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Arbitrage trading making money risk free

Arbitrage trading is one of the least understood and used strategies in


financial markets. This is strange considering arbitrage trading is almost risk
free. There are multiple ways in which one can make money through arbitrage
trading in various segments of financial markets. However, there are
important operational issues that one should be careful about while getting
into arbitrage trading.

What is arbitrage trading?

Theoretically, there should not be any sustained opportunity for arbitrage
trading because for arbitrage opportunity to emerge, prices of same
commodity need to differ in different markets at the same time, which is not
feasible according to the law of single price, which states that in a competitive
environment, assets with same risk and return profile should sell at the same
price. Hence, same asset cannot sell at different prices at different markets.
Any difference would be a temporary phenomenon and speculators would
wipe out any difference by buying in cheaper market and selling in costlier
market. This temporary aberration is what presents arbitrage opportunity and
is exploited by traders.

In simplest terms, arbitrage is the process of making profit from the price
differential of same assets or instruments with same underlying assets in two
or more markets. Now, because trade is carried simultaneously at different
markets, theoretically there is no risk. In its simplest form, it works in this
way a trader spots the price difference of an asset in two markets, he buys the
asset in the market where price is lower and simultaneously sells the asset in
the expensive market, pocketing the difference. In plain vanilla form, same
asset can have different prices in two markets say, !"# and N"#. However,
there are many other ways in which price differentials in assets or indices can
be exploited in cash or derivative markets. At any given point of time, there
are many scrips and #T$s in which price differentials exist which can be
exploited. "imilarly, at any point of time, there are price discrepancies
between spot and future prices which can be arbitraged to gain risk free
returns. And there are substantial profits to be made. It is possible to make as
much as four per cent on a monthly basis with careful exploitation of arbitrage
opportunities.

Types of trades

!efore the introduction of derivatives in India, the most prevalent arbitrage
game used to be on the difference of price of individual stocks in different
markets. "o, a price difference in price of say H%% or Infy on !"# and N"#
would present opportunity for a trader to buy and sell the shares in the
cheaper and costlier markets respectively. Thus he can pocket the difference
without taking any risk. "o, if H%% is trading at &s '() on N"# and at &s '*+
on !"# at the same time, you can simply buy the stock on N"# and sell at
!"#, thus making a profit of &s ) in the trade. "imilarly, many times, you can
find substantial price difference in the #T$ price on exchange and the price at
which the #T$ can be bought from the fund house. There also you can ,ust buy
the #T$ at lower price point and sell at higher price point, making a risk free
profit.

However, one should be a little cautious while executing this arbitrage. &eason
being the prices that you see on the trading screen is the last traded price,
which is not at which your order would go through that is decided by the bid
or ask prices on order book. Hence there is a definite possibility that the trade
may not fetch you the arbitrage gains at all. It is, therefore, important that
arbitrage trade should be tried only in li-uid stocks, in which chances of trade
going through at given price are much higher than illi-uid stocks.

After introduction of derivatives, arbitrage trading in many more types of
assets and market segments has become possible. The most prominent pair of
arbitrage that has come up in derivative era is the spot futures trade. This
works in a very simple manner, on price differentials between spot and futures
market. In a typical trade, the trader would identify an asset whose price in
spot market is lower than price in the future market. %et us say price of stock
is &s. .++ in spot market and ..+ in futures market. To exploit this difference,
he would undertake following se-uence of actions. $irst he would go long on
spot market, i.e. buy the stock at &s. .++. "imultaneously he would sell the
stock futures at &s. ..+. /oving forward, he has two choices. If price
differential narrows down a lot later on that day, or in next day or two, he can
reverse his positions and book profits. 0r else, He can hold both the positions
till the expiry of the futures contract. !ecause at the expiration, the prices of
futures and cash markets would converge, he can then reverse the positions
and make the profit.

Here it is important to understand the concept of cost of carry. The cost of
carry defines the relationship between the futures price and the spot price. To
understand in non mathematical expression, It is the cost of 1carrying1 or
holding a position from the date of entering into the transaction upto the date
of maturity. It measures the storage cost plus interest that is paid to finance
the asset less the income earned on the asset. "o, the future price of an asset
should be taken as the sum of spot price of the asset and the cost of carry.
Technically, you can make a profit from your holdings if future price is higher
than the sum of spot price and cost of carry. "o, in above example, if the cost
of carry is &s. 2, then the net profit from the arbitrage trade would be &s *.

This is the plain vanilla spot future trade. If we were to take advantage of
options on stocks and futures, we can go long with deep in the money option
on spot and simultaneously go short on deep in the money options on $utures.
This way we can take benefit of the widest of price range discrepancy in cash
and futures market.

Another very popular arbitrage play is between Nifty spot and Nifty futures.
There are two types of possibilities here. $irst, whenever Nifty futures trades
at a premium to Nifty spot which is higher than the cost of carry, there is an
arbitrage possible. To play on this discrepancy, one can buy Nifty spot, which
means buying all stocks of Nifty in the same proportion. This can be done by a
special software provided by N"# for buying all )+ Nifty stocks in the spot
market in the same ratio. At the same time, he can sell Nifty futures. As in case
of stock arbitrage, positions can be reversed in case of sudden reduction in
price differential or at the expiry of contract. "econd and ore complex
arbitrage method is to exploit the price differential between Nifty futures and
underlying stock futures, which is called !asis Arbitrage. In this situation, one
can create a short position in Nifty futures and simultaneously create long
positions in Nifty3s underlying stock futures, taking advantage of the
differential 4basis5 between the two.

