Arbitrage is a trading strategy that involves buying and selling the same or similar asset in different markets to profit from price differences. Arbitrageurs exploit market inefficiencies and help bring prices closer to their fair value. There are different types of arbitrage, such as pure arbitrage, merger arbitrage, and convertible arbitrage.
Pure arbitrage is the simplest form of arbitrage, where an asset is bought and sold simultaneously in two different markets at different prices. For example, if a stock is trading at $10 on the New York Stock Exchange and at $10.05 on the London Stock Exchange, an arbitrageur can buy the stock in New York and sell it in London, earning a risk-free profit of 5 cents per share.
Merger arbitrage is a type of arbitrage that involves buying and selling the stocks of two merging companies. When a merger is announced, the stock price of the target company usually rises, while the stock price of the acquirer company usually falls. An arbitrageur can buy the target company’s stock and sell the acquirer company’s stock, betting that the merger will be completed and the price gap will narrow.
Convertible arbitrage is a type of arbitrage that involves buying and selling a convertible security and its underlying stock. A convertible security is a bond or a preferred stock that can be converted into a fixed number of shares of common stock. An arbitrageur can buy the convertible security and sell short the underlying stock, hoping that the convertible security will increase in value while the stock will decrease in value.
Basic Theory:
The foundation of arbitrage lies in the principle that identical assets should have the same price in different
markets. If there is a discrepancy, traders can buy the undervalued asset in one market and sell it in another
where it is overvalued, thereby making a risk-free profit.
Procedures:
- Identify the Assets: Begin by identifying two or more identical assets traded in different
markets. - Calculate the Prices: Determine the prices of the assets in each market.
- Compare Prices: Identify any discrepancies in the prices of the assets. The goal is to find a
situation where the same asset is priced differently in different markets. - Execute Trades: Buy the undervalued asset in the market where it is cheaper and sell it in
the market where it is more expensive.
Scenario:
Let’s consider a scenario with Currency Exchange Rates. Assume you have the following exchange rates:
- USD to EUR: 1.10
- EUR to GBP: 0.90
- GBP to USD: 1.30
Now, calculate the cross rates (USD to GBP) using the formula: Cross Rate = (Rate1 / Rate2)
In this case, USD to GBP = (1.10 / 0.90) = 1.22
Suppose you find an opportunity where the market is offering a rate of 1.25 for USD to GBP. You can exploit this
discrepancy by buying GBP at the market rate (1.25) and immediately selling it at the calculated cross rate
(1.22).
Excel Calculation:
| A | B | C | D | |
|---|---|---|---|---|
| 1 | USD to EUR | EUR to GBP | GBP to USD | USD to GBP |
| 2 | 1.10 | 0.90 | 1.30 | =B2/C2 |
| 3 | Market Rate | 1.25 | ||
| 4 | Arbitrage | =D2-D3 |
Result:
The calculated arbitrage opportunity is 0.03 (1.22 – 1.25). You can profit by buying USD, converting it to GBP, and
then converting it back to USD, making a risk-free gain of 0.03.
Other Approaches:
- Triangular Arbitrage: Involves three currencies and exploits inconsistencies in exchange
rates. - Statistical Arbitrage: Utilizes statistical models to identify trading opportunities based
on historical data. - Options Arbitrage: Exploits mispricings in options and their underlying securities.
