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.