What is arbitrage?
Arbitrage refers to the simultaneous buying and selling of a commodity or a financial instrument in different markets by a trader to gain profits. It involves instantaneous buying and selling of the same underlying asset, and thus, it is a fast process.
Since the prices of an asset are similar even across different markets, the window for arbitrage may not exist in many cases. However, there are a few occasions due to market inefficiency, when a window is created for investors and traders to carry out arbitrage. Eventually as the prices adjust, this window vanishes, and the markets become arbitrage-free.
How does arbitrage work?
As different markets have similar pricing, it might be sometimes difficult to find an arbitrage opportunity where the price in one market is higher than the other. Even when such an opportunity emerges, the difference between the prices is very small.
For instance, the price of an asset is $5 in one market while it is $5.50 in another market. Thus, the difference between both the markets is only 50 cents; however, it is still possible to make huge profits on such a small margin.
By buying 100 units of a commodity in the first market, and selling those units in the other, the trader would earn a profit equal to 100 times the margin. Therefore, in such a case profit will be 100*0.50= $50.
In such cases, not only does the investor get back the money he invested in the first place, but he also earns a profit over it.
At times, there might be no arbitrage even if there is a price difference as the price difference could be due to technical reasons, such as taxes and liquidity.
Most traders who indulge in arbitrage are neither in need of the underlying asset nor sellers of that asset. They are mostly speculators who enter the market to make profits. Buying and selling the asset serves their purpose of profit making without them being interested in the underlying asset itself and its price trend.
What is the Arbitrage Pricing Theory (APT)?
Arbitrage Pricing Theory was developed in 1976 by Stephen Ross as an alternative to the Capital Asset Pricing Model (CAPM). This theory states that the price of an asset depends on various market indicators and can be predicted.
This means that if an asset is cheaper in a market, or if an asset is more expensive in another market then it is only a temporary deferment in prices. A cheaper asset is undervalued while the expensive asset is overvalued. Hence, there is only a temporary asymmetry in the prices.
As the deviation in the prices is realised, the market adjusts to no arbitrage situation. With the advent of fast technology, it has become possible to check for pricing errors in the markets. This makes arbitrage opportunities an even rarer occasion as such deviations are acted upon quickly.
What are the risks associated with arbitrage?
Arbitrage transactions are mostly risk-free transactions as buying and selling happen instantaneously. Nonetheless, it can be argued that there is a possibility that prices adjust within the small time frame when a trader is undertaking the transaction. This means that after the trader buys the assets, the prices adjust and therefore, the arbitrage window vanishes.
Another important aspect to note is that the transaction would only be profitable if the assets bought and sold are identical and have the same quality. If the assets are not identical in both the markets, then the trader might face a problem while selling the asset in another market.
There is also the possibility of counterparty risk happening. This is the risk of the counterparty refusing to complete the transaction.
Arbitrage arises from various inefficiencies in the market. The deviations in prices between markets allow traders to make use of this opportunity and make a profit. However, it is important to note that these opportunities are the result of an inefficient market. The adjustment delays allow for a small window of opportunity. Thus, arbitrage is nothing but a loophole in the market framework.
Most assets or commodities are traded at a fair value, but as they deviate from this value, arbitrage can be spotted. Therefore, investors and traders cannot rely solely on arbitrage to make profits as it is an inefficiency in between the markets and the bigger algo traders with fast execution capabilities take away the opportunity from retail investors.
How does arbitrage affect the market?
Arbitrage is dependent on the inefficiencies in the markets. Speculators and traders can influence the prices as they carry out arbitrage transactions.
Most of the inefficiencies between markets occur because of the differences in the internal pricing system. Arbitrage can be conducted in international markets as well. The pricing differences in international markets occur because of variations in the economic factors between countries.
As an arbitrage opportunity is spotted, the markets try to adjust to eliminate the arbitrage window. This can lead to distortions in the market. As a market adjusts to match the fair value, there may be a disruption because the fair price may not match the prices determined by the internal system. Thus, a drastic adjustment in the prices may affect the economic and financial stability of the market.
