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Sean Hinton

Arbitrage takes advantage of the mis-pricing of securities or a price difference between two or more markets.

Deterministic arbitrage takes advantage of price differences for the same (or similar) assets on different markets. When such price discrepancies exist it is possible to sell short the asset that is overpriced on one market and buy the under-priced asset on the other market. Assuming their prices converge to a correct and equal value, the arbitrageur has earned a profit without any risk.

It is important to note that arbitrage is DIFFERENT from least cost pricing. A situation can only be considered for arbitrage if there exists a way for riskless positive cash flows in the current period through a manipulation of long/short positions. Relative risk arbitrage and bargain hunting are trading strategies, but they are NOT riskless and thus are not true arbitrage opportunities. Arbitrageurs trade on speculation (often with background research) but the nature of their financial transactions should not be confused with technical, or statistical arbitrage, which is a mathematical imbalance that creates opportunity for riskless cash inflows.

[edit] Arbitrage Examples

An example of arbitrage: Say a domestic stock also trades on a foreign exchange in another country, where it hasn't adjusted for the constantly changing exchange rate. A trader purchases the stock where it is undervalued and short sells the stock where it is overvalued, thus profiting from the difference.

Another example of arbitrage: Suppose that the exchange rates between the Euro, US Dollar and Singapore Dollar are as follows:

EUR -USD - 1.4808(buy), 1.5008(sell)

EUR-SGD - 2.0975(buy), 2.1175(sell)

USD-SGD - 1.4472(buy), 1.4672(sell)

This essentially means that the Foreign Exchange firm (say Thomas Cook or ICICI) will sell 1 EUR for 1.5008 USD and buy 1 EUR for 1.4808 USD and so on…

If I do the following:

1. Buy Euros with 1 million SDG. I would have 1,000,000 /2.1175 = 472,257 EUR

2. Buy USD with my 472,257 EUR. I would have 472,257 * 1.4808 = 699,315 USD

3. Buy SGD with my 699,332 USD. I would have 699,315 * 1.4472 = 1,012,048 SGD

Thus, I would have made a risk-free profit of 12,048 SGD !

Obviously, in this case there is some mis-pricing in the market. These prices are not real prices. The spreads between ” buy and sell ” are generally higher in the real world and the prices are such that there is no scope for this kind of arbitrage. In the previous The EUR-USD rate is higher than it should be.

These kinds of situations are rare. However, they do occur. That is when hedge funds and algorithmic traders take advantage of such mis-pricing to make a risk-free profit. The market eventually corrects itself when the prices rise in response to the increased demand, thereby correcting the price differential.

[edit] Limitations of Theoretical Arbitrage in Real World Situations

Although riskless profit through the act of arbitrage can be calculated mathematically and through models, there are several real world limitations of arbitrage from an efficiency standpoint. Firstly, although equities and securities can often be traded on seconds notice, commodities subject to traditional arbitrage methods run the risk of transportation and expiration costs. Likewise, many services in western developed nations are not subject to arbitrage due to the practical concern of localism. Although a haircut in London may cost an individual less money after relative purchasing power parity comparisons, it would be unrealistic to assume that an individual from New York would fly across the Atlantic ocean to exercise the difference in price.

Furthermore, arbitrage opportunities are inherently transient. When price discrepancies exist arbitrageurs immediately begin to take advantage of them and the result is that prices generally converge to their "correct" value. As such, opportunities for abnormal profits without taking abnormal risks vanish quickly in open markets.