If something could be profitable just because of tiny market inefficiencies, you’d want to know how to exploit it, wouldn’t you? And if the process involves little to no inherent risk, you’d probably want to do more of it.
That’s the bottom line of the arbitrage game. Some have become masters of the craft while others find it bewildering.
What is Arbitrage?
Arbitrage is about taking advantage. I’ll buy an investment from one market and sell it, at the same time, at a higher price in another. That means I profit from the difference between the prices in the two markets.
Here, market inefficiencies are our efficiency.
Discrepancies are the key to profiting, and we’re capitalizing on the imbalance between market prices.
Simply put we buy the low priced asset in one market and sell the same high priced asset in another market. But we need to buy and sell at the same time, or almost simultaneously for this strategy to work properly.
The key is to avoid exposure to market risks. Thus, the urgency.
You see, prices can change in the market even before you complete a transaction. While it sounds highly-profitable, arbitrage opportunities can be eliminated in seconds due to advances in technology.
Arbitrage, or simply “arb,” involves the trading of:
Arbitrageurs are the people who engage in arbitrage. Or “arbers” for short.
Legal? Yes. You’re simply exploiting the price differences in the market so no need to be guilty.
Timing is Crucial For Arbitrage
Now, imbalances in price are short-lived. Powerful computers and trading algorithms discover them quickly.
For simultaneous buying and selling, you’ll need an automated mechanism. Otherwise, it’s almost impossible.
Transactions need to be microseconds apart since price fluctuations can swiftly occur.
You see, it’s only in theory that arbitrage is totally riskless. It’s always been said that pure arbitrage involves no market risks. But, is anything truly pure these days?
A Simple Example
Gold is selling at 1300 USD in Australia and 1350 USD in London. You could buy it in Australia, then sell it immediately in London.
Assuming you can execute that without complications, you’ve just gained $50 USD in profits once the two prices converge. Depending on the liquidity of the asset sometimes this divergence in prices can last for days or weeks.
But can you?
Wall Street traders use arbitrage frequently. They use costly databases and software programs that look for opportunities. These execute the trades automatically and within nanoseconds.
They’ve got serious computing power.
Suppose you don’t have the same capacity. And you just want to try arbitrage in principle.
In arbitrage you are simultaneously long an asset in one market and short the same asset trading in different market. When the prices converge you reverse the two trades. The essence is that you never have any exposure to the market.
Arbitrage is Less Simple on Security Exchanges
On security exchanges, however, price variations are quite narrower — if they happen at all. Here, everybody knows what everyone else is doing.
So your most significant opportunity lies in using trading software that is powerful enough to detect even minute variations in prices, and then exploit them.
But it can cost you.
Imagine using an automatic trade-alert and remote-alert software. It can cost thousands of dollars. And it wouldn’t even be as powerful as the commercial-grade software those big hedge funds and investment banks use.
These software giants can detect small price fluctuations that last only a few seconds. No need to run manual calculations.
Without some sort of automated software, capitalizing on stock market arbitrage — or anything near this sort — is a near impossibility.
The opportunities don’t last long.
Up to you to up your game.
Types of Financial Arbitrage
So, I’ve already mentioned a few examples without attempting to categorize them formally. This time, you’ll have to crack your head to get to know the various types of financial arbitrage.
Note, this practice isn’t about financial trading so much as rigging the odds against multiple online bookkeepers, fun to think about nonetheless and still legal.
You engage in arbitrage betting or “arbing” by placing multiple bets. Then you’ll guarantee yourself a profit regardless of the outcome.
Let’s try that again. You place your bets on all the possible outcomes at odds that guarantee a profit. Yep, one bet per each outcome. Whatever comes out, you’ll have your gain.
We call these guarantees “sure wins” or “miracle bets” or simply “arbs,” as we generally do.
And we’ve got betting markets to cater to this type of arbitrage.
But this is not the get-rich-quick scheme that some morons are looking for. Like I said before, you need to compose yourself and stay patient when arbing.
Arbing involves large sums of money, and 98% of arbitrage opportunities would typically return less than 1.2% only.
Also, hackers and scammers swarm the markets to trick bettors like you into providing your security credentials. Not fun.
