What is Arbitrage?

What is Arbitrage?

Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset’s listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms.

Arbitrage exists as a result of market inefficiencies and it both exploits those inefficiencies and resolves them.

Arbitrage is the simultaneous purchase and sale of an asset in different markets to exploit tiny differences in their prices.

Arbitrage trades are made in stocks, commodities, and currencies.

Arbitrage takes advantage of the inevitable inefficiencies in markets.

Types of arbitrage

1. Pure Arbitrage

Pure arbitrage refers to the investment strategy above, in which an investor simultaneously buys and sells a security in different markets to take advantage of a price difference. As such, the terms “arbitrage” and “pure arbitrage” are often used interchangeably.

Many investments can be bought and sold in several markets. For example, a large multinational company may list its stock on multiple exchanges, such as the New York Stock Exchange (NYSE) and London Stock Exchange. Whenever an asset is traded in multiple markets, it’s possible prices will temporarily fall out of sync. It’s when this price difference exists that pure arbitrage becomes possible.

Pure arbitrage is also possible in instances where foreign exchange rates lead to pricing discrepancies, however small.

Ultimately, pure arbitrage is a strategy in which an investor takes advantage of inefficiencies within the market. As technology has advanced and trading has become increasingly digitized, it’s grown more difficult to take advantage of these scenarios, as pricing errors can now be rapidly identified and resolved. This means the potential for pure arbitrage has become a rare occurrence.

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2. Merger Arbitrage

Merger arbitrage is a type of arbitrage related to merging entities, such as two publicly traded businesses.

Generally speaking, a merger consists of two parties: the acquiring company and its target. If the target company is a publicly traded entity, then the acquiring company must purchase the outstanding share of said company. In most cases, this is at a premium to what the stock is trading for at the time of the announcement, leading to a profit for shareholders. As the deal becomes public, traders looking to profit from the deal purchase the target company’s stock—driving it closer to the announced deal price.

The target company’s price rarely matches the deal price, however, it often trades at a slight discount. This is due to the risk that the deal may fall through or fail. Deals can fail for several reasons, including changing market conditions or a refusal of the deal by regulatory bodies, such as the Federal Trade Commission (FTC) or Department of Justice (DOJ).

In its most basic form, merger arbitrage involves an investor purchasing shares of the target company at its discounted price, then profiting once the deal goes through. Yet, there are other forms of merger arbitrage. An investor who believes a deal may fall through or fail, for example, might choose to short shares of the target company’s stock.

3. Convertible Arbitrage

Convertible arbitrage is a form of arbitrage related to convertible bonds, also called convertible notes or convertible debt.

A convertible bond is, at its heart, just like any other bond: It’s a form of corporate debt that yields interest payments to the bondholder. The primary difference between a convertible bond and a traditional bond is that, with a convertible bond, the bondholder has the option to convert it into shares of the underlying company at a later date, often at a discounted rate. Companies issue convertible bonds because doing so allows them to offer lower interest payments.

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Investors who engage in convertible arbitrage seek to take advantage of the difference between the bond’s conversion price and the current price of the underlying company’s shares. This is typically achieved by taking simultaneous positions—long and short—in the convertible note and underlying shares of the company.

Which positions the investor takes and the ratio of buys and sells depends on whether the investor believes the bond to be fairly priced. In cases where the bond is considered to be cheap, they usually take a short position on the stock and a long position on the bond. On the other hand, if the investor believes the bond to be overpriced, or rich, they might take a long position on the stock and a short position on the bond.

Trading with Arbitrage

Even though this a simple strategy very few – if any – investment funds rely solely on such a strategy. This fact can be explained by the difficulties associated with exploiting the commonly short-lived situation.

With the rise of electronic trading, which can execute trade orders within a fraction of a second, mispriced asset differences occur for a minuscule amount of time. The improved trading speed has, in this sense, improved the efficiency of markets.

In addition, equal assets with different prices generally show a small difference in price, smaller than the transaction costs of an arbitrage trade would be. This effectively negates the arbitrage opportunity.

Arbitrage is generally exploited by large financial institutions because it requires significant resources to identify the opportunities and execute the trades.

They are often performed with the use of complex financial instruments, such as derivative contracts and other forms of synthetic instruments, to find equivalent assets. Derivative trading frequently involves margin trading and a large amount of cash required to execute the trades.

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Why Is Arbitrage Important?

In the course of making a profit, arbitrage traders enhance the efficiency of the financial markets. As they buy and sell, the price differences between identical or similar assets narrow.

The lower-priced assets are bid up while the higher-priced assets are sold off. In this manner, arbitrage resolves inefficiencies in the market’s pricing and adds liquidity to the market.

Examples of Arbitrage

The standard definition of arbitrage involves buying and selling shares of stock, commodities, or currencies on multiple markets in order to profit from inevitable differences in their prices from minute to minute.

However, the word arbitrage is also sometimes used to describe other trading activities. Merger arbitrage, which involves buying shares in companies prior to an announced or expected merger, is one strategy that is popular among hedge fund investors.

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