between the two instruments returns to its statistical norm.
- Cross-Broker Arbitrage This is probably the simplest form of Forex arbitrage, whereby a trader tries to profit from the price differential between two brokers or dealers. To implement this strategy, you need at least two separate trading accounts. Since foreign currency markets are non-centralized, differences in quotes may surface depending on who is making the market. A trader can profit from this mispricing.
Risks in Arbitrage Trading
In principle, an arbitrage is risk-free. But in practice, certain risks do tend to exist. Let us look at some of the factors that contribute to the uncertainty.
- Execution Risk – Since pricing mismatches typically exist for very brief periods of time, successful arbitrage demands rapid execution. If your trading platform is slow or if you delay in entering the trades, the window of opportunity is lost. Most professional arbitrageurs use automated software that greatly expedites the trade execution process.
- Liquidity Discount – When an arbitrage opportunity presents itself, the price anomaly might not always boil down to some demand-supply mismatch. It can also arise due to vastly divergent liquidity conditions in the two markets under consideration. An asset may trade at a discount in a less liquid market, in which case, the price differential is a liquidity discount.
- Counterparty Risk – Since arbitrages often involve future movements of cash, they are susceptible to counter party risk or default risk. In the event of a financial crisis, a counter party in an arbitrage trade may not be able to live up to their end of the transaction, turning the entire process in to one big loss-making exercise.
- Competitive Risk – Competition in the marketplace also has the potential to generate risk during an arbitrage transaction. For example, if an investor trying to profit from a price discrepancy in shares of IBM on the New York Stock Exchange and the London Stock Exchange, buys a large block of shares on the NYSE and then finds that he cannot simultaneously short sell on the London bourse, he is left stranded with a big unhedged risk position.
- Final Words Arbitrageurs play a key role in making markets more efficient. The trades in themselves have the effect of causing prices in different markets to converge. However, since the past decade or so, financial markets have become pre-dominantly computer-run, resulting in arbitrage opportunities becoming fewer and harder to exploit for the average, retail trader.