So, to avoid detection by bookmakers, arbers sometimes use VPNs meant for arbing. The eager ones can indeed win.
And you don’t need to be a world cup fan to do arbing.
Covered Interest Arbitrage
Now this one’s about arbitraging the interest rate differences to hedge the interest rate risk in currency markets.
The process can be complicated and might not be totally worth it as it offers low returns. Especially in competitive markets.
Again, you’re going to use a forward contract to hedge yourself against an exchange rate risk.
You capitalize on the difference in the interest rates between two countries using a forward contract. This contract would be your cover against exposure to exchange rate risks.
With forward contracts, you can make use of forward-premiums so you can earn a “riskless” profit from the difference between the interest rates between the two countries.
The opportunity comes from the fact that the interest rate parity condition does not always hold. Not constantly, I mean.
So, this is about investing in whichever currency offers a higher rate of return.
To execute, you exchange domestic currency for foreign currency using the spot exchange rate. Then you invest the foreign money at the foreign interest rate.
At the same time, you work on a forward contract so you can sell the amount of the future value of your foreign investment. At a date that agrees with the foreign investment’s date of maturity. And then, you receive the domestic currency in exchange for the foreign-currency funds.
Fixed Income Arbitrage
Fixed-income arbitrage is generally associated with hedge funds. It exploits the inefficiencies in the pricing of bonds.
And it can yield a fixed stream of income. It’s also used mostly in global trading.
It’s about profiting from temporary price differences in bonds and interest-rate securities. So, you’re going to purchase a security at a low price. Then, of course, you sell it at a higher price within seconds.
If you want to receive fixed returns for an agreed period, you’ll like this kind of arbitrage. Despite it being risky.
A security’s price may decrease, and you could suffer losses, or your issuer might not be able to maintain their fixed payments. Or, they might not be able to pay your investment in full by the term’s end.
To profit significantly, you need to be a fast trader. And it helps to have an investment experience that’s already extensive.
This trading strategy makes use of estimates of future political activity or knowledge of it so one could forecast and discount security values.
Impending elections, for example, can trigger political arbitrage activities in a specific state. Another significant trigger is a threat of war. And this can involve a couple or more countries.
Say, for instance, that the majority of the winning political leaders in a country are not business-friendly. Consequently, you might anticipate a steep decline and short the benchmark equity index of that country.
Meanwhile, in the case of a coming conflict in the Middle East, you may short stocks of oil companies from this region and have long positions with oil companies from others.
How profitable your move turns out depends on the final political outcomes.
Risk / Merger Arbitrage
The term risk arbitrage seems ironic in its very core. Arbitrage is supposed to be riskless, but this one version of it depends on a risky corporate development and not on a successful business transaction.
Anyhow, risk arbitrage, or merger arbitrage is about exploiting the pricing inefficiencies caused by a corporate event.
And it applies to both mergers and acquisitions.
A merger occurs when two companies combine into one new company, while an acquisition occurs when one company buys another company.
And you can only use merger arbitrage when public companies are involved.
Usually, the merger will benefit one company and hurt the other. Then, the prices will reflect this situation in the stock’s prices.
It’s a type of event-driven investing.
Basically, you can profit by simultaneously purchasing and selling stocks of two merging companies. You’ll be buying the stock before the acquisition. And then you’ll make a profit after the acquisition is completed.
Regular portfolio managers would focus on the profitability of the merger. Meanwhile, merger arbitrageurs would focus on the probability of the merger being approved.
But the deal may eventually break. So it carries some risk. That’s why it’s called risk arbitrage in the first place.
Well, it’s a popular strategy among hedge funds.
Here’s how it usually goes. A company intends to purchase another, announces it. The stock price of the acquirer declines typically. The stock price of the target rises (but not to the offer price yet).
The company’s stock price remains slightly below the cost of acquisition.
You buy the target’s stocks. You short-sell the acquirer’s stocks.
And you’ll be speculating the completion of company acquisitions and mergers.
Now, rather than being passive, some active arbers buy enough stocks in the target to control the merger’s outcome.
The constraint here is in the transaction costs. You could generate high returns, but the high price of trades can negate the profits significantly.
