What is Arbitrage? The Features and Benefits of Arbitrage

Arbitrage is the practice of taking advantage of price differences between two or more markets. Arbitragers are traders who take on positions in one market and simultaneously sell them at a higher price in another, thereby earning profits from the difference between the prices. The term "arbitrage" comes from French for "to arbitrate", which means to settle an argument by arbitration. In finance, it refers to buying securities that have been issued with borrowed money and selling those same securities back into the capital markets using proceeds from their sale.

This strategy can be used as a hedge against inflation or deflation. It also allows investors to profit when interest rates differ across countries. However, this technique may not always work because there could be adverse selection problems where only riskier borrowers borrow funds; thus, the borrower's creditworthiness will affect the value of his/her assets.


Also, if the asset being sold has no liquidity, then the buyer must pay a premium over its current market price to obtain it. If the asset does have some liquidity, but the seller wants immediate payment, he/she might accept less than what they would receive in the open market.

In general, arbitrageurs seek to exploit small discrepancies in pricing information among different financial instruments so that they can make trades without having to worry about changes in relative values due to time-varying factors such as supply and demand. For example, suppose you want to buy 100 shares of IBM stock today, paying $100 per share. You find out that someone else bought 500 shares yesterday for $50 each.

Since you know how much IBM stock costs, you realize that your purchase was profitable: you made a gain of $450. On the other hand, if you had found out that the person who purchased the 500 shares actually paid $60 instead of $50, you would still have lost $350 since you now own fewer shares than before. Thus, knowing the true cost of the stocks helps prevent losses through arbitrage.

Features of Arbitrage

The following features help identify potential opportunities for arbitrage trading:

  • A large spread between bid and ask prices.

  • An imbalance between buyers and sellers.

  • Liquidity – ability to quickly convert cash into the desired security.

  • No transaction fees.

  • Low correlation with other investments.

  • High return on investment.

How do they work?

The term "arbitrage" means the purchase and sale of a security at two different prices on one or more exchanges, where such purchases are made to cover sales previously effected.

b. It is not unlawful for any person who has been engaged in an arbitrage transaction involving securities registered under this chapter to engage thereafter in transactions with respect thereto which would be lawful if conducted by him prior to his engagement in the first-mentioned transactions.

This section provides protection for persons engaging in arbitrage activities. Under Section 10, a broker cannot trade after purchasing a security unless it sells within five days. A dealer cannot trade after acquiring a security unless it resells within seven days. These provisions were enacted to protect retail customers from excessive markups charged by brokers and dealers. They apply even though the customer did not initiate the transaction.


c. No commission shall be payable upon any contract entered into pursuant to subsection of this section except commissions incurred in connection with orders placed for delivery during the period beginning thirty minutes before and ending fifteen minutes after the close of business on the day preceding the date fixed for settlement of accounts.

d. Any person violating any provision of this section shall forfeit all moneys received by reason thereof, together with all brokerage commissions earned thereon. e. The Commission may prescribe rules and regulations necessary to carry out the purposes of this section. Such rules and regulations shall include reasonable requirements designed to insure fair dealing and just treatment of investors, including those relating to disclosure of material facts concerning transactions in securities.

e. Nothing contained herein shall affect the right of any party aggrieved thereby to maintain suit against any officer, director, member, agent or employee of any corporation involved in violation of any rule or regulation prescribed hereunder.

f. This section does not prohibit bona fide hedging transactions nor transactions otherwise authorized by law.

Benefits of Arbitrage

Arbitrage can reduce risk because it allows traders to take advantage of price differences across markets. For example, suppose that you want to buy 100 shares of IBM but find that the best offer available is only 50% higher than what you could get elsewhere. If you sell some of your holdings immediately, you will make money as long as the difference between the market price and the amount you sold exceeds the cost of buying back the shares. In other words, you have created value through arbitrage.

Arbitrage also reduces costs because it enables traders to avoid paying fees when they execute trades. When trading stocks, many brokers charge a fee each time a trader buys or sells stock. By using arbitrage, however, a trader avoids these charges since he executes both sides of the same order simultaneously. Thus, arbitrage helps keep prices more stable.

In addition, arbitrage makes sense economically. Suppose that two companies are selling their products at different prices. One company's product is much better than another's so its sales should exceed the latter's. However, if one company's sales fall below expectations while the other rises above them, then the excess profits must come from somewhere. It comes either from an increase in production or from a decrease in demand. Either way, the result is profit. But if the low-price company increases its output without reducing its price, then the high-price company would lose money. So, if the low-price firm raises its price, then the firms' combined revenues will rise. And if the high-priced firm lowers its price, then the total revenue will decline. Therefore, the firms' combined revenues remain unchanged.

The net effect is that the low-price firm loses less money than expected, which means that it has made a profit. Similarly, the high-price firm gains less than anticipated, which implies that it too has profited.

As a consequence, arbitrage provides economic benefits.

  • First, it keeps prices closer to equilibrium levels.

  • Second, it prevents overproduction on the part of producers.

  • It encourages efficient allocation of resources among competing uses.

  • It promotes competition among sellers.

  • It discourages monopolies.

  • It facilitates international trade.

  • It creates incentives for innovation.

  • It fosters efficiency.

  • It enhances productivity.

  • It improves financial stability.

  • It supports investment decisions.

  • It stimulates entrepreneurship.

  • It contributes to growth.

  • It leads to greater equality.

  • It spurs technological progress.

  • It strengthens national economies.

  • It boosts employment rates.

  • It generates tax receipts.

  • It protects consumers against inflationary pressures.

  • It preserves jobs.

The most common form of arbitrage involves transactions involving securities listed on foreign exchanges.

Cons

It may be difficult to identify opportunities for arbitrage. The process requires extensive research into various aspects of the economy. This work often takes place during off hours.

There is no guarantee that arbitrage will always pay off. Sometimes, even though there is a discrepancy in prices, neither side will change his position.

If the opportunity for arbitrage does not exist, then the situation becomes unstable. For example, suppose that A and B sell goods at $1 per unit and C purchases those goods at $2 per unit. Then, if A and B raise their prices by 1 cent, C will buy fewer units. In this case, the market value of all three items declines by 2 cents.

If you want to use arbitrage as a strategy, make sure that your analysis includes all relevant factors. Otherwise, you might miss out on some profitable deals.

Conclusion

Arbitrage can help stabilize markets. If both sides agree to engage in arbitrage, they will have little incentive to cheat each other.