Arbitrage in Trading
Arbitrage is a trading strategy used by investors to make profits by exploiting price differences in different markets or between different instruments. Technically, arbitrage consists of buying a commodity or security in one market and selling it immediately in another market for a higher price, earning a profit in the process. However, the term “arbitrage” has expanded to include a wide range of activities aimed at buying underpriced items and selling overpriced items, with the expectation of earning a profit when prices return to their theoretical or historical relationships.
Deterministic Arbitrage
Deterministic arbitrage is the classic definition of arbitrage, which involves buying and selling the same asset in two different markets simultaneously. For example, an investor may purchase a stock on the New York Stock Exchange (NYSE) and simultaneously sell it on the London Stock Exchange (LSE) at a higher price, making a profit in the process. This strategy works when the price differences in the two markets are significant enough to cover transaction costs and earn a profit.
Statistical Arbitrage
Statistical arbitrage involves using statistical models to identify price discrepancies between two or more assets that are expected to move in a similar direction. In this type of arbitrage, the investor does not buy and sell the same asset in two different markets but instead buys an underpriced asset and sells an overpriced asset with similar characteristics. The goal is to earn a profit when the prices of the two assets converge to their theoretical or historical relationship.
Arbitrage in Options, Convertible Securities, and Futures
Arbitrage techniques can also be applied to trading options, convertible securities, and futures. In these markets, investors can use arbitrage strategies whenever a trading strategy involves buying and selling related instruments simultaneously. For example, an investor can use arbitrage to profit from discrepancies between the price of a stock and its corresponding options or futures contracts.
Risk Arbitrage
Risk arbitrage involves buying and selling securities of companies that are involved in mergers or other major corporate developments. In this type of arbitrage, the investor takes a risk offsetting position to protect themselves from any adverse events that may occur during the merger or acquisition process. However, the risk offsetting position does not completely protect the investor from certain event risks, such as termination of a merger agreement or the failure of a transaction to complete within a certain time frame.
Tax Arbitrage
Tax arbitrage involves transactions that are undertaken to share the benefit of differential tax rates or circumstances of two or more parties to a transaction. For example, an investor may engage in tax arbitrage by purchasing a security in a tax-exempt account and then selling it in a taxable account, earning a profit by avoiding tax obligations.
Regulatory Arbitrage
Regulatory arbitrage involves transactions designed to provide indirect access to a risk management market where one party is denied direct access by law or regulation. This type of arbitrage involves finding loopholes in regulations to gain an advantage in the market. For example, a financial institution may create a subsidiary in a jurisdiction with less strict regulations to engage in riskier activities that would not be allowed in its home jurisdiction.
Swap-Driven Arbitrage
Swap-driven arbitrage involves exploiting comparative advantages that swap counterparties enjoy in different debt and currency markets. For example, one counterparty may borrow at a relatively lower rate in the intermediate or long-term US dollar market, while the other may have a comparative advantage in floating rate sterling. In this type of arbitrage, the counterparties exchange instruments to take advantage of these differences in borrowing costs.