Third popular arbitrage play is the reverse arbitrage. The strategy here is
opposite of a regular cash6futures stock arbitrage, where one buys shares and
simultaneously sell stock futures. In reverse arbitrage, one sells shares in spot
market and buys stock futures in the beginning and reverses the positions
moving forward. This type of arbitrage works best in a falling market when
futures are at a discount to the cash market. 7enerally, mutual funds are big
players in this category of arbitrage trading.
$rom institutional perspective, arbitrage between A8&s 4American 8epository
&eceipts5 or 78&s 47lobal 8epository &eceipts5 and local shares are also an
interesting segment of arbitrage play. !ecause there is two6way fungibility
allowed between A8&s978&s and local listed shares, many $IIs convert these
to India listed shares whenever A8&s9 78&s are in discount to local price and
sell converted shares in India at higher price, making a profit at no risk.

Operational issues to remember

/ost important aspect of arbitrage trading is swiftness of execution of trade.
To remove the possibility of price fluctuation it is imperative that both legs of
transaction are executed very fast. $rom this perspective, arbitrage should be
tried only in those assets which are highly li-uid. "econdly, interest rate
fluctuations can make calculations go awry, as cost of carry is an important
link between prices in cash and future markets. $inally, trading circuit on
individual stocks and restriction on short selling for various market players
create impediments in exploitation of arbitrage opportunities.
Automated arbitrage trade

:ery often it is not possible for individuals to track multiple markets
simultaneously and also execute trades in -uick succession. To address this
problem, automated trading software packages have come into being. It
started with spot trading but -uickly upgraded to derivatives and arbitrage
trading. These softwares identify price discrepancies across markets on a real
time basis and also execute automated trades depending upon parameters
passed by users. $or example, 08IN; <rogram Trading software by $inancial
Technologies facilitates auto6execution of the trades based on the defined
parameters. It identifies arbitrage opportunities that exist across the spot and
futures markets and even spreads, which means price discrepancies across
futures of different trading contracts, across exchanges can be exploited.

Arbitrage funds
If you are intimidated by the complexity of the arbitrage trading and
strategies, you can still take benefit of arbitrage opportunities by investing in
arbitrage funds. These mutual funds are created to exploit the arbitrage
opportunity in market that may exist in any exchange in cash or derivative
segments. !ecause of the nature of inherent transactions, these funds are
mostly low risk investments. They generally generate returns in line with those
of li-uid and money market funds. However, in a momentum market where
prices are volatile, these funds can generate higher returns than other near
risk free funds. $or example, over one year period ending /arch =>, =+.2, top
one do?en arbitrage funds generated returns in excess of nine per cent, with
four fund clocking over ten per cent. This compares decently with best of debt
funds.

In a nutshell, arbitrage trading is a well developed but complex trading
strategy which presents opportunity to earn risk free return in cash and
derivative segments for smart investors. However, it must be undertaken with
extreme caution because inherent complexities and uncertain factors could
make potential profits disappear in no time.

