Arbitrage PDF

A STUDY ON ARBITRAGE 1
CHP 1: ARBITRAGE
1.1) Introduction
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 are market
neutral attempts to identify and exploit (usually short lived) anomalies in pricing. The
terminology used usually adds a qualifier 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 definition 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 profit can be bought with
borrowed money.
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 flows. These
range from the relatively simple, such as delta and gamma hedges, to extremely complex
strategies based on quantitative models.
Much of financial 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 financial 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
financial theory on.
When persistent arbitrage opportunities do exist it means that there is something badly wrong
with financial markets. For example, there is evidence that during the dotcom boom the value
of internet related tracker stocks and listed subsidiaries was not consistent with the market
value of parent companies: an arbitrage opportunity existed and persisted.
In economics and finance, arbitrage 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 by
academics, an arbitrage is a transaction that involves no negative cash flow at any
probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it
is the possibility of a risk-free profit after transaction costs. For instance, an arbitrage is
present when there is the opportunity to instantaneously buy low and sell high.
In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical
arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are
always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit
margins), some major (such as devaluation of a currency 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.
People who engage in arbitrage are called arbitrageurs such as a bank or brokerage firm. The
term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives,
commodities and currencies.
1.2) Conditions for Arbitrage
Arbitrage is possible when one of three conditions is met:
 The same asset does not trade at the same price on all markets ("the law of one
price").Two assets with identical cash flows do not trade at the same price.
 An asset with a known price in the future does not today trade at its future price
discounted at the risk-free interest rate (or, the asset has significant costs of storage; as
such, for example, this condition holds for grain but not for securities).
 Arbitrage is not simply the act of buying a product in one market and selling it in another
for a higher price at some later time. The transactions must occur simultaneously to avoid
exposure to market risk, or the risk that prices may change on one market before both
transactions are complete. In practical terms, this is generally possible only with
securities and financial products that can be traded electronically, and even then, when
each leg of the trade is executed the prices in the market may have moved. Missing one
of the legs of the trade (and subsequently having to trade it soon after at a worse price) is
called 'execution risk' or more specifically 'leg risk'.
In the simplest example, any good sold in one market should sell for the same price in
another. Traders may, for example, 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. This type of price arbitrage is the most common, but this simple example ignores the
cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no
market risk involved. Where securities are traded on more than one exchange, arbitrage
occurs by simultaneously buying in one and selling on the other.

CHP 2: TYPES OF ARBITRAGE
2.1) Spatial Arbitrage
Also known as Geographical arbitrage is the simplest form of arbitrage. In case of spatial
arbitrage, an arbitrageurs looks for pricing discrepancies across geographically separate
markets. For example, there may be a bond dealer in Virginia offering a bond at 100-12/23
and a dealer in Washington is bidding 100-15/23 for the same bond. For whatever reason, the
two dealers have not spotted the aberration in the prices, but the arbitrageur does. The
arbitrageurs immediately buy the bond from the Virginia dealer and sells it to the
Washington dealer.
2.2) Merger Arbitrage
Also called risk arbitrage, merger arbitrage generally consists of buying/holding the stock of
a company that is the target of a takeover while shorting the stock of the acquiring company.
Usually the market price of the target company is less than the price offered by the acquiring
company. The spread between these two prices depends mainly on the probability and the
timing of the takeover being completed as well as the prevailing level of interest rates.
The bet in a merger arbitrage is that such a spread will eventually be zero, if and when the
takeover is completed. The risk is that the deal "breaks" and the spread massively widens.
2.3) Municipal Bond Arbitrage
Also called municipal bond relative value arbitrage, municipal arbitrage, or just muni
arbitrageurs, this hedge fund strategy involves one of two approaches.

