Arbitrage

In grade school, there was always that one kid who would go around selling things, whether it was erasers, gum, bracelets, or anything really. They would buy it from the store, or maybe they had it at home and then would sell it to their classmates for a markup. They were engaging in arbitrage! A very simplified form, but nonetheless. They were buying cheap in one market and selling for profit in another.

Don't get too excited, though. It is a little more complex than that. But fear not; by the end of this explanation, you will have a pretty good grasp of arbitrage, the different types, and its risks. You've just got to hang in there!

Arbitrage Definition

What is the definition of arbitrage? Arbitrage is a term in financial economics that describes when investors who are looking to earn a profit sell an asset only to buy a very similar asset but with a higher rate of return. Arbitrage happens when there is an inefficiency in the market. Investors see that two very similar assets have different rates of return and want to take advantage of this discrepancy and turn a profit.

Arbitrage is a legal practice in the United States and is even encouraged as it serves to encourage efficiency in the market by reducing price discrepancies between similar assets.

Arbitrage stops when the rates of return of the two assets equalize. Investors sell assets with a lower rate of return in order to buy assets with a higher rate of return. As the price of the asset with a lower rate of return decreases due to less demand by investors, its rate of return will increase. As the price of the asset with a higher rate of return increases due to higher demand by investors, its rate of return will fall. This means that eventually, both assets will be of equal value, and this window of making a risk-free profit has shut.

Types of Arbitrage

There are many different types of arbitrage. There is financial arbitrage, statistical arbitrage, convertible arbitrage, dividend arbitrage... the list goes on. Depending on the goals of the investor, familiarizing oneself with the various markets and forms of arbitrage that go with them is vital. To understand arbitrage as a concept, we will familiarize ourselves with some of the larger categories of arbitrage.

Pure Arbitrage

Pure arbitrage is arbitrage that involves no risk from the investor. It is what is most commonly thought of as the term "arbitrage." It occurs when you have two identical assets with the same cash flows and they have two different market prices. Investors sell the stocks with a low rate of return and buy the stocks with a high rate of return. While the prices eventually converge and the opportunity for arbitrage is eliminated, investors do not increase their risk since they are simply swapping between two identical products.

Another form of arbitrage that is considered risk-free or very low-risk is engaging in arbitrage with futures contracts. A futures contract is an agreement to complete a transaction at a set date in the future at a predetermined price. The arbitrage opportunity comes when the investor can purchase the goods at a lower price than what is guaranteed to be paid out by the futures contract in the future date.

Risk arbitrage is also referred to as merger arbitrage and is an event-driven trading strategy. This means that the investor only profits if a specific event -- namely, a merger of two companies -- occurs. Investors would buy stock of the target company while simultaneously selling the stock of the acquiring company. The risk portion of this form of arbitrage comes from the possibility of the deal falling through and the investors losing a portion of their funds because they were betting on the deal going through and that the newly merged company would be more valuable.

Fig. 1 - The formation of a merged company, StudySmarter Originals

Retail Arbitrage

The term "arbitrage" can also apply to the goods market. It is the act of buying a good at a lower price in one market and selling it at a higher price in another. As an example, vintage clothing presents a massive opportunity for arbitrage. Old clothing is something that can be purchased rather cheaply from the people who are done with it and just looking to get rid of it. It can then be resold in the market for vintage clothing, where people are more likely to pay a higher price for it. Retail arbitrage can be done with any good as long as there are two markets that offer different prices.

Conditions for Arbitrage

There are a few conditions that have to be met for arbitrage to be possible. If these conditions in the market do not exist, there is no real opportunity for earning profits. And that is the whole point of arbitrage: to earn money and earn enough money to be profitable. As previously mentioned, arbitrage is also useful to the market because it equalizes the prices of very similar assets.

Let's look at some of the most important conditions for arbitrage:

• Assets that have similar profitability trade at different prices in different markets.
• All costs associated with the deal must be included in the transaction cost.
• Trades must happen quickly before the window of opportunity closes since prices tend to change and equalize rapidly depending on the assets.

For arbitrage to be possible, similar assets that are either identical or bring in the same profits (the stocks of two companies that have similar profit prospects) must be priced differently in different markets. There is no room for arbitrage if assets have the same price in different markets.

The point of arbitrage is to earn a profit. If fees, transport costs, storage costs, or taxes will cost so much that they will eat up the difference in price in the two markets, there is no point in engaging in arbitrage. These extra costs must be accounted for when calculating the total expenses.

Since prices can change rapidly, more so for assets like stock and securities, arbitrageurs must act quickly to secure their trades, lest the window closes and they are left with an asset that won't earn the profit they expected, if any at all.

Arbitrage Example

Why don't we look at some arbitrage examples to help us understand the concept better? If an arbitrager is looking to earn a low-risk or risk-free profit, they might look around their local markets and compare prices with outside markets to identify arbitrage opportunities.

Let's start with a straightforward example of arbitrage in the goods market:

In real life, there would be transaction costs such as the cost of transportation and maybe a fee for a place at the market, but as long as Joe is able to sell the potatoes for more money than he spends on acquiring and selling them, his endeavor is considered successful.

These are 2 examples of how people can earn money from arbitrage. Keep in mind there are many different variations of these scenarios that have an opportunity for arbitrage. People can buy low and sell high, and they can borrow funds when they are guaranteed to profit from a deal.

Another situation where people engage in arbitrage is when people "flip" houses. They take out a loan to purchase a house, possibly pay to fix it up and add value so that they can sell it for a higher price or profit in the future. Note that this is not completely risk-free since there is no way to guarantee the prices in the housing market will stay high in the future - who knows if there will be a recession or a pandemic to derail plans!

Risk of Arbitrage

Unfortunately, there are risks when engaging in arbitrage. When an investor buys an asset with the expectation that they will be able to sell it for a profit and this does not happen, the investor suffers a financial loss. Some risks of arbitrage are the buyers falling through, improper execution of arbitrage, and fluctuations in the exchange rate.

Risk of Arbitrage: The Buyer Falls Through

The buyer falling through is an issue for those engaging in arbitrage because it leaves them holding the asset, whether it is a bond, security, share, or a physical good, that they only bought so that they could sell it and profit off of it. This is a known risk that arbitragers take, although the risk is not spread evenly across the board. In the case of trading on the stock exchange, the risk of the buyer falling through is much lower since trades happen very rapidly and there are many buyers.

The buyer falling through is more of a risk when buying and selling physical goods where the exchange is not instantaneous such as the buying and selling of a stock or a house. The arbitrager buys the goods at a certain price because they are confident they will be able to sell them to someone else at a higher price. But what if the buyer changes their mind and backs out of the deal? Then the arbitrager has to find a new buyer, and there is no guarantee that they can see it and turn a profit.

Improper Execution

Improper execution of arbitrage can happen when the arbitrager is not properly informed or they miss their opportunity to sell at a profit. This can happen if the arbitrager has more than one deal occurring simultaneously or the completion of one deal causes the price of another to converge, and the investor misses the opportunity for profit.

Fluctuations in Exchange Rate

Oftentimes, arbitrage takes place in international markets because, depending on the technology and resources available, one nation may be able to charge more or less for a good than another, which creates an opportunity for arbitrage.

However, if the exchange rate changes, it can cause the arbitrager to lose the margin of profit they were expecting if the value of their currency falls, and it either makes purchasing the good more expensive or it means that it will be sold at a lower price in the other currency.