Issue: 10, 30 April,2013
[http://moneymantra.co.in/detailsPage.php?id=5358&title=Special
%20Story&rt=!nand%20"ishra#
!r$itrage
Arbitrage is the making of a gain through trading without committing
any money and without taking a risk of losing money. The term is also
used more loosely to cover a range of activities, such as statistical
arbitrage, risk arbitrage, and uncovered interest arbitrage, that are not
true arbitrage (because they are risky).
Many of these strategies bear some similarities to true arbitrage, in that
they aremarket neutral attempts to identify and exploit (usually short
lived) anomalies in pricing. The terminology used usually adds a
qualifer to make it clear that it is not real arbitrage. The discussion
below is of true arbitrage.
An arbitrage opportunity exists if it is possible to make a gain that is
guaranteed to be at least equal to the risk free rate of return, with a
chance of making a greater gain. This is equivalent to the defnition of an
arbitrage opportunity as the possibility of a riskless gain with a zero cost
portfolio, because a portfolio that is guaranteed to make a proft can be
bought with borrowed money.
Less rigorously, an arbitrage opportunity is a "free lunch", that allows
investors to make a gain for no risk. Being less rigorous means that it is
not really possible to distinguish between arbitrage and the closely
related concepts of dominant trading strategies and the law of one price.
Arbitrage should not be possible as, if an arbitrage opportunity exists,
then market forces should eliminate it. Taking a simple example, if it is
possible to buy a security in one market and sell it at a higher price in
another market, then no-one would buy it at the more expensive price,
and no one would sell it at the cheaper price. The prices in the two
markets would converge.
Arbitrage between markets is the simplest type of arbitrage. More
complex strategies such as arbitraging the price of a security against a
portfolio that replicates its cash fows. These range from the relatively
simple, such as delta and gammahedges, to extremely complex strategies
based on quantitative models.
Much of fnancial theory (and therefore most methods for valuing
securities) are ultimately built on the assumption that securities will
trade at prices that make arbitrage impossible. In particular, if there is no
arbitrage then a risk neutral pricing measure exists and vice versa.
Although this result is not something that is used by most investors, it is
of great importance in the theory of fnancial economics.
Although arbitrage opportunities do exist in real markets, they are
usually very small and quickly eliminated, therefore the no arbitrage
assumption is a reasonable one to build fnancial theory on.
When persistent arbitrage opportunities do exist it means that there is
something badly wrong with fnancial markets. For example, there is
evidence that during the dotcom boom the value of internet
related tracker stocks and listed subsidiarieswas not consistent with the
market value of parent companies: an arbitrage opportunity existed and
persisted.
[http://moneyterms.co.%&/ar$itrage/#
In economics and finance, arbitrage (/' r ( b )tr(* + /) is the practice of taking advantage of a price
difference between two or more markets: striking a combination of matching deals that capitalize
upon the imbalance, the profit being the difference between the market prices. When used b
academics, an arbitrage is a transaction that involves no negativecash flow at an probabilistic or
temporal state and a positive cash flow in at least one state! in simple terms, it is the possibilit of a
risk"free profit after transaction costs. #or instance, an arbitrage is present when there is the
opportunit to instantaneousl bu low and sell high.
In principle and in academic use, an arbitrage is risk"free! in common use, as in statistical arbitrage,
it ma refer to expected profit, though losses ma occur, and in practice, there are alwas risks in
arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some ma$or (such as
devaluation of a currenc or derivative). In academic use, an arbitrage involves taking advantage of
differences in price of a single asset or identical cash"flows! in common use, it is also used to refer to
differences between similar assets (relative value or convergence trades), as in merger arbitrage.
%eople who engage in arbitrage are called arbitrageurs (I%& /, r ( b )tr(* '+ r - /)'such as a bank or
brokerage firm. (he term is mainl applied to trading in financial instruments, such
as bonds, stocks, derivatives, commodities and currencies.
Arbitrage-Free
If the market prices do not allow for profitable arbitrage, the prices are said to constitute an arbitrage
equilibrium or arbitrage-free market. &n arbitrage e)uilibrium is a precondition for a general
economic e)uilibrium. (he *no arbitrage* assumption is used in )uantitative finance to calculate a
uni)ue risk neutral price for derivatives.
&rbitrage free pricing approach for bonds
(his refers to the method of valuing a coupon bearing financial instrument b discounting its future
cash flows b multiple discount rates. + doing so, a more accurate price will be obtained than if the
price is calculated with a present value pricing approach. &rbitrage"free pricing is used for bond
valuation and used to detect arbitrage opportunities for investors.
#or purpose of valuing the price of a bond its cash flows can each be thought of as packets of
incremental cash flows with a large packet upon maturit, being the principal. ,ince the cash flows
are dispersed throughout future periods the must be discounted back to the present. In the present
value approach, the cash flows are discounted with one discount rate to find the price of the bond. In
arbitrage"free pricing, multiple discount rates are used.
(he present value approach assumes that the ield of the bond will sta the same until maturit. (his
is a simplified model because interest rates ma fluctuate in the future, which in turn affects the ield
on the bond. (he discount rate ma be different for each of the cash flows for this reason. -ach cash
flow can be considered a zero"coupon instrument that pas one pament upon maturit. (he
discount rates used should be the rates of multiple zero"coupon bonds with maturit dates same as
each cash flow and similar risk as the instrument being valued. + using multiple discount rates the
arbitrage"free price will be the sum of the discounted cash flows. &rbitrage"free price refers to the
price at which no price arbitrage is possible.
(he ideas of using multiple discount rates obtained from zero"coupon bonds and discount a similar
bonds cash flow to find its price is derived from the ield curve. (he ield curve is a curve of the
ields of the same bond with different maturities. (his curve can be used to view trends in the
markets e.pectations of how interest rates will move in the future. In arbitrage"free pricing of a bond
a ield curve of similar zero"coupon bonds with different maturities is created. If the curve were to be
created with (reasur securities of different maturities the would be stripped of their coupon
paments through bootstrapping. (his is to transform the bonds into zero"coupon bonds. (he ield of
these zero"coupon bonds would then be plotted on a diagram with time on the ."a.is and ield on
the "a.is.
