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Arbitrage refers to the practice of taking advantage of a difference in prices in two or more markets to make a risk-free profit. It involves simultaneously buying an asset in one market and selling it in another market at a higher price.
The key aspects of arbitrage are:
- Taking advantage of price differences: Arbitrageurs identify situations where the same asset is priced differently in different markets.
- Simultaneous buying and selling: Arbitrageurs buy the asset in the lower-priced market and immediately sell it in the higher-priced market. This ensures they lock in a profit.
- Aiming for risk-free profit: True arbitrage is considered a risk-free transaction, as there is no market risk involved. The profit is the difference between the buy and sell prices.
Arbitrage helps improve market efficiency by causing prices in different markets to converge. It reduces price discrimination and moves currencies towards purchasing power parity.
Some common types of arbitrage include:
- Retail arbitrage: Buying a product in one market and reselling it in another for a profit.
- Simple arbitrage: Simultaneously buying and selling the same asset on different exchanges.
- Merger arbitrage: Betting on the successful completion of a merger or acquisition.
- Triangular arbitrage: Exploiting price differences across three currency pairs in the FOREX market.
While arbitrage opportunities exist, they are often short-lived as markets quickly adjust to eliminate the price discrepancies. Factors like transaction costs and market inefficiencies can limit the ability to execute profitable arbitrage trades.
Types
Here are the key types of arbitrage:
- Forex Arbitrage: This involves simultaneously buying and selling the same currency pair in different markets to profit from the price difference. For example, buying EUR/USD in one market and selling it in another at a higher price.
- Convertible Arbitrage: This involves buying a convertible security (e.g. convertible bond) and short-selling the underlying stock. The arbitrageur profits from the price differential between the two.
- Merger Arbitrage (Risk Arbitrage): This involves buying the stock of a company that is the target of a takeover, and short-selling the stock of the acquiring company. The arbitrageur profits if the deal goes through and the target company's stock price rises.
- Dividend Arbitrage: This involves buying a stock just before its ex-dividend date and selling put options on that stock, profiting from the difference between the stock's price and the option premium.
- Statistical Arbitrage: This uses complex statistical models and algorithms to identify and exploit small pricing discrepancies across different securities or markets.
- Retail Arbitrage: This involves buying products at a low price from one retailer and reselling them at a higher price on an e-commerce platform.
The key to arbitrage is identifying and quickly capitalizing on temporary price differences for the same asset across different markets or instruments, with minimal risk.
Risks
Here are the key risks associated with arbitrage:
- Deal Risk: The biggest risk in arbitrage is that the deal being speculated on may not go through. If the merger or acquisition is not completed, the arbitrageur can suffer significant losses as the target company's stock price will likely fall back to pre-deal levels.
- Pricing Discrepancies: Arbitrage opportunities arise due to temporary pricing inefficiencies between markets. However, these discrepancies are often short-lived as markets quickly adjust to eliminate them. Arbitrageurs may not be able to execute trades fast enough to capitalize on the price differences.
- Uncertain Timeline: mergers and acquisitions can take months or even years to complete. The arbitrageur's capital is tied up during this uncertain period, leading to opportunity costs. derivatives used in arbitrage also have expiration dates that may not align with the deal timeline.
- Leverage Risk: Arbitrage trades often involve leverage to magnify potential profits. However, this also amplifies losses if the trade goes against the arbitrageur. Overleveraging can lead to significant losses.
- Tracking Difficulty: It can be challenging for arbitrageurs to stay on top of all the latest developments around mergers and acquisitions. Inaccurate or incomplete information can result in poor trade execution.
- Overpriced premiums: Sometimes the acquiring company may overpay for the target, leading to a drop in the acquirer's stock price if the deal fails. This can result in losses for the arbitrageur who has shorted the acquirer's stock.
- Market Volatility: Arbitrage returns can be sensitive to overall market conditions. During market downturns, arbitrage strategies may suffer losses even if the specific deal being traded is successful.
Here is the key difference between positive and negative arbitrage:
Positive Arbitrage: This occurs when a borrower invests the proceeds of a tax-exempt obligation (such as a bond) in investments that have a yield above the tax-exempt obligation yield. This allows the borrower to profit from the difference in yields. If the borrower is not subject to federal income tax, the value of positive arbitrage increases as they do not owe taxes on the investment earnings.
Negative Arbitrage: This occurs when the cost of borrowing money is higher than the return earned on investments made with the borrowed funds. For example, if a borrower issues bonds at a 6% interest rate but can only earn 4.2% on the invested bond proceeds, they are experiencing negative arbitrage and incurring a 1.8% opportunity cost. Negative arbitrage can result from interest rate changes, market inefficiencies, or intentional strategies to leverage investments.
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