Arbitrage is an investment approach in which an investor buys an asset in one market and sells the same asset on a different market at the same time. With a significant volume of transactions, even the tiniest price changes can have a big impact. Hedge funds and other experienced investors frequently use arbitrage to their advantage.
The concept of riskless profit motivates arbitrage, which is the practice of earning profits by leveraging price disparities between markets. If you employ arbitrage in its purest form, it can be as simple as purchasing an asset for less than its real value in one market and selling it for more than its value in another place. Having said that, it is a costly investment strategy that requires a lot of money and many trades to earn a good return.
Indeed, markets rarely run as effectively as they could in a perfect world of theory; nonetheless, price discrepancies are often minor, making it difficult to find profitable arbitrage opportunities.
Large financial organizations often stand a better chance at employing arbitrage. This is because it requires a substantial investment of time and money to locate and execute trades. To find similar assets, they are frequently accomplished with the assistance of complicated financial structures, such as derivative contracts and other kinds of synthetic instruments.
These requirements are the core requirements of arbitrage:
- Price variations in an asset: A price differential in an asset can take a variety of shapes and sizes. For example, an identical asset may trade at different prices in different markets, or a disparity in the pricing of assets with similar cash flows may exist between two or more markets.
- Variations between current market prices and futures prices: It is also not uncommon for an asset in the current market with an established future price to trade at a price that is different from the projected value of future cash flows.
- Simultaneous transactions: To take advantage of price disparities, it is necessary to make simultaneous purchases and sales of the same or similar assets. Because of this, the investment is subject to significant risks if an investor fails to close out the transactions at the same time.
Types of arbitrage
Arbitrage operates on the principle of leveraging market inefficiencies. Nonetheless, it comes in different forms, as discussed below. Primarily, these strategies differ depending on the different types of markets applicable.
As described above, true arbitrage is all about leveraging price variations in markets in their purest form. In simple terms, it exploits market inefficiencies by exchanging two assets of identical value at different prices. However, as technology has progressed, it has become increasingly rare to find markets with inefficiencies that allow for actual arbitrage.
Investors trade risk arbitrage when the market expects a rise or fall in the value of an asset due to a shift in market fundamentals.
For instance, this can involve the currency of a commodity-dependent economy such as Australia. The country may find itself in a long-term trade tiff with its biggest market, China. If you go long on the Australian dollar as a result of a temporary lifting of trade barriers by China, you are taking a risk. However, you also stand to make substantial profits. However, if negotiations between China and Australia bear no fruit, then your long position on the aussie could result in losses if China reinstates the barriers.
At any given time, we have different interest rates across different countries. For example, UK interest rates might be among the lowest globally. Buying GBP and taking out loans from UK financial institutions becomes more attractive. This can then be leveraged by depositing the borrowed money in countries with high interest rates, making a profit.
For instance, you may borrow a loan from a UK bank at an interest rate of 0.25% and deposit it in a Canadian bank offering a yield of 1.25%. In such a situation, you will earn a profit equivalent to the difference in the two rates (1%-0.25%). Note that, you will only realize a profit if the GBPCAD exchange rate doesn’t change significantly during the lockup period.
Because of its high liquidity, the currency market has many arbitrage opportunities. Eventually, arbitrage has become a common practice in the forex market.
To maximize your gains, though, you’ll need access to margin, specialist analysis tools, as well as access to real-time currency price data.
Forex calculators assist traders in determining the potential reward and risk of different arbitrage methods in the forex market. They can also estimate the profit with greater accuracy.
When traders profit from price disparities in the money markets, they engage in currency arbitrage.
An investor will acquire a currency and subsequently short sell it in the futures market on this approach. For a single currency pair, a trader can leverage the wide range of spreads on offer by different brokers on the market.
You can also profit from different spreads by adjusting your bid and ask prices to take advantage of the varied rates.
Let’s take an instance where your broker quotes the ask price for GBPUSD at 1.4345. At the same time, your local over the counter market has an bid price of 1.4350 on the pair. Assuming you bought a standard lot of $100,000, from the broker and sold , you would make a profit of:
($100000/1.4345)-($100,000/1.4350)= 69710.70-69686.41= $24.29
The profit may seem small, but considering that you would make it without taking any risk and without breaking a sweat, it is certainly worth it. Also, remember that this is a profit realized within a few minutes.
Arbitrage opportunities exist when there are price disparities across asset classes. Arbitrage is the practice of purchasing an asset on one market and then selling it on another in order to make a quick profit. The Efficient Market Theory argues that an asset with equal risk and returns should fetch the same value in all markets. This strategy takes advantage of this assumption by comparing the prices of the same security or asset in multiple markets.