Generally, managers seek relative value opportunities by being both long and short municipal
bonds with a duration-neutral book. The relative value trades may be between different
issuers, different bonds issued by the same entity or capital structure trades referencing the
same asset (in the case of revenue bonds). Managers aim to capture the inefficiencies arising
from the heavy participation of non-economic investors (i.e., high income "buy and hold"
investors seeking tax-exempt income) as well as the "crossover buying" arising from
corporations' or individuals' changing income tax situations (i.e., insurers switching their
muni for corporates after a large loss as they can capture a higher after-tax yield by offsetting
the taxable corporate income with underwriting losses). There are additional inefficiencies
arising from the highly fragmented nature of the municipal bond market which has two
million outstanding issues and 50,000 issuers in contrast to the Treasury market which has
400 issues and a single issuer.
Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal
bonds with the duration risk hedged by shorting the appropriate ratio of taxable corporate
bonds. These corporate equivalents are typically interest rate swaps referencing Libor or
SIFMA. The arbitrage manifests itself in the form of a relatively cheap longer maturity
municipal bond, which is a municipal bond that yields significantly more than 65% of a
corresponding taxable corporate bond. The steeper slope of the municipal yield curve allows
participants to collect more after-tax income from the municipal bond portfolio than is spent
on the interest rate swap; the carry is greater than the hedge expense. Positive, tax-free carry
from muni arbitrageurs can reach into the double digits. The 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; they are both very high quality credits, have
the same maturity and are denominated in U.S. dollars. Credit risk and duration risk are
largely eliminated in this strategy. However, basis risk arises from use of an imperfect hedge,
which results in significant, but range-bound principal volatility. The end goal is to limit this
principal volatility, eliminating its relevance over time as the high, consistent, tax-free cash
flow accumulates. Since the inefficiency is related to government tax policy, and hence is
structural in nature, it has not been arbitraged away.
Note, however, that many municipal bonds are callable, and that this imposes substantial
additional risks to the strategy.
2.4) Convertible Bond Arbitrage
A convertible bond is a bond that an investor can return to the issuing company in exchange
for a predetermined number of shares in the company. A convertible bond can be thought of
as a corporate bond with a stock call option attached to it.
The price of a convertible bond is sensitive to three major 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 many cases, the
call option part of the convertible bond moves higher (since credit spread correlates with
volatility).
Given the complexity of the calculations involved and the convoluted structure that a
convertible bond can have, an arbitrageur often relies on sophisticated quantitative models in
order to identify bonds that are trading cheap versus their theoretical value.
Convertible arbitrage consists of buying a convertible bond and hedging two of the three
factors in order to gain exposure to the third factor at a very attractive price.
For instance an arbitrageur would first buy a convertible bond, then sell fixed income
securities or interest rate futures (to hedge the interest rate exposure) and buy some credit
protection (to hedge the risk of credit deterioration). Eventually what he'd be left with is
something similar to a call option on the underlying stock, acquired at a very low price. He
could then make money either selling some of the more expensive options that are openly
traded in the market or delta hedging his exposure to the underlying shares.
2.5) Depository Receipts
A depositary receipt is a security that is offered as a "tracking stock" on another foreign
market. For instance a Chinese company wishing to raise more money may issue a
depository receipt on the New York Stock Exchange, as the amount of capital on the local
exchanges is limited. These securities, known as ADRs (American depositary receipt) or
GDRs (global depository receipt) depending on where they are issued are typically
considered "foreign" and therefore trade at a lower value when first released. Many ADR's
are exchangeable into the original security (known as fungibility) and actually have the same
value. In this case there is a spread between the perceived value and real value, which can be
extracted. Other ADR's that are not exchangeable often have much larger spreads. Since the
ADR is trading at a value lower than what it is worth, one can purchase the ADR and expect
to make money as its value converges on the original. However there is a chance that the
original stock will fall in value too, so by shorting it one can hedge that risk.
2.6) Dual-Listed Companies
A dual-listed company (DLC) structure involves two companies incorporated in different
countries contractually agreeing to operate their businesses as if they were a single enterprise,
while retaining their separate legal identity and existing stock exchange listings. In integrated
and efficient financial markets, stock prices of the twin pair should move in lockstep. In
practice, DLC share prices exhibit large deviations from theoretical parity. Arbitrage
positions in DLCs can be set up by obtaining a long position in the relatively underpriced
part of the DLC and a short position in the relatively overpriced part. Such arbitrage
strategies start paying off as soon as the relative prices of the two DLC stocks converge
toward theoretical parity. However, since there is no identifiable date at which DLC 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 may
receive margin calls, after which they would most likely be forced to liquidate part of the
position at a highly unfavorable moment and suffer a loss. Arbitrage in DLCs may be
profitable, but is also very risky.
A good illustration of the risk of DLC arbitrage is the position in Royal Dutch Shell which
had a DLC structure until 2005 by the hedge fund Long-Term Capital Management(LTCM,
see also the discussion below). Lowenstein (2000) describes that LTCM established an
arbitrage position in Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at
an 8 to 10 percent premium. In total $2.3 billion was invested, half of which long in Shell
and the other half short in Royal Dutch. In the autumn of 1998 large defaults on Russian debt
created significant losses for the hedge fund and LTCM had to unwind several positions.
Lowenstein reports that the premium of Royal Dutch had increased to about 22 percent and
LTCM had to close the position and incur a loss. According to Lowenstein, LTCM lost $286
million in equity pair’s trading and more than half of this loss is accounted for by the Royal
Dutch Shell trade.
2.7) Private to Public Equities
The market prices for privately held companies are typically viewed from a return on
investment perspective (such as 25%), whilst publicly held and or exchange listed companies
trade on a Price to earnings ratio (P/E) (such as a P/E of 10, which equates to a 10% ROI).
Thus, if a publicly traded company specializes in the acquisition of privately held companies,
from a per-share perspective there is a gain with every acquisition that falls within these
guidelines. A hedge fund that is an example of this type of arbitrage is Green ridge Capital,
which acts as an angel investor retaining equity in private companies which are in the process
of becoming publicly traded, buying in the private market and later selling in the public
market. Private to public equities arbitrage is a term which can arguably be applied to
investment banking in general. Private markets to public markets differences may also help
explain the overnight windfall gains enjoyed by principals of companies that just did an
initial public offering (IPO).

