A quick introduction to arbitrage

A quick introduction to arbitrage

What Is Arbitrage?

Arbitrage involves the simultaneous buying and selling of an asset to profit from a difference in the asset’s price. 

Arbitrage is a trading strategy that can be used to earn a risk-free profit on the price of an asset, by exploiting the price differential between two or more markets.

In financial markets, arbitrage has traditionally been associated with the simultaneous buying and selling of securities or other assets in different markets, to take advantage of price discrepancies. Arbitrage is especially common in case of precious metals hence for instance if you look up today’s gold rate in Akola and compare that with the price at a different location you might see some opportunity to make profits. 

Arbitrage opportunities are rare and fleeting, the more important role that arbitrage plays in financial markets is that it reinforces market efficiency and helps to keep prices aligned across different geographic locations and time horizons.

There are many types of arbitrage, each with its unique characteristics.

  • Statistical arbitrage

Statistical arbitrage is generally performed with computer algorithms. These algorithms are programmed to find pricing discrepancies between various securities, and then execute trades based on those discrepancies. Some arbitragers make money when the discrepancy narrows, while others make money when it widens.

  • Merger arbitrage

Merger arbitrage is performed by taking a position in securities involved in a merger transaction. These arbitragers typically purchase stocks of companies that are being acquired and short sell their target company’s stock. This helps them to profit from any changes in the spread between the two stocks as the merger progresses.

  • Fundamental or convertible bond arbitrage

Fundamental or convertible bond arbitrage is when an investor profits from mispricings between convertible bonds and their underlying common stock. Many times, some fundamental or macroeconomic factor will cause the price of a company’s common stock to move independently from its convertible bonds. As a result, this can create an opportunity to execute a risk-free arbitrage strategy by purchasing one security and selling another simultaneously.

  • Market Location Arbitrage

The difference in demand and supply of precious metals in one geographical location can lead to arbitrage opportunities.

For example, if there is a limited supply of gold in the US, but a huge demand for the same in India, the price of gold will be higher in India than in the US. This creates an arbitrage opportunity as an investor can buy gold from the US and sell it in India at a higher price to make a profit.

  • Time Arbitrage

The difference in the prices of precious metals at different points in time can lead to arbitrage opportunities. For example, if spot prices are lower than futures prices, it is profitable to buy the metal now and sell it later at a higher price when the future expire. This type of arbitrage is more common with commodity trading strategies especially those involving gold. If you have ever tracked things like today gold rate Pollachi or for any other place and made use of variations of price with time you might have participated in arbitrage. Visit this page for more info.

  • Cash and Carry Arbitrage

Cash and carry arbitrage involves creating a portfolio of long positions in one market while simultaneously creating a portfolio of short positions in another market. This strategy is based on the fact that traders have to pay interest on their long positions while they receive interest on their short positions. These long/short portfolios allow traders to lock in an interest rate differential while earning a profit in the underlying market.

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