,ince the ield curve in a wa displas the markets e.pectations on how ields and interest rates
ma move, the arbitrage"free pricing approach is more realistic than using onl one discount rate.
With this, investors can use this approach to value bonds and find mismatches in prices, resulting in
an arbitrage opportunit. If a bond valued with the arbitrage"free pricing approach turns out to be
priced higher in the market an investor could have such an opportunit:
/. Investor goes short the bond at price at time t/.
0. Investor goes long the zero"coupon bonds making up the related ield curve and strip and
sell an coupon paments at t/.
1. &s t2t/ the price spread between the prices will decrease.
3. &t maturit the prices will converge and be e)ual. Investor e.its both the long and short
position, realizing a profit.
If the outcome from the valuation were the reversed case the opposite positions would be taken in
the bonds. (his arbitrage opportunit comes from the assumption that the prices of bonds with the
same properties will converge upon maturit. (his can be e.plained through market efficienc, which
states that arbitrage opportunities will eventuall be discovered and corrected accordingl. (he
prices of the bonds in t/ move closer together to finall become the same at t(.
.onditions 0or ar$itrage
&rbitrage is possible when one of three conditions is met:
/. (he same asset does not trade at the same price on all markets (*the law of one price*).
0. (wo assets with identical cash flows do not trade at the same price.
1. &n asset with a known price in the future does not toda trade at its future
price discounted at the risk"free interest rate (or, the asset has significant costs of storage!
as such, for e.ample, this condition holds for grain but not for securities).
&rbitrage is not simpl the act of buing a product in one market and selling it in another for a higher
price at some later time. (he transactions must occur simultaneously to avoid e.posure to market
risk, or the risk that prices ma change on one market before both transactions are complete. In
practical terms, this is generall possible onl with securities and financial products that can be
traded electronicall, and even then, when each leg of the trade is e.ecuted the prices in the market
ma have moved. 4issing one of the legs of the trade (and subse)uentl having to trade it soon
after at a worse price) is called 5e.ecution risk5 or more specificall 5leg risk5.
6note /7
In the simplest e.ample, an good sold in one market should sell for the same price in
another. (raders ma, for e.ample, find that the price of wheat is lower in agricultural regions than in
cities, purchase the good, and transport it to another region to sell at a higher price. (his tpe of
price arbitrage is the most common, but this simple e.ample ignores the cost of transport, storage,
risk, and other factors. *(rue* arbitrage re)uires that there be no market risk involved. Where
securities are traded on more than one e.change, arbitrage occurs b simultaneousl buing in one
and selling on the other.
,ee rational pricing, particularl arbitrage mechanics, for further discussion.
4athematicall it is defined as follows:
where and denotes the portfolio value at time t.
Examples
,uppose that an e.change rate (after taking out the fees for making the e.change) in
8ondon is 9: ; </=== and the e.change rate in (oko is </=== ; 9>. ?onverting <0=== to 9/0 in
(oko and converting that 9/0 into <03== in 8ondon, for a profit of <3==, would be arbitrage. In
realit, this arbitrage is so simple that it almost never occurs. +ut more complicated foreign
e.change arbitrages, such as the spot"forward arbitrage (see interest rate parit) are much more
common.
@ne e.ample of arbitrage involves the Aew Bork ,tock -.change and the ,ecurit #utures
-.change @ne?hicago (@?C). When the price of a stock on the AB,- and its
corresponding futures contract on @?C are out of snc, one can bu the less e.pensive one and
sell it on the more e.pensive market. +ecause the differences between the prices are likel to be
small (and not to last ver long), this can be done profitabl onl with computers e.amining a
large number of prices and automaticall e.ercising a trade when the prices are far enough out
of balance. (he activit of other arbitrageurs can make this risk. (hose with the fastest
computers (i.e. lowest latenc to respond to the market) and the most e.pertise take advantage
of series of small differences that would not be profitable if taken individuall.
-conomists use the term *global labor arbitrage* to refer to the tendenc of manufacturing
$obs to flow towards whichever countr has the lowest wages per unit output at present and has
reached the minimum re)uisite level of political and economic development to
support industrialization. &t present, man such $obs appear to be flowing towards ?hina, though
some that re)uire command of -nglish are going to India and the %hilippines. In popular terms,
this is referred to as offshoring. (Aote that *offshoring* is not snonmous with *outsourcing*,
which means *to subcontract from an outside supplier or source*, such as when a business
outsources its paroll or cleaning. Dnlike offshoring, outsourcing alwas involves subcontracting
$obs to a different compan, and that compan can be in the same countr, even the same
building, as the outsourcing compan.)
,ports arbitrage E numerous internet bookmakers offer odds on the outcome of the same
event. &n given bookmaker will weight their odds so that no one customer can cover all
outcomes at a profit against their books. Fowever, in order to remain competitive the must keep
margins usuall )uite low. Gifferent bookmakers ma offer different odds on the same outcome
of a given event! b taking the best odds offered b each bookmaker, a customer can under
some circumstances cover all possible outcomes of the event and lock a small risk"free profit,
known as a Gutch book. (his profit will tpicall be between /H and :H but can be much higher.
@ne problem with sports arbitrage is that bookmakers sometimes make mistakes and this can
lead to an invocation of the 5palpable error5 rule, which most bookmakers invoke when the have
made a mistake b offering or posting incorrect odds. &s bookmakers become more proficient,
the odds of making an 5arb5 usuall last for less than an hour and tpicall onl a few minutes.
#urthermore, huge bets on one side of the market also alert the bookies to correct the market.
-.change"traded fund arbitrage E -.change (raded #unds allow authorized participants to
e.change back and forth between shares in underling securities held b the fund and shares in
the fund itself, rather than allowing the buing and selling of shares in the -(# directl with the
fund sponsor. -(# trade in the open market, with prices set b market demand. &n -(# ma
trade at a premium or discount to the value of the underling assets. When a significant enough
premium appears, an arbitrageur will bu the underling securities, convert them to shares in the
-(#, and sell them in the open market. When a discount appears, an arbitrageur will do the
reverse. In this wa, the arbitrageur makes a low"risk profit, while keeping -(# prices in line with
their underling value.
,ome tpes of hedge funds make use of a modified form of arbitrage to profit. Iather than
e.ploiting price differences between identical assets, the will purchase and