What are some examples of arbitrage?
For instance, consider the following hypothetical situation:
Current exchange rate between currencies X and Y is X = 65.60 Y.
One year forward Bid-Ask rate is X = 69.38 /69.50 Y
One-year interest rates in currency X is 0.13% to 0.14%.
One-year interest rate in currency Y is 6.25% to 7.25%.
In such a case, there exists an arbitrage opportunity. A trader can borrow 1,000,000 units of currency X at 0.14% for one year. Therefore, he would have to repay 1001400 units of currency X after one year.
Now the borrowed amount, when converted to currency Y, becomes equal to 65,600,000 units of Y.
This amount in currency Y can be invested at the rate of 6.25%. Thus, after one year it would become equal to 69,700,000 units of Y.
This can be sold in the one year forward market at the rate X = 69.50 Y. Therefore, selling this amount in a forward market will fetch an amount equal to 1,002,878 units of X (69,700,000/69.50).
Hence, after one year he will receive 1,002,978 units of currency X while he would have to repay 1,001,400 units of X. Hence, net profit: 1,478 units of currency X.
Consider the following:
Bank A has the Bid- Ask rate of GBP/USD = 1.4550/1.4560
Bank B has the Bid-Ask rate of GBP/USD = 1.4538/1.4548
Now a trader can buy GBP from Bank B by paying 1.4548 USD in return. The 1 GBP bought from Bank B can be sold to Bank A to receive 1.4550 USD in return. This is higher than what the trader paid to Bank B earlier. This small margin can be increased when the amount of GBP bought and sold between the banks is increased, for instance, to 1,000,000 units. In that case, the profit would be:
(1.4550-1.4548) *1,000,000 = 200 USD.
Therefore, by investing a larger amount, traders can gain profits which are much larger than the arbitrage margin.
What is a Futures Contract? Futures contract refers to a binding agreement between two parties to buy and sell a fixed quantity of an underlying asset on a later date at a pre-determined price. The underlying asset upon which the futures contracts are made can be a commodity, shares of a company, or any other listed security. Futures contracts are exchange-traded contracts, and all the contract specifications are defined by the exchange. Unlike a forward contract, there is a clearing corporation which is associated with the respective exchange that guarantees the settlement of these trades. Therefore, there is almost no risk of default or counterparty risk associated with a futures contract which is one of the primary concerns in a forward contract. FOR FURTHER UNDERSTANDING OF FUTURES ALSO READ: What is a Futures Contract? How to Calculate the Contract value? Future contracts are traded in lots which is essentially the quantity of underlying upon which the futures contract is made. Contract size or value is the total worth of the contract that is being traded. For, e.g. a futures contract of XYZ share having a lot size of 100 shares is currently quoting at $50. Then the contract value would be equal to $5000 ($50 per share for 100 shares). What is Long/Short position? A person having an unsettled or outstanding buy position in a futures contract is said to have a long position. Similarly, if a person has outstanding sell position which has not been squared off is said to have a short position. What is Settlement Day? All futures contracts have a limited span of existence beyond which they cease to exist. The last trading day of the contract is the settlement day. All the obligations of buyers and sellers are needed to be settled on this day. There are two mechanisms in which settlement takes place, namely: Cash settlement At the time of expiration, the seller of the contract does not deliver the underlying asset but instead settles his net obligation in cash. For, e.g. If B goes long on a contract of 100 shares of XZY at $100 and at the expiration, the price settles at $110, then instead of delivering 100 shares at $100 (pre-determined price), the sellers settle his net loss in cash and pays the difference to the buyer. i.e $1000 Physical settlement In a physical settlement, the obligation of both the parties settles through the physical delivery of the underlying by the seller. The buyer receives the asset, unlike price difference, in the case of cash settlement. In every case, it is the exchange which defines the settlement mechanisms, and the parties cannot deviate from it despite a mutual agreement. How are futures prices determined? The prices of futures contracts move in positive correlation with the spot market prices of the underlying assets. Spot market price refers to the current price of the asset in the physical market. Let us assume a person wants to buy the shares of a company and he/she enters into a futures contract. Now if the share price of the company is rising, then it is highly likely that the futures price would also rise and the buyer can sell his futures contract at a higher price. However, many times, it