CHP 3: WHAT IS ARBITRAGE TRADING?
3.1) Introduction
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, BSE and NSE. 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 scripts and ETFs in which price differentials exist
which can be exploited. Similarly, 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.
3.2) Types of Arbitrage Trades
Before 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. So, a price difference in
price of say HLL or Infy on BSE and NSE 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. So, if HLL is trading at Rs 465 on NSE and at Rs 470 on
BSE at the same time, you can simply buy the stock on NSE and sell at BSE, thus making a
profit of Rs 5 in the trade. Similarly, many times, you can find substantial price difference in
the ETF price on exchange and the price at which the ETF can be bought from the fund
house. There also you can just buy the ETF 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. Reason 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 liquid stocks, in which chances of trade
going through at given price are much higher than illiquid 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. Let us say price of
stock is Rs. 100 in spot market and 110 in futures market. To exploit this difference, he
would undertake following sequence of actions. First he would go long on spot market, i.e.
buy the stock at Rs. 100. Simultaneously he would sell the stock futures at Rs. 110. Moving
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. Or else, He can hold both the
positions till the expiry of the futures contract. Because 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 "carrying" or holding a position from the date of entering into the
transaction up to 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. So, 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. So, in above example, if the cost of carry is Rs. 3, then the net profit from the
arbitrage trade would be Rs 7.

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 Futures. 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. First, 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 special software provided by NSE for buying all 50 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. Second and ore complex arbitrage method is to
exploit the price differential between Nifty futures and underlying stock futures, which is
called Basis Arbitrage. In this situation, one can create a short position in Nifty futures and
simultaneously create long positions in Nifty's underlying stock futures, taking advantage of
the differential (basis) between the two.
Third popular arbitrage play is the reverse arbitrage. The strategy here is opposite of a regular
cash-futures 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. Generally, mutual funds are big players in
this category of arbitrage trading.

