What is arbitrage opportunity?

Arbitrage refers to the practice of buying an asset followed by its immediate sale, to take advantage of the difference in price.

The asset will generally be sold in a different market, in a different form, or with a different financial instrument, depending on the price difference it brings.

Arbitrage opportunities can arise for almost any financial instrument: options (available only for individual clients), equities, Forex, or derivatives. For example, with regard to equities, an arbitrage may take place when a share is exchangeable on stock exchanges in two different countries. Because of the exchange rate of one of the two countries, the price of the stock varies from one stock market to another.

A financial strategy

In the field of finance, the term arbitration refers to a practice that leaves no room for value judgment. In the broadest sense, arbitration in finance means choosing from among several similar, most advantageous strategies. By extension, this term refers to the possibility of making a gain without risk. An arbitrage opportunity is defined as aa financial investment strategy which, by combining several operations, ensures a profit and does not require any initial down payment.

The simplest arbitration is to buy an asset (a share, a bond, a currency, etc.) on a financial center with the certainty of reselling it immediately, and more expensive, on another place. Another elementary arbitrage is to borrow at a fixed rate to lend instantly at a higher fixed rate. With the liberalization of capital movements and the development of means of communication, such simple arbitrations have become increasingly rare. Certainly, we can still sometimes find small differences in price between two identical financial assets, but that does not mean that one can for sure make a profit without risk; transaction costs must be taken into account (in the same way as under the law of the single price, the same good sold in two markets must have the same price, at the transport cost). The fact that there are fewer and fewer price differences between markets does not mean that arbitrageurs are now wasting time. Market development has been accompanied by increased sophistication of products, but it is still possible, at the cost of sometimes very complex strategies, to take advantage of certain market imperfections.. And even if the gains are modest relative to the amounts committed, arbitrage remains a widespread activity in the trading rooms.

Genuine arbitration

True arbitration is arbitration in its raw form, as described above. In essence, true arbitrage involves taking advantage of the inefficiency of the market, just as it involves two assets of equal value traded at different prices. Both of these characteristics make true arbitrage a safe practice. The inefficiency of the market, which makes true arbitrage possible, is becoming increasingly rare because of technological change.

Risky arbitration

For this reason, riskier forms of arbitration are gaining importance. Risky arbitrage involves the trading of an asset whose current price will vary rapidly, for example, the shares of a company that is the subject of an issuer bid. Unlike true arbitrage, this practice is not risk free because the change in asset value may never materialize.

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Created on Sep 27th 2018 19:35. Viewed 440 times.

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