Arbitrage

The strategy of exploiting the benefits from the price difference of two markets is known as arbitrage. Matching deals are combined to capitalize the imbalance and profit from the difference between market prices. It is also a term used to denote a transaction that has no negative cash flow at any probabilistic or temporal state and has a positive cash flow at least in one state. It ensures risk free profit at zero cost. Arbitrage expects profit though losses may occur in practical situations due to the presence of minor and major risks. The expected profit is statistical arbitrage. The strategy which uses the advantage of difference between two similar assets is known as merger arbitrage. Banks or brokerage firms which engage in arbitrage are known as arbitrageurs. It involves the trading of financial instruments such as stocks, bonds, derivatives, commodities and currencies.

Absence of differences results in arbitrage equilibrium or arbitrage free market. Such a condition would result in general economic equilibrium. Absence of the arbitrage is employed in quantitative finance to compute unique risk price for derivatives.

Requisites for Arbitrage

Arbitrage occurs when same products are not traded for same price or when two assets of similar cash flow are not traded in same price or when an asset of known future price is not traded in the future price but is discounted at risk free interest rate. It is not a mere practice of buying in low cost and selling in high cost. The transactions must be done simultaneously to avoid market risks. Such advantage is possible when securities and financial products are traded electronically. Missing one of the legs of the trade in this condition is known as execution risk or leg risk.

It is defined in the following mathematical form.

Where V_t refers to portfolio at time t.

Arbitrage effects the currency exchange rates and prices of commodities. It also reduces price discrimination. It moves various currencies to purchasing power parity. It also affects the difference in interest paid by government bonds issued by different countries taking the depreciations of currencies into account.

Risks of arbitrage

Arbitrage transactions could be risky during financial crisis since it may lead to bankruptcy. When minor price differences are converted to big profits through leverage, big loss occurs. These risks along with execution risk limit the potentials of arbitrage. When arbitrage is conducted for non identical items which are known as convergence trade, loss occurs due to the mismatch.

Questions:

• What are the requisites of arbitrage?
• What are the risks involved in arbitrage?