From institutional perspective, arbitrage between ADRs (American Depository Receipts) or
GDRs (Global Depository Receipts) and local shares are also an interesting segment of
arbitrage play. Because there is two-way fungibility allowed between ADRs/GDRs and local
listed shares, many FIIs convert these to India listed shares whenever ADRs/ GDRs 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
Most 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. From this perspective, arbitrage should be tried only in those assets which are highly
liquid. Secondly, interest rate fluctuations can make calculations go awry, as cost of carry is
an important link between prices in cash and future markets. Finally, trading circuit on
individual stocks and restriction on short selling for various market players create
impediments in exploitation of arbitrage opportunities.
• Automated Arbitrage Trade
Very often it is not possible for individuals to track multiple markets simultaneously and also
execute trades in quick succession. To address this problem, automated trading software
packages have come into being. It started with spot trading but quickly upgraded to
derivatives and arbitrage trading. These software’s identify price discrepancies across
markets on a real time basis and also execute automated trades depending upon parameters
passed by users. For example, ODIN™ Program Trading software by Financial Technologies
facilitates auto-execution 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. Because of the nature of inherent transactions, these funds are mostly
low risk investments. They generally generate returns in line with those of liquid 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. For example, over one year period
ending March 28, 2013, top one dozen 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.
3.3) Types of Risks Attached to Arbitrage Trade
Arbitrage transactions in modern securities markets involve fairly low day-to-day risks, but
can face extremely high risk in rare situations, particularly financial crises, and can lead to
bankruptcy. Formally, arbitrage transactions have negative skew prices can get a small
amount closer (but often no closer than 0), while they can get very far apart. The day-to-day
risks are generally small because the transactions involve small differences in price, so an
execution failure will generally cause a small loss (unless the trade is very big or the price
moves rapidly). The rare case risks are extremely high because these small price differences
are converted to large profits via leverage (borrowed money), and in the rare event of a large
price move, this may yield a large loss.
The main day-to-day risk is that part of the transaction fails – execution risk. The main rare
risks are counterparty risk and liquidity risk – that a counterparty to a large transaction or
many transactions fails to pay, or that one is required to post margin and does not have the
money to do so. In the academic literature, the idea that seemingly very low risk arbitrage
trades might not be fully exploited because of these risk factors and other considerations is
often referred to as limits to arbitrage.

• Execution risk
Generally it is impossible to close two or three transactions at the same instant; therefore,
there is the possibility that when one part of the deal is closed, a quick shift in prices makes it
impossible to close the other at a profitable price. However, this is not necessarily the case.
Many exchanges and inter-dealer brokers allow multi legged trades (e.g. basis block trades
on LIFFE).
Competition in the marketplace can also create risks during arbitrage transactions. As an
example, if one was trying to profit from a price discrepancy between IBM on the NYSE and
IBM on the London Stock Exchange, they may purchase a large number of shares on the
NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur
in an un-hedged risk position.
In the 1980s, risk arbitrage was common. In this form of speculation, one trades a security
that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to
be corrected by events. The standard example is the stock of a company, undervalued in the
stock market, which is about to be the object of a takeover bid; the price of the takeover will
more truly reflect the value of the company, giving a large profit to those who bought at the
current price—if the merger goes through as predicted. Traditionally, arbitrage transactions
in the securities markets involve high speed, high volume and low risk. At some moment a
price difference exists, and the problem is to execute two or three balancing transactions
while the difference persists (that is, before the other arbitrageurs act). When the transaction
involves a delay of weeks or months, as above, it may entail considerable risk if borrowed
money is used to magnify the reward through leverage. One way of reducing the risk is
through the illegal use of inside information, and in fact risk arbitrage with regard to
leveraged buyouts was associated with some of the famous financial scandals of the 1980s
such as those involving Michael Milken and Ivan Boesky.
• Mismatch
Another 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 narrowly referred to as a convergence trade. In the extreme case this is merger
arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an
operation can produce disastrous losses.
• Counterparty risk
As arbitrages generally involve future movements of cash, they are subject to counterparty
risk: if counterparty fails to fulfill their side of a transaction. This is a serious problem if one
has either a single trade or many related trades with a single counterparty, whose failure thus
poses a threat, or in the event of a financial crisis when many counterparties fail. This hazard
is serious because of the large quantities one must trade in order to make a profit on small
price differences.
For example, if one purchases many risky bonds, then hedges them with CDSes, profiting
from the difference between the bond spread and the CDS premium, in a financial crisis the
bonds may default and the CDS writer/seller may itself fail, due to the stress of the crisis,
causing the arbitrageur to face steep losses.