is possible that the change in the price of the underlying asset does not have any impact on the futures contract prices. Although there is a precise mathematical model, i.e. “Cost of Carry” which determines the theoretical price of a futures contract. In real-time, the current market price may not be equal to the theoretical price as the forces of demand and supply also fluctuate the price. ALSO READ: An Insight Into ASX 200 And Futures What is ‘basis’ and the risk attached to it? Although spot prices are highly correlated with the prices of the futures contract, these two prices are never the same. Basis refers to the difference between the spot price of an asset and the price of a futures contract of that asset. If the price of a futures contract is greater than the spot price, the basis for the asset is negative. Similarly, if the spot price is greater than the futures price, the basis for the asset is positive. It turns to zero at the expiry of the futures contract, i.e. there should not be any difference between futures price and spot price at the time of expiry of the contract. Basis keeps weakening and strengthening according to the market situation. Thus, there are certain risks attached to basis. What futures contracts do is that they convert the price risk, i.e., the risk attached to falling and rising prices of the underlying asset, into basis risk. Basis risk is better than price risk as it provides a window between which profits and losses are locked. Thus, with the correct hedging strategy, it is possible to set a limit beyond which losses will not be incurred to either the seller or to the buyer. Who trades in futures contract and what are the benefits? Speculator/Trader Futures contracts are well suited to place directional bets on interest rates, stock market indices, currency exchange rates etc. As futures is a leveraged product; therefore, the potential return on the capital deployed is relatively high as compared to transacting the same underling in the spot market. Hedgers Hedging was the primary reason for the introduction of the derivatives market. Corporations, Government, banks etc. all hedge their exposure to their underlying business through the derivatives market. Hedging simply means to make a counter position to mitigate the risk of the initial position. Arbitrageurs Arbitrageurs are the once who try to make risk free profits by exploiting mispricing in the market. An Arbitrage opportunity occurs when a single asset is being priced differently in two different markets, and Arbitrageurs looks to buy in the market with less price and sell in the market with high price simultaneously. This helps to make the difference between the two as a risk-free profit.
Who are Fund Managers? Fund Managers, aka Investment Managers, Money Managers, are the institutional investors that manage money on behalf of their clients, which may include individuals and groups. Often referred to as Smart Money, they are perceived to be equipped with better resources and information. Investment management industry is huge and includes a range of asset classes and products like equity, fixed income, global, country-specific, multi-asset, commodity, money markets, IPOs, fund of funds, real estate. A firm seeks to fulfil investment goals of the clients, which may include pension funds, insurance companies, endowment funds, charity, corporations. When you go shopping for funds, you will find a range of products from different businesses. Investment Management (IM) refers to the complete management of funds, which are invested in securities. IM professionals devise an investment strategy for the fund and raise money from the public to implement the strategy. They are not just involved in buying and selling of securities but a broader range of processes, including research, strategy implementation, development of strategy, income distribution of funds, banking, performance evaluation. Investment Management is also referred to as Funds Management, Asset Management. IM companies are traditionally known as buy-side firms since these firms mostly purchase securities, whereas sell-side include institutions that are selling the research, providing research facilities. Buy-side firms include IM companies, pension funds, insurance funds, endowment funds, sovereign wealth funds, mutual funds. These institutions invest in a significant amount of funds and invest for the purpose of funds management. Sell-side firms are more into insights, research, advisory, promotion, market-making for the companies. These firms may also provide services like broking, investment banking, advisory, and deal in transactions like IPOs, capital raising, investment research, trading and settlement. IM businesses are regulated by a market regulator in most of countries. Regulators also ensure that investor interests are protected, market ethics are maintained, and necessary disclosures and regulations are honoured by the companies. Read: ASIC Issues Notice to REs of MISs to Ensure Balanced & Accurate Information In Investment Fund Advertising Fund Management companies charge fees to their clients, which is expressed as a percentage of money invested in the fund. The revenue earned by funds managers tends to fluctuate due to market movement in funds/assets under management. Sometimes IM companies also charge performance fees depending on the stated performance hurdles. Active Management: In this type of IM, the manager seeks to invest in asset classes in an index-agnostic approach by actively picking stocks based on proprietary or sourced research rather than a benchmark. Passive Management: Passive Investing vehicles have gained a lot of demand over the past two decade, largely due to lower fees. Investment Managers benchmark portfolio to an index and try to replicate the performance of the benchmark. More on passive investing approach: What Is Passive Investing? Type of Fund Managers/Funds Equity: They invest in equity or stocks, which happen to be among leading asset classes in the history of mankind. Equity funds are relatively riskier but boast better return potential as well. Investment Managers can further segregate these funds into sectors, countries, market capitalisation. Bonds: Also known as Fixed Income Funds, the money is invested in fixed income instruments like Government Bonds, Corporate Bonds, Perpetual Bonds, Asset-backed Securities, Mortgage-backed Securities etc. Good read: Fixed Income Securities – A look Into Bonds Multi-asset: In this strategy, the objective is to invest in multiple asset classes, including commodity, equity, bonds, currencies, derivatives. These funds seek to deliver risk-adjusted returns based on the prevailing investment climate. Index: Index Funds are one of the passive investing vehicles seeking to match the performance of the underlying benchmark. These funds are available at relatively lower fee expense and provide exposure to only a group of asset classes based on the benchmark index. Real Estate: Real Estate funds invest in real assets like property and land. These funds further segregated into a type of the properties under management like commercial, retail, office, residential, industrial. Must read: Australian Real Estate Investment Trusts Global: A global fund is allocated across geographies and provides exposure to industries of other nations. These funds also provide currency exposure to the investor as well as diversification. Speciality: Speciality managers can run a range of funds based on their belief, such as e-commerce fund, agriculture fund, e-vehicle fund, disruptive or innovation fund, cannabis fund, country-specific fund, ESG fund, automated vehicle fund. Hedge Funds: Hedge funds have grown extremely popular over the past decades because of their high returns, which come with similar scale of risks. These funds invest in a range of asset classes, including commodity, equity, bonds. Investment managers charge a relatively high fee. Related: Hedge Funds Now Focused on Refined Oil Products What is an investment philosophy? An investment philosophy is something you apply when constructing an investment strategy. It is your perception of market and the wide variety of asset classes available in markets. It also reflects how investor behaviour has evolved over time. Understanding a fund managers investment philosophy is paramount. Some investment philosophies: Value Investing: Value investing is perceived as picking stocks that are available at a discount to current market price. Investors prefer businesses that are underestimated by large sections of markets, thus undervalued. Watch: Kalkine Big Story - Value Investing amid Market Correction Growth Investing: Growth investors chase companies that are exhibiting better-than-average in earnings. The expectations from growing enterprises are generally higher due to stage of business, target market, product, disruptive products. Growth Stocks have delivered substantial return over the last decade and continue to be market darlings. Related: How To Identify A Growth Stock? Arbitrage Investing: In this philosophy, investors seek to benefit from the existing inefficiency of asset prices. This practice in markets also ensures that price of asset classes do not stay diverted from fair-value for a long time. Arbitrage strategies can be applied on almost every liquid asset classes that are available to trade. Market Timing: Investors seek to maximise their returns by undertaking investment decisions based on a future prediction of the asset class. Market Timing predictions can be based on Fundamental Analysis, Technical Analysis, Economic Conditions etc.
Index arbitrage is an investment strategy that is designed in a way to obtain profit from the difference between the actual price of a stock and its theoretical futures price in cases where the current price of the stock does not indicate the recent news about the stock.