sellsecurities, assets and derivatives with similar characteristics, and hedge an significant
differences between the two assets. &n difference between the hedged positions represents
an remaining risk (such as basis risk) plus profit! the belief is that there remains some
difference which, even after hedging most risk, represents pure profit. #or e.ample, a fund ma
see that there is a substantial difference between D.,. dollar debt and local currenc debt of a
foreign countr, and enter into a series of matching trades (including currenc swaps) to
arbitrage the difference, while simultaneousl entering into credit default swaps to protect
against countr risk and other tpes of specific risk.
Joogle uses the term arbitrage to label certain advertisers who litter their website with ads.
Joogle doesn5t allow them to advertise with them because the advertiser would be making more
to host these ads on their site than Joogle would be making from the single click.
Price convergance
&rbitrage has the effect of causing prices in different markets to converge. &s a result of arbitrage,
the currenc e.change rates, the price of commodities, and the price of securities in different
markets tend to converge. (he speed
6/7
at which the do so is a measure of market efficienc.
&rbitrage tends to reduce price discrimination b encouraging people to bu an item where the price
is low and resell it where the price is high (as long as the buers are not prohibited from reselling
and the transaction costs of buing, holding and reselling are small relative to the difference in prices
in the different markets).
&rbitrage moves different currencies toward purchasing power parit. &s an e.ample, assume that a
car purchased in the Dnited ,tates is cheaper than the same car in ?anada. ?anadians would bu
their cars across the border to e.ploit the arbitrage condition. &t the same time, &mericans would
bu D, cars, transport them across the border, then sell them in ?anada. ?anadians would have to
bu &merican dollars to bu the cars and &mericans would have to sell the ?anadian dollars the
received in e.change. +oth actions would increase demand for D, dollars and suppl of ?anadian
dollars. &s a result, there would be an appreciation of the D, currenc. (his would make D, cars
more e.pensive and ?anadian cars less so until their prices were similar. @n a larger scale,
international arbitrage opportunities in commodities, goods, securities and currencies tend to
changee.change rates until the purchasing power is e)ual.
In realit, most assets e.hibit some difference between countries. (hese, transaction costs, ta.es,
and other costs provide an impediment to this kind of arbitrage. ,imilarl, arbitrage affects the
difference in interest rates paid on government bonds issued b the various countries, given the
e.pected depreciations in the currencies relative to each other (see interest rate parit).
Risks
&rbitrage transactions in modern securities markets involve fairl low da"to"da risks, but can face
e.tremel high risk in rare situations,
6/7
particularl financial crises, and can lead to bankruptc.
#ormall, arbitrage transactions have negative skew E prices can get a small amount closer (but
often no closer than =), while the can get ver far apart. (he da"to"da risks are generall small
because the transactions involve small differences in price, so an e.ecution failure will generall
cause a small loss (unless the trade is ver big or the price moves rapidl). (he rare case risks are
e.tremel high because these small price differences are converted to large profits
via leverage (borrowed mone), and in the rare event of a large price move, this ma ield a large
loss.
(he main da"to"da risk is that part of the transaction fails E e.ecution risk. (he main rare risks are
counterpart risk and li)uidit risk E that a counterpart to a large transaction or man transactions
fails to pa, or that one is re)uired to post margin and does not have the mone to do so.
In the academic literature, the idea that seemingl ver low risk arbitrage trades might not be full
e.ploited because of these risk factors and other considerations is often referred to as limits to
arbitrage.
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Execution risk[edit]
Jenerall it is impossible to close two or three transactions at the same instant! therefore, there is
the possibilit that when one part of the deal is closed, a )uick shift in prices makes it impossible to
close the other at a profitable price. Fowever, this is not necessaril the case. 4an e.changes and
inter"dealer brokers allow multi legged trades (e.g. basis block trades on 8I##-).
?ompetition in the marketplace can also create risks during arbitrage transactions. &s an e.ample, if
one was tring to profit from a price discrepanc between I+4 on the AB,- and I+4 on the 8ondon
,tock -.change, the ma purchase a large number of shares on the AB,- and find that the
cannot simultaneousl sell on the 8,-. (his leaves the arbitrageur in an unhedged risk position.
In the /KL=s, risk arbitrage was common. In this form of speculation, one trades a securit that is
clearl undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected
b events. (he standard e.ample is the stock of a compan, undervalued in the stock market, which
is about to be the ob$ect of a takeover bid! the price of the takeover will more trul reflect the value of
the compan, giving a large profit to those who bought at the current price'if the merger goes
through as predicted. (raditionall, arbitrage transactions in the securities markets involve high
speed, high volume and low risk. &t some moment a price difference e.ists, and the problem is to
e.ecute two or three balancing transactions while the difference persists (that is, before the other
arbitrageurs act). When the transaction involves a dela of weeks or months, as above, it ma entail
considerable risk if borrowed mone is used to magnif the reward through leverage. @ne wa of
reducing the risk is through the illegal use of inside information, and in fact risk arbitrage with regard
to leveraged buouts was associated with some of the famous financial scandals of the /KL=s such
as those involving 4ichael 4ilken and Ivan +oesk.
Mismatch[edit]
For more details on this topic, see Convergence trade.
&nother risk occurs if the items being bought and sold are not identical and the arbitrage is
conducted under the assumption that the prices of the items are correlated or predictable! this is
more narrowl referred to as a convergence trade. In the e.treme case this is merger arbitrage,
described below. In comparison to the classical )uick arbitrage transaction, such an operation can
produce disastrous losses.
Counterparty risk[edit]
&s arbitrages generall involve future movements of cash, the are sub$ect to counterpart risk: if a
counterpart fails to fulfill their side of a transaction. (his is a serious problem if one has either a
single trade or man related trades with a single counterpart, whose failure thus poses a threat, or
in the event of a financial crisis when man counterparties fail. (his hazard is serious because of the
large )uantities one must trade in order to make a profit on small price differences.
#or e.ample, if one purchases man risk bonds, then hedges them with ?G,es, profiting from the