• Liquidity risk
Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a short position.
If the assets used are not identical (so a price divergence makes the trade temporarily lose
money), or the margin treatment is not identical, and the trader is accordingly required to
post margin (faces a margin call), the trader may run out of capital (if they run out of cash
and cannot borrow more) and be forced to sell these assets at a loss even though the trades
may be expected to ultimately make money. In effect, arbitrage traders synthesize a put
option on their ability to finance themselves.
Prices may diverge during a financial crisis, often termed a "flight to quality"; these are
precisely the times when it is hardest for leveraged investors to raise capital (due to overall
capital constraints), and thus they will lack capital precisely when they need it most.
CHP 4: 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. Many times, arbitrage is
considered to be risk-free as the two simultaneous acts automatically hedge the price risk of
the asset going up or down in value. Let’s take an example. Suppose Reliance Industries’
shares are trading at ₹860 on the BSE and at ₹862 on the NSE. One could simply purchase
the shares at ₹860 from the BSE and sell the same quantity at ₹862 on the NSE.
In most equity markets, the trader can immediately claim a profit of ₹2; however, since
cross-clearing has not been approved in India, the trader would need to sell the BSE shares
and purchase back the NSE shares within the same day to capture the ₹2 profit.
Due to arbitrage, the prices tend to converge andthe price of Reliance shares may overlap on
both the exchanges. At that point, the trader can execute his reversal trades. For example,
assume Reliance Industries is priced at ₹865 later in the same day.
• Cash-Futures Arbitrage
The trader would sell his shares at ₹865 on the BSE and purchase shares at the same price on
the NSE. He has now earned ₹2 in profit per share. Another common arbitrage strategy is the
Cash-Futures arbitrage. Suppose Reliance Industries equity is trading at ₹860 on the NSE,
and the near month Futures contract is trading at ₹870 on the NSE. The trader can buy the
underlying and sell the Futures contract.

Since Futures contracts are traded in lots, the trader should execute the same number of
shares. Since Reliance Industries has a lot size of 250, the trader could purchase 250 shares
of Reliance Industries at ₹860 and sell one lot of Reliance Futures at ₹870.
Now, the trader has two options. As the price difference between the Futures price and the
Equities price is ₹10, he needs to wait for the price difference to be lower than ₹10 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 Securities Transaction Tax for delivery shares (holding shares
overnight) is significantly higher than that on sale of shares within the same day (known as
intraday). So, it’s best to wait for the price difference to be below ₹10 within the same day.
• Patience pays
Suppose, later in the day, Reliance shares are trading at ₹864 and Reliance Futures, at ₹872.
He sells his 250 shares and buys one lot of Reliance Futures. He has now earned ₹2 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. Over time, you can
look to increase your position sizes.

CHP 5: ARBITRAGE AND SPECULATION
• Arbitrage
Arbitrage involves the simultaneous buying and selling of an asset in order to profit from
small differences in price. Often, arbitrageurs buy stock on one market (for example, a
financial market in the United States like the NYSE) while simultaneously selling the same
stock on a different market (such as the London Stock Exchange). In the United States, the
stock would be traded in US dollars, while in London; the stock would be traded in pounds.
As each market for the same stock moves, market inefficiencies, pricing mismatches and
even dollar/pound exchange rates can affect the prices temporarily. Arbitrage is not limited to
identical instruments; arbitrageurs can also take advantage of predictable relationships
between similar financial instruments, such as gold futures and the underlying price of
physical gold.
Since arbitrage involves the simultaneous buying and selling of an asset, it is essentially a
type of hedge and involves limited risk, when executed properly. Arbitrageurs typically enter
large positions since they are attempting to profit from very small differences in price.
• Speculation
Speculation, on the other hand, is a type financial strategy that involves a significant amount
of risk. Financial speculation can involve the trading of instruments such as bonds,
commodities, currencies and derivatives. Speculators attempt to profit from rising and falling
prices. A trader, for example, may open a long (buy) position in a stock index futures
contract with the expectation of profiting from rising prices. If the value of the index rises,
the trader may close the trade for a profit. Conversely, if the value of the index falls, the trade
might be closed for a loss.
Speculators may also attempt to profit from a falling market by shorting(selling short, or
simply "selling") the instrument. If prices drop, the position will be profitable. If prices rise,
however, the trade may be closed at a loss.