Again, up to you.
We commonly refer to this type of arbitrage as Stat Arb or StatArb. It’s one of those arbs that require rather sophisticated data mining and statistical methods, so it might not be for weaker minds.
Yep, it’s a heavily quantitative strategy. A computational approach to securities trading. A rigorous approach to investing where the math can be overwhelming.
For starters, StatArb uses mean reversion analyses in diversified portfolios of securities that are held for short periods — lasting seconds to days.
Those who successfully mine profits in StatArb use automated trading systems, using sophisticated statistical models to find arbitrage. And it requires significant computational power.
It uses the basic concept of pairs trading that involves two correlated companies. Here, the underperforming stock is bought long while the outperforming stock is sold short.
You expect the underperforming stock to be on par with its outperforming partner later. You trade when these two stocks get out of sync of one another.
Now StatArb considers not only a pair of stocks. It’s not limited to just two. It works for a group of correlated securities that are not necessarily from the same industries. It considers a portfolio of hundreds. They’re matched by sector and region, so exposure to beta and other risk factors are eliminated.
Obviously, it involves huge risks.
To profit, you need to take advantage of high-frequency trading algorithms. Just to catch small inefficiencies lasting for just milliseconds.
StatArb is also subject to model weakness. As well as to risks based on the stocks or the securities themselves.
And so, it requires continual updating of the models.
Even so, StatArb faces different regulations in different countries. In China, for instance, it’s not the mainstream investment approach. They have restrictions on short selling, which sets obstacles to individuals and institutions alike when trying to apply the StatArb-based strategies.
A triangle has three points, three angles, and three sides. In triangular arbitrage, three foreign currencies are involved.
The opportunity comes whenever currency exchange rates don’t match up exactly. Whenever the exchange rate of a currency doesn’t match the cross-exchange rate. Whenever there are discrepancies in the quoted prices.
So, it involves a consecutive exchange of one currency to another.
You can gain a net profit assuming low transaction costs. So, it’s basically riskless.
Consider this example involving the US dollar, euro, and pound sterling. Assume the following exchange rates in different markets:
1 USD = 0.9113 EUR or USD/EUR = 0.9113
1 EUR = 0.8900 GBP or EUR/GBP = 0.8900
1 GBP = 1.2359 USD or GBP/USD = 1.2359
The cross-rate for GBP/EUR = 1/(EUR/GBP) = 1/(1.2359 x 0.9113) = 0.8879. Supposedly.
If you compare this calculation with the quoted price, you’ll find that the EUR/GBP rate is overvalued.
Now suppose you have $1,000,000. You can profit from these discrepancies if you do the following:
- Sell USD for EUR: $1,000,000 x 0.9113 = €911,300.
- Sell EUR for GBP: €911,300 x 0.8900 = £811,057.
- Sell GBP for USD: £811,057 x 1.2359 = $1,002,385.35.
And just like that, you got $2,385.35 in profits. In an instant.
But, you need to trade a substantial capital for your gains to even be significant. Note that the difference in these exchange rates is only in fractions of a cent.
Plus, you have to account for the transaction costs. So your net profit can become smaller. High transaction costs can quickly erase your gains from the price discrepancies.
Also, you’ll need to have some advanced equipment to automate the exchange of currencies. Moreover, you need to use high-speed algorithms to spot mispricing to execute the triple exchange immediately.
Otherwise, the arbitrage opportunity would vanish immediately.
In fact, opportunities rarely exists in the real world as competitions in the markets constantly correct the market inefficiencies on currency exchange.
Ironically though, high-frequency traders make the markets even more efficient.
Still, the principle behind triangular arbitrage provides cryptocurrency applications.
So, more arbitrage opportunities exist in cryptocurrency markets than in traditional markets.
Uncovered Interest Arbitrage
This, perhaps, is the riskiest form of arbitrage. It assumes you can correctly guess the future spot exchange rate in a particular country.
And it uses no hedging.
Uncovered interest arbitrage involves exchanging one currency for another.
And you aim to earn higher interest returns due to a difference in the interest rates between two currencies. You capitalize on this difference.