difference between the bond spread and the ?G, premium, in a financial crisis the bonds ma
default and the ?G, writer/seller ma itself fail, due to the stress of the crisis, causing the arbitrageur
to face steep losses.
iquidity risk
&rbitrage trades are necessaril snthetic, leveraged trades, as the involve a short position. If the
assets used are not identical (so a price divergence makes the trade temporaril lose mone), or the
margin treatment is not identical, and the trader is accordingl re)uired to post margin (faces
a margin call), the trader ma run out of capital (if the run out of cash and cannot borrow more) and
be forced to sell these assets at a loss even though the trades ma be e.pected to ultimatel make
mone. In effect, arbitrage traders snthesize a put option on their abilit to finance themselves.
6:7
%rices ma diverge during a financial crisis, often termed a *flight to )ualit*! these are precisel the
times when it is hardest for leveraged investors to raise capital (due to overall capital constraints),
and thus the will lack capital precisel when the need it most.
6:7
Types of arbitrage
!patial arbitrage[edit]
&lso known as Jeographical arbitrage is the simplest form of arbitrage. In case of spatial arbitrage,
an arbs (arbitrageurs) looks for pricing discrepancies across geographicall separate markets. #or
e.ample, there ma be a bond dealer in Mirginia offering a bond at /=="/0/01 and a dealer in
Washington is bidding /=="/:/01 for the same bond. #or whatever reason, the two dealers have not
spotted the aberration in the prices, but the arbs does. (he arb immediatel bus the bond from the
Mirginia dealer and sells it to the Washington dealer.
Merger arbitrage[edit]
&lso called risk arbitrage, merger arbitrage generall consists of buing/holding the stock of a
compan that is the target of a takeover while shorting the stock of the ac)uiring compan.
Dsuall the market price of the target compan is less than the price offered b the ac)uiring
compan. (he spread between these two prices depends mainl on the probabilit and the timing of
the takeover being completed as well as the prevailing level of interest rates.
(he bet in a merger arbitrage is that such a spread will eventuall be zero, if and when the takeover
is completed. (he risk is that the deal *breaks* and the spread massivel widens.
Municipal bond arbitrage[edit]
&lso called municipal bond relative value arbitrage, municipal arbitrage, or $ust muni arb, this hedge
fund strateg involves one of two approaches.
Jenerall, managers seek relative value opportunities b being both long and short municipal bonds
with a duration"neutral book. (he relative value trades ma be between different issuers, different
bonds issued b the same entit, or capital structure trades referencing the same asset (in the case
of revenue bonds). 4anagers aim to capture the inefficiencies arising from the heav participation of
non"economic investors (i.e., high income *bu and hold* investors seeking ta."e.empt income) as
well as the *crossover buing* arising from corporations5 or individuals5 changing income ta.
situations (i.e., insurers switching their munis for corporates after a large loss as the can capture a
higher after"ta. ield b offsetting the ta.able corporate income with underwriting losses). (here are
additional inefficiencies arising from the highl fragmented nature of the municipal bond market
which has two million outstanding issues and :=,=== issuers in contrast to the (reasur market
which has 3== issues and a single issuer.
,econd, managers construct leveraged portfolios of &&&" or &&"rated ta."e.empt municipal bonds
with the duration risk hedged b shorting the appropriate ratio of ta.able corporate bonds. (hese
corporate e)uivalents are tpicall interest rate swaps referencing 8ibor or ,I#4& 6/7 607. (he
arbitrage manifests itself in the form of a relativel cheap longer maturit municipal bond, which is a
municipal bond that ields significantl more than >:H of a corresponding ta.able corporate bond.
(he steeper slope of the municipalield curve allows participants to collect more after"ta. income
from the municipal bond portfolio than is spent on the interest rate swap! the carr is greater than the
hedge e.pense. %ositive, ta."free carr from muni arb can reach into the double digits. (he bet in
this municipal bond arbitrage is that, over a longer period of time, two similar instruments'municipal
bonds and interest rate swaps'will correlate with each other! the are both ver high )ualit credits,
have the same maturit and are denominated in D.,. dollars. ?redit risk and duration risk are largel
eliminated in this strateg. Fowever, basis risk arises from use of an imperfect hedge, which results
in significant, but range"bound principal volatilit. (he end goal is to limit this principal volatilit,
eliminating its relevance over time as the high, consistent, ta."free cash flow accumulates. ,ince the
inefficienc is related to government ta. polic, and hence is structural in nature, it has not been
arbitraged awa.
Aote, however, that man municipal bonds are callable, and that this imposes substantial additional
risks to the strateg.
Con"ertible bond arbitrage[edit]
& convertible bond is a bond that an investor can return to the issuing compan in e.change for a
predetermined number of shares in the compan.
& convertible bond can be thought of as a corporate bond with a stock call option attached to it.
(he price of a convertible bond is sensitive to three ma$or factors:
interest rate. When rates move higher, the bond part of a convertible bond tends to move
lower, but the call option part of a convertible bond moves higher (and the aggregate tends to
move lower).
stock price. When the price of the stock the bond is convertible into moves higher, the price
of the bond tends to rise.
credit spread. If the creditworthiness of the issuer deteriorates (e.g. rating downgrade) and
its credit spread widens, the bond price tends to move lower, but, in man cases, the call option
part of the convertible bond moves higher (since credit spread correlates with volatilit).
Jiven the comple.it of the calculations involved and the convoluted structure that a convertible
bond can have, an arbitrageur often relies on sophisticated )uantitative models in order to identif
bonds that are trading cheap versus their theoretical value.
?onvertible arbitrage consists of buing a convertible bond and hedging two of the three factors in
order to gain e.posure to the third factor at a ver attractive price.
#or instance an arbitrageur would first bu a convertible bond, then sell fi.ed
income securities or interest rate futures (to hedge the interest rate e.posure) and bu some credit
protection (to hedge the risk of credit deterioration). -ventuall what he5d be left with is something
similar to a call option on the underling stock, ac)uired at a ver low price. Fe could then make
mone either selling some of the more e.pensive options that are openl traded in the market
or delta hedging his e.posure to the underling shares.
#epository receipts[edit]
& depositar receipt is a securit that is offered as a *tracking stock* on another foreign market. #or
instance a ?hinese compan wishing to raise more mone ma issue a depositor receipt on
the Aew Bork ,tock -.change, as the amount of capital on the local e.changes is limited. (hese