Definition – Implied Volatility Implied volatility is typically defined as the gauge/measure of markets forecast on the possible movement in an asset/security’s price. The movement in price could be on account of market forces, or increased level of buying or selling. An index such as VIX, which is based on the implied volatility of the S&P 500 index displays the market’s estimation of volatility of the underlying security in future. Read: What Is Volatility? There are two main types of volatility, i.e., historical volatility, which could be calculated by using recent trading activities of a stock or other security and are factual in nature, and forward-looking volatility, referred to as implied volatility. The implied volatility component of option prices is the factor that can give all options traders, novice to expert, a hard time as the implied volatility of an option may change while all other pricing factors impacting the price of an option remain unchanged. In general, a result of increased buying of options by market participants leads to higher implied volatility, and conversely, when there is net selling of options, the implied volatility indicated by option prices moves lower. The implied volatility follows the basic fundamental principle of economics, i.e., a large options buying pushes it higher, and options selling pushes it lower, or simply, the implied volatility reacts to the basic demand and supply of the marketplace. What are the Applications of Implied Volatility Implied volatility of an option could be considered as a measure of risk in an underlying security, which pertains to the expected movement in the price of that security irrespective of its direction over the life of the option. Moreover, while understanding the implied volatility and its application, it should be kept in mind that implied volatility only deals with the expected movement in an underlying stock and does not consider the direction of the movement. Ideally, when investors consider risk, it is usually in terms of a stock falling in value. Implied volatility is similar to looking at the variance or the standard deviation of a mean value, as using it as a risk measure involves the estimation of the price either on the upside or down side. For example, during a financial year, a company releases price-sensitive information, including the quarterly performance, news on Merger & Acquisition, product launch, etc. which may contain data that could assist investors in refining their forecasts regarding the company or re-value their investment. Moreover, this information could have a considerable impact on the share price of the company under consideration, and in tandem, its option price, which usually trades on high premium; thus, are quick to adjust to new market information as a lot of anticipation is baked into option prices. High demand for option pushes option prices up, and typically, a high price in options leads to high implied volatility. However, it would not be wrong to say that higher implied volatility leads to high option prices, either. So, when the market anticipates a large move to the upside in the underlying security, it creates a high demand for call options in anticipation of this move, leading to an increase in option prices and its implied volatility. Do read: Understanding Volatility; ASX VIX Spikes and Skyrockets 4x in a Month! Likewise, if there is an expectation of a lower price move, the market may see an increase in put buying, and with higher demand for put contracts, the price of puts may increase resulting in higher implied volatility for those options as well. An increase in put prices eventually pushes call prices at expiry due to a concept known as put-call parity, which serves as the foundation stone of understanding the ramification of implied volatility and estimating non-arbitrage option prices. Put-Call Parity Put and call are linked together through the price of an underlying stock via put-call parity, which exists because combining stock and put position can result in the same payoff as a position in a call option with a same strike price as the put. The put-call parity is usually maintained in the market as any mispricing in prices create arbitrage opportunities, and usually, large funds or arbitragers seize this opportunity quickly to bring back the put-call parity in place. Parity between the call and put results in a similar implied volatility output. For example; consider a following situation An investor can easily replicate the payout of long in ABC 50 Call by using the ABC 50 Put and ABC stock. The combination of owning a stock along with the put has the same payout structure as a long call option position. With our ABC 50 Call trading at $1.00 and the ABC 50 Put price at $2.00, there may be a mispricing scenario. Consider the following payout of combining Long Call, Long Stock, and Long Put. Note, that in the table above, the combination of owning stock and owning a put should ideally have the same payout structure as a long call option. However, with the ABC 50 Call trading at $1.00 and the ABC 50 Put trading at $2.00, at any expiration, the long call position is worth $1.00 more than the combined stock and put position. With this pricing difference, there is the ability to take a short position in the strategy that will be worth less and buy the strategy that will be worth more on expiry date. Estimating Price Movement from Implied Volatility What the implied volatility of an option projects onto the underlying security is the expected range of price movement over a certain period of time. This estimation of the expected price movement is based on statistics and the bell curve or the normal distribution curve. The implied volatility of an option is the projection of an annualised one standard deviation move in the underlying stock over the life of an option. To Know More About the Application and Calculation of VIX, Do Read: Implied Volatility- A Roadmap to Gauge Market Sentiment