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Making Sense of Arbitrage Various Types

Introduction

Arbitrage is based on the concept of market efficiency, which states that the prices of securities reflect all the available information and are, therefore, fair. However, in reality, markets are only sometimes efficient, and there may be temporary or persistent price differences due to various factors, such as supply and demand, liquidity, transaction costs, regulations, etc. Arbitrageurs exploit these inefficiencies and help restore the market equilibrium.

There are different types of arbitrage based on the risk involved. Let's learn about them.

Types of Arbitrage

There are two types of arbitrage, which are further subclassified. Here are the details.

1. Pure Arbitrage

It is a type of arbitrage that involves buying and selling the same asset or its derivative simultaneously in different markets with no risk. That means the price difference is guaranteed, and there is no uncertainty about the outcome. Pure arbitrage is also known as riskless arbitrage or arbitrage in the strict sense.

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Some examples of pure arbitrage are:

  • Forex arbitrage: You can trade the same currency pair in different markets or platforms to exploit the exchange rate difference. For example, if you buy 1 USD for Rs 50 in the Indian market and sell it for Rs. 51 in the foreign market, you can make a profit of Rs. 1 per dollar.
  • Cash and carry arbitrage: Here, you may buy an asset in the spot market (where the asset is delivered immediately) and sell it in the futures market (where the asset is delivered later) or vice versa to take advantage of the price difference. If you buy gold in the spot market for Rs. 50,000 per kg and sell it in the futures market for Rs. 51,000 per kg, you can lock in a profit of Rs. 1,000 per kg.
  • Dividend arbitrage: You can buy a stock before the ex-dividend date (when the stock price drops by the dividend amount) and sell it after the ex-dividend date or vice versa to take advantage of the dividend payment. For example, if you buy a stock for Rs. 100 before the ex-dividend date and receive a dividend of Rs. 10, you can sell the stock for Rs. 90 after the ex-dividend date and still make a profit of Rs. 10.

2. Risk Arbitrage

It is a type of arbitrage involving betting on the future event's outcome, such as a merger, acquisition, or restructuring. That means the price difference is not guaranteed, and there is some uncertainty about the outcome. Risk arbitrage is also known as speculative arbitrage or event-driven arbitrage.

Some examples of risk arbitrage are:

  • Merger arbitrage: This involves buying and selling the stocks of the companies involved in a merger or acquisition. For example, if Company A announces to acquire Company B for Rs. 100 per share, and the share price of Company B is Rs. 90, you can buy the shares of Company B and sell them for Rs. 100 when the deal is completed, making a profit of Rs. 10 per share.
  • Convertible arbitrage: You can transact in a convertible security (bond or preferred stock that can be converted into a common stock) and its underlying stock. For example, if you buy a convertible bond of company C for Rs. 1000 that can be converted into 10 shares of company C, and the share price of company C is Rs. 110, you can convert the bond into shares and sell them for Rs. 1100, making a profit of Rs. 100.
  • Statistical arbitrage: It involves buying and selling a basket of securities that are statistically related to each other. For example, buy a portfolio of undervalued stocks and sell a portfolio of overvalued stocks based on some mathematical model. You can make a profit when the prices converge.

Conclusion

Arbitrage trading can be lucrative and rewarding for traders, as the Indian stock market offers various arbitrage opportunities due to its size, diversity, and dynamism. However, arbitrage trading also involves challenges and risks, such as transaction costs, market liquidity, regulatory restrictions, market volatility, deal failure, and competition.

Therefore, choose the right arbitrage strategy that suits your goals, preferences, and capabilities, diversify your portfolio to reduce the exposure to specific risks and stay updated on the market trends and events that may affect the arbitrage opportunities.

 

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