What is arbitrage?

Arbitrage is a trading strategy that involves taking advantage of price differences for the same asset in two or more markets. Traders, or arbitrageurs, buy the asset at a lower price in one market and sell it at a higher price in another, capitalizing on the price discrepancy.

Arbitrate strategies rely on identifying temporary inefficiencies in market pricing. While arbitrage aims to capitalize on these differences, it can also contribute to market efficiency by helping align prices across markets. These transactions must occur simultaneously to minimize the risk of the price changing before both transactions are complete.

Arbitrage opportunities often arise due to factors such as supply and demand imbalances, variations in currency exchange rates, transaction costs, or regulatory restrictions. For example, a stock might trade at a lower price on one exchange compared to another. Arbitrageurs act quickly on these opportunities by buying from the lower-priced exchange and selling on the higher-priced one to capitalize on the disparity.

The three conditions required for arbitrage to take place are:

• The same asset is priced differently across two or more markets
• Two assets with identical cash flows are not trading at the same price
• An asset with a known future price is not trading today at its discounted value, based on risk-free interest rates.

Although arbitrageurs exploit market inefficiencies, their actions actually end up benefiting the market as a whole. By exploiting price gaps, they force prices across markets to converge, reducing price disparities and creating a more efficient pricing system. For example, arbitrage minimizes slippage – the difference between an asset’s expected and actual trade price. This benefits all market participants.

Types of arbitrage and their impact on market stability

There are different types of arbitrage, including spatial arbitrage, statistical arbitrage, merger arbitrage, triangular arbitrage, latency arbitrage, and convertible arbitrage. Below, we explain each of these types and how they work.

Spatial arbitrage

Spatial arbitrage involves taking advantage of price differences for the same asset in different geographic markets. For example, a commodity may be priced lower in one country and priced higher in another. Traders can buy the commodity in the cheaper market and sell it in the pricier one, potentially benefiting from the price difference.

Spatial arbitrage is sometimes used as part of commodities risk management and commodities supply chain management as it can help mitigate risks associated with price fluctuations across regions. However, it’s important to consider storage costs, exchange fees, and other costs that may not allow for a perfect arbitrage opportunity.

Statistical arbitrage

Statistical arbitrage uses mathematical models and historical data to identify and exploit pricing inefficiencies between related assets. Traders analyze historical patterns and correlations between assets, and when these relationships deviate from historical norms, they initiate a trade to potentially profit from the expected convergence. Subtypes of statistical arbitrage include:

• Index arbitrage: Compares the individual prices of all components in a stock index against prices in the futures and options markets.
• Volatility arbitrage: Compares the prices and implied volatility of options relative to other options and their underlying securities.
• Fixed-income arbitrage: Compares the prices of bonds and other fixed-income securities based on their ratings and yield to maturity.

Merger (Risk) arbitrage

Merger arbitrage focuses on the price gap between a company’s stock before and after a merger, acquisition, or other significant event is announced. When a public company is acquired, the purchasing company typically buys their outstanding shares at a premium over the current market price.

When a merger is announced, merger arbitrageurs buy the target company’s stock – often trading at a slight discount due to the uncertainty of the deal going through. Once the acquisition is finalized, the arbitrageur potentially benefits from the increase in stock price.

Triangular arbitrage

Triangular arbitrage is used in the foreign exchange market to exploit inconsistencies in exchange rates between three currencies. Traders convert currency A to B, then to C, and back to A, capturing any potential profit.

Pure arbitrage

Pure arbitrage, often used interchangeably with the term ‘arbitrage’, involves the simultaneous purchase and sale of the same asset in different markets to potentially profit from minor price differences (with exchange fees, commissions, and other costs considered).

For example, a stock trading at $50 on the New York Stock Exchange (NYSE) and $50.10 on the London Stock Exchange (LSE) presents an arbitrage opportunity. Arbitrageurs can buy the stock on the NYSE at the lower price and sell it on the LSE at the higher price, capturing the $0.10 price difference per share.

Convertible arbitrage

Convertible arbitrage focuses on trading convertible bonds. A convertible bond is a corporate bond which provides the bondholder the option to convert into stock at a later date, often at a discounted rate. With convertible arbitrage, traders seek to benefit from the difference between the bond’s conversion price and the current price of the underlying company’s stock.

Latency arbitrage

Latency arbitrage takes advantage of temporary price discrepancies due to delays in market information or price updates. These momentary delays provide a small window of opportunity for arbitrageurs to capitalize on the difference between the mismatched prices. Latency arbitrage is heavily dependent on speed – arbitrageurs may have only nanoseconds to exploit the mispricing before markets are updated.

Understanding the risks and limitations of arbitrage strategies

As with any strategy, arbitrage can come with its own set of risks and limitations. These include:

Execution risk

The success of an arbitrage strategy relies on a trader’s ability to execute trades quickly. Markets are highly competitive and automated systems can execute trades in a fraction of a second. Any delays, system failure, or human error can reduce or eliminate potential profits.

For example, a slight delay in executing a price disparity between two exchanges could result in a missed opportunity as prices adjust.

Transaction costs

Arbitrage strategies usually involve minimal profit margins for each transaction. This makes them highly sensitive to broker commissions, taxes, and exchange fees, all of which can reduce or eliminate these margins. If the cost of executing the trades exceeds the price discrepancy, it can even result in losses.

Liquidity risk

Arbitrageurs are exposed to liquidity risk. Traders depend on their ability to enter and exit positions quickly. Any lack of market liquidity or slippage – when trades are executed at a different price than expected – can cause potential losses.

In a spatial arbitrage situation, for example, a trader might buy an asset in one market only to find that there aren’t enough buyers in the second market to sell at the expected price.

Model risk

Statistical arbitrage strategies rely on mathematical models and algorithms to identify price discrepancies. These models are at risk of being unable to account for periods of extreme market volatility or unprecedented events, leading to failure.

For example, the hedge fund Long-Term Capital Management (LTCM) famously collapsed in 1998 due to unforeseen market conditions that rendered its strategies ineffective.

Regulatory and legal risk

Arbitrage strategies are subject to legal and regulatory constraints, especially those involving cross-border transactions. Changes in laws or regulations can limit arbitrage opportunities or increase risk.

The role of technology in modern arbitrage

Advances in technology have changed the way traders identify and exploit price inefficiencies. Tools like advanced algorithms and high-frequency trading (HFT) systems allow arbitrageurs to scan multiple markets simultaneously and identify price discrepancies in fractions of a second. These tools also execute trades faster to minimize the risk of delays and potential losses.

Machine learning models and big data analytics are also used to predict price movements and reveal subtle inefficiencies that might otherwise go unnoticed.

While technology has simplified arbitrage in some regard, it has also increased competition. As more traders adopt advanced technology, arbitrage opportunities become increasingly rare and more short-lived – which improves efficiency and fairness in global markets.

How does arbitrage contribute to market liquidity and efficiency?

Arbitrage plays an important role in improving market efficiency and liquidity. By exploiting price discrepancies across different markets or securities, arbitrageurs help align prices to reflect accurate market values. This process corrects mispricings and ensures that assets are fairly priced.

As a result, markets become more stable and efficient with more transparent and reliable pricing, benefitting all market participants and making for a healthier global financial system.

Market makers can also play a role in reducing pricing efficiencies and maintaining balanced markets.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.