securities, known as &GIs (&merican depositar receipt) or JGIs (global depositor receipt)
depending on where the are issued, are tpicall considered *foreign* and therefore trade at a
lower value when first released. 4an &GI5s are e.changeable into the original securit (known
as fungibilit) and actuall have the same value. In this case there is a spread between the
perceived value and real value, which can be e.tracted. @ther &GI5s that are not e.changeable
often have much larger spreads. ,ince the &GI is trading at a value lower than what it is worth, one
can purchase the &GI and e.pect to make mone as its value converges on the original. Fowever
there is a chance that the original stock will fall in value too, so b shorting it one can hedge that risk.
#ual-listed companies[edit]
& dual"listed compan (G8?) structure involves two companies incorporated in different countries
contractuall agreeing to operate their businesses as if the were a single enterprise, while retaining
their separate legal identit and e.isting stock e.change listings. In integrated and efficient financial
markets, stock prices of the twin pair should move in lockstep. In practice, G8? share prices e.hibit
large deviations from theoretical parit. &rbitrage positions in G8?s can be set up b obtaining a long
position in the relativel underpriced part of the G8? and a short position in the relativel overpriced
part. ,uch arbitrage strategies start paing off as soon as the relative prices of the two G8? stocks
converge toward theoretical parit. Fowever, since there is no identifiable date at which G8? prices
will converge, arbitrage positions sometimes have to be kept open for considerable periods of time.
In the meantime, the price gap might widen. In these situations, arbitrageurs ma receive margin
calls, after which the would most likel be forced to li)uidate part of the position at a highl
unfavorable moment and suffer a loss. &rbitrage in G8?s ma be profitable, but is also ver risk.
6>76N7
& good illustration of the risk of G8? arbitrage is the position in Ioal Gutch ,hell'which had a G8?
structure until 0==:'b the hedge fund 8ong"(erm ?apital 4anagement(8(?4, see also the
discussion below). 8owenstein (0===)
6L7
describes that 8(?4 established an arbitrage position in
Ioal Gutch ,hell in the summer of /KKN, when Ioal Gutch traded at an L to /= percent premium.
In total O0.1 billion was invested, half of which long in ,hell and the other half short in Ioal Gutch
(8owenstein, p. KK). In the autumn of /KKL large defaults on Iussian debt created significant losses
for the hedge fund and 8(?4 had to unwind several positions. 8owenstein reports that the premium
of Ioal Gutch had increased to about 00 percent and 8(?4 had to close the position and incur a
loss. &ccording to 8owenstein (p. 013), 8(?4 lost O0L> million in e)uit pairs tradingand more than
half of this loss is accounted for b the Ioal Gutch ,hell trade.
$ri"ate to public equities[edit]
(he market prices for privatel held companies are tpicall viewed from a return on investment
perspective (such as 0:H), whilst publicl held and or e.change listed companies trade on a %rice to
earnings ratio (%/-) (such as a %/- of /=, which e)uates to a /=H I@I). (hus, if a publicl traded
compan specialises in the ac)uisition of privatel held companies, from a per"share perspective
there is a gain with ever ac)uisition that falls within these guidelines. -.empli gratia, +erkshire
Fathawa. & hedge fund that is an e.ample of this tpe of arbitrage is Jreenridge ?apital, which
acts as an angel investor retaining e)uit in private companies which are in the process of becoming
publicl traded, buing in the private market and later selling in the public market. %rivate to public
e)uities arbitrage is a term which can arguabl be applied to investment banking in general. %rivate
markets to public markets differences ma also help e.plain the overnight windfall gains en$oed b
principals of companies that $ust did an initial public offering (I%@).
%egulatory arbitrage[edit]
For more details on this topic, see Jurisdictional arbitrage.
Iegulator arbitrage is where a regulated institution takes advantage of the difference between its
real (or economic) risk and the regulator position. #or e.ample, if a bank, operating under the +asel
I accord, has to hold LH capital against default risk, but the real risk of default is lower, it is profitable
to securitise the loan, removing the low risk loan from its portfolio. @n the other hand, if the real risk
is higher than the regulator risk then it is profitable to make that loan and hold on to it, provided it is
priced appropriatel. Iegulator arbitrage can result in parts of entire businesses being unregulated
as a result of the arbitrage.
(his process can increase the overall riskiness of institutions under a risk insensitive regulator
regime, as described b &lan Jreenspan in his @ctober /KKL speech on (he Iole of ?apital in
@ptimal +anking ,upervision and Iegulation.
Iegulator &rbitrage was used for the first time in 0==: when it was applied b ,cott M. ,impson, a
partner at law firm ,kadden, &rps, to refer to a new defence tactic in hostile mergers and
ac)uisitions where differing takeover regimes in deals involving multi"$urisdictions are e.ploited to
the advantage of a target compan under threat.
In economics, regulator arbitrage (sometimes, ta. arbitrage) ma be used to refer to situations
when a compan can choose a nominal place of business with a regulator, legal or ta. regime with
lower costs. #or e.ample, an insurance compan ma choose to locate in +ermuda due to
preferential ta. rates and policies for insurance companies. (his can occur particularl where the
business transaction has no obvious phsical location: in the case of man financial products, it ma
be unclear *where* the transaction occurs.
Iegulator arbitrage can include restructuring a bank b outsourcing services such as I(. (he
outsourcing compan takes over the installations, buing out the bank5s assets and charges a
periodic service fee back to the bank. (his frees up cashflow usable for new lending b the bank.
(he bank will have higher I( costs, but counts on the multiplier effect of mone creation and the
interest rate spread to make it a profitable e.ercise.
-.ample: ,uppose the bank sells its I( installations for 3= million D,G. With a reserve ratio of /=H,
the bank can create 3== million D,G in additional loans (there is a time lag, and the bank has to
e.pect to recover the loaned mone back into its books). (he bank can often lend (and securitize the
loan) to the I( services compan to cover the ac)uisition cost of the I( installations. (his can be at
preferential rates, as the sole client using the I( installation is the bank. If the bank can generate :H
interest margin on the 3== million of new loans, the bank will increase interest revenues b 0=
million. (he I( services compan is free to leverage their balance sheet as aggressivel as the and
their banker agree to. (his is the reason behind the trend towards outsourcing in the financial sector.
Without this mone creation benefit, it is actuall more e.pensive to outsource the I( operations as
the outsourcing adds a laer of management and increases overhead.
&ccording to %+, #rontline5s 0=/0 four"part documentar, *4one, %ower, and Wall ,treet,*
regulator arbitrage, along with asmmetric bank lobbing in Washington and abroad, allowed
