In this article, you will learn what does arbitrage mean. In the world of alternative investments, there are several strategies and tactics you can employ. These strategies often differ from the typical buy and hold tactics leveraged by most long-term stock and bond investors—and are usually more complicated. Arbitrage is one alternative investment strategy that can prove exceptionally profitable when leveraged by a sophisticated investor.
What Does Arbitrage Mean?
Arbitrage is the trading of financial instruments in two different markets simultaneously to profit from their difference in prices in the two markets. These financial instruments may include shares, bonds, derivatives, currencies, and commodities.
The idea is to earn profits by buying an instrument in one market where prices are lower and selling it in another market at a higher price. This difference or imbalance in prices of the same asset in different markets is generally due to market inefficiency.
If there is no inefficiency, the prices in the two markets will converge, and there will be no arbitrage opportunity. Individuals, banks, or brokerage firms who adopt this strategy in trading are called Arbitrageurs.
What are the Risks in Arbitrage?
Some of the risks involved in the strategy of arbitrage are
- Execution Risk
If an arbitrageur enters into multiple trades at a time, there is a high risk that while closing one position, there is a price convergence in his other deal, and his chances of making a profit are over. He may even incur a loss due to transaction charges.
-Failure of the Buyer
There are many instances when a buyer backtracks or is not in a position to fulfill his financial commitments. In such cases, an arbitrageur may incur substantial losses. For example, if he purchases commodity A from a market and the buyer in the second market backtracks and denies buying, he will get into serious trouble. If the prices of the commodity fall before selling, or the funds may remain blocked.
- Exchange Rate Fluctuations
In times of volatile global markets, the exchange rates of different currencies fluctuate constantly. An arbitrageur faces the risk of losses if there is a devaluation of the currency suddenly, where he has to sell the stock or instrument.
- Any Important International Event
In between the time of purchase and sale, if there is any big event that happens at the international level, which can impact the exchange rates or supply of that currency or commodity, etc., due to trade agreement or political situation. Then also, the buyer may run into losses.
Bottom Line
Arbitrage offers excellent return opportunities if things go as planned. But hardly any investment house relies solely on this strategy. Electronic trading has left an almost negligible scope of difference in prices of stock across different exchanges worldwide. This article is about what does arbitrage mean.