Your money is invested abroad at a higher interest rate to profit.
As opposed to covered interest arbitrage, the uncovered interest arb doesn’t involve the hedging of foreign exchange risks using forward contracts or anything similar.
The strategy here welcomes risk by exposing yourself to fluctuations in the exchange rate. You’re speculating that these rates would stay in your favor for the arb to be profitable.
Note that the interest rate on investments in a particular country won’t always be equal to the interest rate on investments using foreign currencies plus the expected appreciation rate.
Vol arb or volatility arbitrage is a type of statistical arbitrage. The unit of relative measure here is the volatility rather than the price. And you’re looking at the difference between the forecasted and implied volatilities.
Essentially, you’re comparing the forecasted future price-volatility of an asset vs. the implied volatility of the options based on the asset.
So, you are attempting to buy volatility while it’s low and sell it when it’s high.
Let’s say it another way. You have a forecast of volatility, and you can measure an option’s market price through the implied volatility. You can then begin a vol arb trade.
You’re looking at options where the implied volatility is either one of two conditions. Significantly higher than or lower than the forecast realized volatility for the underlying.
Suppose it’s the first condition. You buy the option then hedge with the underlying, so you can have a delta-neutral portfolio.
If it’s the second condition, you sell the option and then hedge the position.
During the holding period, you will realize a profit on the trade if the underlying’s realized volatility is closer to your forecast. That is, compared to the implied volatility — which is the market’s forecast.
You continually re-hedge and keep your portfolio delta-neutral so you can extract profit from the trade.
Again, your goal is to take advantage of the differences between the two financial instruments. Here, it’s the implied volatility of the option vs. a prediction of the future realized volatility of the option’s underlying.
Municipal Bond Arbitrage
In the case of muni arb, you’re building a portfolio of tax-exempt municipal bonds. Then at the same time, you’re going to hedge the duration risk of the portfolio.
Here, you seek to minimize credit and duration risk.
Now note that interest on municipal bonds is exempt from federal income tax. And this is why you can receive an after-tax income from your municipal bond portfolio. This would be higher than the interest paid on the interest rate swap.
If you belong to those in high income-tax brackets, muni arb can be an especially attractive option.
It’s often considered low-risk, plus there’s very little to no negative cash flow.
Just try to purchase a set of high-quality municipal bonds. And choose those that are tax-exempt.
Private to Public Equities
We look at the market prices for private companies in terms of their ROI. On the other hand, we view publicly-listed companies in terms of their P/E or price-to-earnings ratio.
If a public company has a hobby of acquiring private entities, then using a per-share perspective, then there are gains per acquisition.
So, the principle behind private to public equities arbitrage applies to investment banking. Generally.
Now you know how principals of companies enjoy huge gains overnight when they make an IPO.
Regarb is a trickster’s favorite. If you like evading cancer, it’s highly likely that you’ve already been doing this. In principle.
After all, this is about evading unwelcome regulation in a specific locality. It’s avoiding the capital adequacy requirements by banks.
Banks require you to have adequate capital. But some regimes are more lenient with a lower amount of money needed.
You want to avoid the more stringent requirement?
Look for more favorable laws in one place, then circumvent regulations elsewhere.
The term “regulatory arbitrage” ‘also applies to the structuring or relocating of transactions to choose the least burdensome regulator. That’s why this is better described as regulator shopping.
Regulatory arbitrage can transform how assets are treated. Here, you’re using internal and external differences in business activity to win for yourself.
You capitalize on loopholes in regulatory systems. You take advantage of tax havens. In other words, you benefit from the differences in regulation in different jurisdictions.
What Makes Arbitrage Attainable
Three fundamental conditions make arbitrage attainable.
1. Assets don’t trade at the same price in all markets.
Consider one asset. Suppose it trades for different prices in various markets.
Let’s say stock Y is trading at $50 per share on the NYSE, while it’s trading on a foreign market at $50.25 per share. Little difference, or so it seems.
Suppose you buy the stock for the lower price and sell it for the higher one at the same time.
You immediately gain $0.25 per share. Use the power of multiplication, and you have considerable profits.
Well, this example isn’t typical in the real world. Arbitrage opportunities like the one I just described can happen but last only for a few seconds.
