What is Arbitrage?

Notes from the video ‘Diffusion Academy| Finance |What is Arbitrage?‘ :

What is an Arbitrage?

Arbitrage is the process of simultaneously buying and selling an asset to profit from the differences in the price of the asset.

Let’s take a look at how arbitrage works in a simplified example.

Imagine we are living in City A.

City A has two markets – market A and B.

In market A, the shops are selling berries at $30 per kilogram.

And just down the street in Market B, the shops are selling berries at $40 per kilogram.

However, most people buying berries in market B don’t know that they could buy berries at a much cheaper price at market A.

And if they knew, they will probably walk to market A to buy the cheaper berries.

The difference in prices is because of imperfect information.

 

As a smart businessman, you decide to take advantage of this.

So, every morning, you go to market A to buy the berries at a cheaper price and go to market B to sell the berries at a higher price.

For every kilogram of berries you sell, you earn a risk-free profit of $10 from the price difference in the markets.

In fact, in the next few months, you became so successful that you start buying large quantities of berries in market A and selling them in market B.

This affects the demand and supply of berries in market A and B respectively.

The demand of berries in market A increases so their price increases in Market A and the supply of berries in market B increase so their price decreases in market B.

Eventually, the prices of the berries in the two markets will become so close together that you can’t make a profit from their price differences.

 

Something similar happens in the financial marketplace as well.

A company stock could be trading on the New York Stock Exchange for $1.00 per share and trading on the London Stock Exchange for $1.05 per share.

An arbitrageur could pocket the difference of $0.05 per share by buying the stock for $1.00 on the New York Stock Exchange and selling it on the London Stock exchange.

Such arbitrage opportunities arise usually because of imperfect information.

Arbitrage is often called “riskless profit” because it’s theoretically a riskless activity – traders are buying and selling the same asset simultaneously and pocketing the price difference as profit.

 

However, the modern technology has significantly reduced arbitrage opportunities.

The advancement of technology has led to the advent of automated trading systems programmed to monitor fluctuations or price differences in similar financial instruments.

These systems are able to detect and act on the inefficient pricing setups so rapidly that the price difference of similar financial instruments, and arbitrage opportunity, is quickly eliminated.

 

There is also another type of arbitrage: risk arbitrage.

Risk arbitrages aren’t arbitrage in the truest sense because it’s not risk-free and speculative in nature.

A risk arbitrage is usually created by speculation of merger and acquisition.

 

Here’s how it may work:

Tom hears news that company X may be acquired by a company Y.

Tom thinks that the trading price of company X will increase after the acquisition, so he purchases the shares of company X in the hope that he can generate a profit from the price difference between the current trading price and the trading price of company X after the takeover deal.

However, such a strategy is not risk-free because the takeover deal could always break.

If this was the case, Tom might make a loss as the trading price of company X will likely fall after the bad news.

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