investment banks in the pre" and post"0==L period to continue to skirt laws and engage in the risk
proprietar trading of opa)ue derivatives, swaps, and other credit"based instruments invented to
circumvent legal restrictions at the e.pense of clients, government, and publics.
Gue to the &ffordable ?are &ctPs e.pansion of 4edicaid coverage, one form of Iegulator &rbitrage
can now be found when businesses engage in Q4edicaid 4igrationR, a maneuver b which )ualifing
emploees who would tpicall be enrolled in compan health plans elect to enroll in 4edicaid
instead. (hese programs that have similar characteristics as insurance products to the emploee,
but have radicall different cost structures, resulting in significant e.pense reductions for emploers.
6K7
&elecom arbitrage[edit]
Main article: International telecommunications routes
(elecom arbitrage companies allow phone users to make international calls for free through certain
access numbers. ,uch services are offered in the Dnited Singdom! the telecommunication arbitrage
companies get paid an interconnect charge b the DS mobile networks and then bu international
routes at a lower cost. (he calls are seen as free b the DS contract mobile phone customers since
the are using up their allocated monthl minutes rather than paing for additional calls.
,uch services were previousl offered in the Dnited ,tates b companies such as #uture%hone.com.
6/=7
(hese services would operate in rural telephone e.changes, primaril in small towns in the state
of Iowa. In these areas, the local telephone carriers are allowed to charge a high *termination fee* to
the caller5s carrier in order to fund the cost of providing service to the small and sparsel populated
areas that the serve. Fowever, #uture%hone (as well as other similar services) ceased operations
upon legal challenges from &(T( and other service providers.
6//7
!tatistical arbitrage[edit]
Main article: tatistical arbitrage
,tatistical arbitrage is an imbalance in e.pected nominal values.
6/76/07
& casino has a statistical
arbitrage in ever game of chance that it offers'referred to as the house advantage, house
edge, vigorish or house vigorish.
6http://en.wikipedia.org/wiki/&rbitration7
How to play the arbitrage game
Arbitrage, in layman@s terms, involves simultaneously buying and selling the same asset across two
different markets, profiting from the price difference. /any times, arbitrage is considered to be risk6
free as the two simultaneous acts automatically hedge the price risk of the asset going up or down in
value. %et@s take an example. "uppose &eliance Industries@ shares are trading at 1>(+ on the !"#
and at 1>(= on the N"#. 0ne could simply purchase the shares at 1>(+ from the !"# and sell the
same -uantity at 1>(= on the N"#.
In most e-uity markets, the trader can immediately claim a profit of 1= however, since cross6
clearing has not been approved in India, the trader would need to sell the !"# shares and purchase
back the N"# shares within the same day to capture the 1= profit.
8ue to arbitrage, the prices tend to converge andthe price of &eliance shares may overlap on both the
exchanges. At that point, the trader can execute his reversal trades. $or example, assume &eliance
Industries is priced at 1>() later in the same day.
ash!"utures arbitrage
The trader would sell his shares at 1>() on the !"# and purchase shares at the same price on the
N"#. He has now earned 1= in profit per share. Another common arbitrage strategy is the Aash6
$utures arbitrage.
"uppose &eliance Industries e-uity is trading at 1>(+ on the N"#, and the near month $utures
contract is trading at 1>*+ on the N"#. The trader can buy the underlying and sell the $utures
contract.
"ince $utures contracts are traded in lots, the trader should execute the same number of shares.
"ince &eliance Industries has a lot si?e of =)+, the trader could purchase =)+ shares of &eliance
Industries at 1>(+ and sell one lot of &eliance $utures at 1>*+.
Now, the trader has two options. As the price difference between the $utures price and the #-uities
price is 1.+, he needs to wait for the price difference to be lower than 1.+ to earn a profit. If this is
not possible, he can hold the positions overnight and execute the reverse trades on a future date.
The risk here is that the "ecurities Transaction Tax for delivery shares 4holding shares overnight5 is
significantly higher than that on sale of shares within the same day 4known as intraday5. "o, it@s best
to wait for the price difference to be below 1.+ within the same day.
#atien$e pays
"uppose, later in the day, &eliance shares are trading at 1>(' and &eliance $utures, at 1>*=. He sells
his =)+ shares and buys one lot of &eliance $utures. He has now earned 1= in profit.
There are many profitable arbitrage traders who use automated algorithms that constantly scan the
markets for price discrepancies. If you@re looking to play the arbitrage game, be patient and seek out
opportunities where the price discrepancy is large. 0ver time, you can look to increase your position
si?es.
4The writer is the co6founder of www.rksv.in5
(This article was published on January 26, 2014)
[http://.thehind%$%sinessline.com/0eat%res/in2estment3orld/mar&et3
atch/ho3to3play3the3ar$itrage3game/article5420522.ece#
Bhat is the difference between arbitrage and
speculationC
By Jean Folger A A A
Related Searches: New York Stock Exchange, Yahoo Finance, Bloomberg, Halifax, Stock
Market
Arbitrage and !ec"lation are #ery different trategie$ Arbitrage in#ol#e the
im"ltaneo" b"ying and elling of an aet in order to !rofit from mall
difference in !rice$ %ften, arbitrage"r b"y tock on one market &for exam!le,
a financial market in the 'nited State like the NYSE( while im"ltaneo"ly
elling the ame tock on a different market &"ch a the )ondon Stock
Exchange($ *n the 'nited State, the tock wo"ld be traded in 'S dollar, while
in )ondon, the tock wo"ld be traded in !o"nd$
A each market for the ame tock mo#e, market inefficiencie, !ricing
mimatche and e#en dollar+!o"nd exchange rate can affect the !rice
tem!orarily$ Arbitrage i not limited to identical intr"ment, arbitrage"r can
alo take ad#antage of !redictable relationhi! between imilar financial
intr"ment, "ch a gold f"t"re and the "nderlying !rice of !hyical gold$
Since arbitrage in#ol#e the im"ltaneo" b"ying and elling of an aet, it i
eentially a ty!e of hedge and in#ol#e limited rik, when exec"ted !ro!erly$
Arbitrage"r ty!ically enter large !oition ince they are attem!ting to !rofit
from #ery mall difference in !rice$
S!ec"lation, on the other hand, i a ty!e financial trategy that in#ol#e a
ignificant amo"nt of rik$ Financial !ec"lation can in#ol#e the trading of
intr"ment "ch a bond, commoditie, c"rrencie and deri#ati#e$
S!ec"lator attem!t to !rofit from riing and falling !rice$ A trader, for
exam!le, may o!en a long &b"y( !oition in a tock index f"t"re contract with
the ex!ectation of !rofiting from riing !rice$ *f the #al"e of the index rie, the
trader may cloe the trade for a !rofit$ -on#erely, if the #al"e of the index fall,
the trade might be cloed for a lo$
S!ec"lator may alo attem!t to !rofit from a falling market by horting&elling
hort, or im!ly .elling.( the intr"ment$ *f !rice dro!, the !oition will be
!rofitable$ *f !rice rie, howe#er, the trade may be cloed at a lo$
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