Also, there are opportunity costs. You’ll have some time spent sourcing lower-priced goods and researching for the competing market prices. There’s also the risk of a stock losing its value after the initial purchase.
2. Assets with the same cash flow trade for different prices.
Consider two bonds that sell for different prices. Bond A sells for $800 and Bond B, for $820. They both pay $40 in interest yearly.
So, what you have right there is another type of an arbitrage opportunity.
To profit, you buy the cheaper one and then sell the more expensive one.
3. Assets with an identifiable future price don’t trade at a discount today.
Assume that in one month, Company M is going to be acquired by Company N. For $200 per share.
The deal’s already approved, but the stock trades at $195 per share.
Once again, an arbitrage opportunity.
What you can do is to purchase shares. Then, hold it until the acquisition is final. Once it’s finalized, you can make a profit of $5 per share.
Effects of Arbitrage in Different Markets
One significant natural impact of arbitrage activities is price convergence. As traders continue to buy from the cheaper market to sell on another, the supply-and-demand ratio shifts.
Suppose you’ve been buying product X from Market A. You’re selling it in Market B. Again, you profit from the price difference.
Now, you continue to do this because you’re becoming greedier about gaining more. Others begin mimicking your strategy.
As the arbitrage transactions increase, demand for product X grows in Market A. Of course, you’re constantly buying from there. Meanwhile, supply increases in Market B.
In the language of economics, it’s illogical for the same asset to trade at varying prices. Eventually, the two prices must converge.
While the above is a very simplified example, it explains the principle.
Consider the trade of goods, commodities, securities, and currencies on the international level.
Arbitrage opportunities in these financial instruments tend to affect exchange rates.
Is arbitrage risk-free? No.
Risk-free is a misinterpretation. You’re just not aware of the potential dangers or simply do not disclose them.
To be fair, pure arbitrage opportunities don’t have any risk. Not inherently, not internally.
Think about the opportunities you could afford if you can sell what you don’t have.
But these pure arbitrage opportunities don’t present themselves very often.
Risks exist in the real world, and ideal situations do not exist. So arbitrage funds are not totally risk-free. But you got to stack the odds in your favor.
Simultaneously is inaccurate. Think about how impossible it is to close two or three transactions in one blink of an eye. Especially if you don’t have powerful tools.
“Perfect” execution is like buying with one hand and selling with the other.
But during the process, prices can quickly shift. Even the slightest change can wash away your gains. Worse, it might cause one heck of a loss.
Plus, there’s always competition in real-world markets. And this can create risks during an arbitrage transaction. Or an attempt of it.
Consider a convergence trade. You’re buying one asset forward (going long) while selling a similar asset (going short) but for a higher price.
Upon delivery, the prices will have converged or become close to equal. And you’re supposed to profit from the convergence.
But note that the items you’re buying and selling here are not identical. Instead, you’re conducting an arbitrage transaction based on the assumption that the prices of these items are correlated.
If the assumption doesn’t match with reality, imagine what losses you’d have to suffer.
Since future movements are usually involved in arbitrage trades, they’re subject to counterparty risk. In this case, the counterparty simply fails to fulfill their side of the transaction.
That poses a serious problem.
For instance, you purchase many risky bonds, then hedge them with CDSes. You profit from the bond spread and the CDS premium.
But during a financial crisis, the bonds may default. The CDS itself can fail, so you, the arbitrageur, can face steep losses.
Liquidity risk is involved if either the assets used or the margin treatment is not identical.
You could face a margin call and eventually run out of capital. You don’t have cash and can’t borrow any more. So, you’d be forced to sell your assets at a significant loss.
Any long-term investment requires a mix of patience and impatience. Patience for the right opportunity as well as eagerness to execute an arbitrage trade right away.
Now, you can begin watching the market or have some software to do it for you. In whatever way you’d want to approach it, arbitrage can be profitable. Only tricky.
So, choose to be wise about it. Or be willing to shed more dollars. You can then share with us once you’ve made your capital work for you.
Join Over 30,000 Investors Getting Unique, Unfiltered Analysis Of Events Shaping Our World.