CONCLUSION
Arbitrage has many forms and encompasses many strategies; however, they all seek to take
advantage of increased chances of success. Many of the risk-free forms of pure arbitrage are
typically unavailable to retail traders, although several types of risk arbitrage do offer
significant profit opportunities to all arbitrageurs.
In the private sector, true arbitrage is completely hedged. In other words, both sides of the
transaction are guaranteed at the time the position is taken so there is no risk of loss.
Arbitrage differs from traditional investing in that profits are made by the trade itself, not
from the appreciation of a security. In fact, holding securities long enough for them to change
in value is generally considered a risk by the arbitrageur.
Riskless, or near riskless, profit opportunities without the need for actual work are so
attractive to arbitrageurs that they continue to search and exploit them using whatever means
necessary. In so doing, it appears that they also contribute to the smooth functioning of the
market.
APPENDIX/BIBLIOGRAPHY
 Books
Financial Market and Services - Gordan & Natrajan
Financial Management - PRASANNA CHANDRA
 Magazines
Business Today
Business world
Business India
 Webilography
http://www.investopedia.com/terms/a/arbitrage.asp
http://shabbir.in/arbitrage-trading/
http://www.indianinfoline.com
http://www.nseindia.com

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A STUDY ON ARBITRAGE 1

not true arbitrage (because they are risky).

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

strategies based on quantitative models.

in the theory of financial economics.

quickly eliminated; therefore the no arbitrage assumption is a reasonable one to build

financial theory on.

value of parent companies: an arbitrage opportunity existed and persisted.

academics, an arbitrage is a transaction that involves no negative cash flow at any

In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical

margins), some major (such as devaluation of a currency or derivative). In academic use, an

value or convergence trades), as in merger arbitrage.

commodities and currencies.

1.2) Conditions for Arbitrage

Arbitrage is possible when one of three conditions is met:

called 'execution risk' or more specifically 'leg risk'.

occurs by simultaneously buying in one and selling on the other.

CHP 2: TYPES OF ARBITRAGE

2.1) Spatial Arbitrage

arbitrage, an arbitrageurs looks for pricing discrepancies across geographically separate

2.2) Merger Arbitrage

2.3) Municipal Bond Arbitrage

arbitrageurs, this hedge fund strategy involves one of two approaches.

400 issues and a single issuer.

Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal

structural in nature, it has not been arbitraged away.

additional risks to the strategy.

2.4) Convertible Bond Arbitrage

as a corporate bond with a stock call option attached to it.

The price of a convertible bond is sensitive to three major factors:

aggregate tends to move lower).

price of the bond tends to rise.

2.5) Depository Receipts

A depositary receipt is a security that is offered as a "tracking stock" on another foreign

exchanges is limited. These securities, known as ADRs (American depositary receipt) or

2.6) Dual-Listed Companies

A dual-listed company (DLC) structure involves two companies incorporated in different

profitable, but is also very risky.

Dutch Shell trade.

2.7) Private to Public Equities

initial public offering (IPO).

CHP 3: WHAT IS ARBITRAGE TRADING?

arbitrage opportunity to emerge, prices of same commodity need to differ in different

presents arbitrage opportunity and is exploited by traders.

trade is carried simultaneously at different markets, theoretically there is no risk. In its

basis with careful exploitation of arbitrage opportunities.

3.2) Types of Arbitrage Trades

making a risk free profit.

arbitrage trade would be Rs 7.

price range discrepancy in cash and futures market.

the differential (basis) between the two.

this category of arbitrage trading.

From institutional perspective, arbitrage between ADRs (American Depository Receipts) or

• Operational Issues to Remember

impediments in exploitation of arbitrage opportunities.

• Automated Arbitrage Trade

In a nutshell, arbitrage trading is a well-developed but complex trading strategy which

investors. However, it must be undertaken with extreme caution because inherent

3.3) Types of Risks Attached to Arbitrage Trade

price move, this may yield a large loss.

often referred to as limits to arbitrage.

in an un-hedged risk position.