What is Arbitrage?
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets like the picture shows above: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.
You’ll make profit as a result of market inefficiency. The process of buying low in one market and selling high in another market is called arbitrage. Arbitrage trades are made in stocks, commodities, and currencies.
Types of Arbitrage
There are two main types of arbitrage: Pure (True Arbitrage) and Risky Arbitrage. Pure arbitrage is a risk-free arbitrage while risk arbitrage is speculative arbitrage. Speculative, from the word speculation means that it depends on future events which may or may not happen hence it involves risk.
Riskless, Pure or “True” Arbitrage
In its purest form, arbitrage contains no element of risk. True arbitrage is a trading strategy that requires no investment of capital, cannot lose money, and the odds favor it making money. Any transaction or portfolio that is risk-free and makes a profit is also considered arbitrage.
Simplest is simultaneous purchase and sale of the same thing in different markets (Deardoff 2006).
Risk-less arbitrage is arbitrage when attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.
- Inward arbitrage: This form of arbitrage involves rearranging a bank’s cash by borrowing from the inter-bank market, and re-depositing the borrowed money locally at a higher interest rate.
- Outward arbitrage: This form of arbitrage involves the rearrangement of a bank’s cash by taking its local currency and depositing it into eurobanks.
- Triangular arbitrage: This is the process of converting one currency to another, converting it again to a third currency, and finally converting it back to the original currency within a short time span.
- Statistical arbitrage: This is an attempt to profit from pricing inefficiencies that are identified through the use of mathematical models.
- Pairs trading: Pairs trading, also known as relative-value arbitrage, is a far less common form (Reverre 2001).
- Takeover and merger arbitrage: This typically involves an undervalued business that has been targeted by another corporation for a takeover bid.
By identifying a company targeted for takeover arbitrageurs can buy stock at the pre-takeover price and sell them after the takeover has been completed at the higher price. If the merger or takeover goes through successfully, all those who took advantage of the opportunity make a significant profit; if it falls through, however, the price usually falls. That is, the element of risk that is always there.