Different Types of Arbitrage
There are various forms of arbitrage possibilities spanning different tradeable marketplaces, even though arbitrage often refers to trading opportunities in financial markets. These include statistical arbitrage, negative arbitrage, retail arbitrage, convertible arbitrage, and risk arbitrage.
This type of arbitrage is also known as merger arbitrage because it involves purchasing stocks during the process of mergers, acquisitions, spin-offs, or restructuring. In this arbitrage, arbitrageurs focus on the anticipated events rather than any price discrepancies. In this, arbitrageurs take a probable chance of event occurrence, evaluate the circumstances and invest on the assets. It is a more probabilistic approach.
Hedge funds frequently use the risk arbitrage approach, in which they short-sell the stocks of the acquirer while purchasing the stocks of the target.
People can employ arbitrage as a strategy with everyday retail goods from their favorite supermarket, similar to how it is utilized in financial markets. For example, when you visit eBay, you will come across hundreds of items that individuals purchased in China and then resold there for a higher price.
Many individuals and small scale entrepreneurs participate in retail arbitrage where they purchase product from retail stores and online platforms from across the world and sell it or ship it to another marketplace at higher price, making profit.
Convertible arbitrage, another well-liked arbitrage technique, is purchasing a convertible asset and shorting its underlying stock. In this investment strategy, arbitrageurs purchase the convertible hybrid securities of a company with a short position in the underlying assets of the same company. The arbitrageurs benefit from the price difference between convertible assets and their underlying assets.
For instance, an investor purchases convertible bonds of a company X, holding a short selling position of equivalent shares of Company X. When the stock price of Company X increases, the convertible bonds will also appreciate in value. The investor then can have the option to convert the bonds to share and sell them at a higher price , making the profit out of this conversion.
It is another condition in arbitration. Negative carry or reverse arbitrage is the alternative term used to refer to it. This defines the missed opportunity that occurs when holding an investment. It signifies that the cost or expenses associated with holding or utilizing the investment exceed the potential return or gains that it can generate. Such negatives can happen due to borrowing cost, transaction costs, commission and fees and other expenses associated with holding the investment.
When an arbitration is making a loss instead of profit, it is considered as a negative arbitration.
The arbitrage method, sometimes referred to as stat arb, uses sophisticated statistical models to identify trading opportunities among financial assets with various market prices. These models often rely on mean-reverting techniques and need a lot of processing power. Statistical arbitrage uses statistical methods to identify relationships between different securities or asset classes and take advantage to generate profits.
For instance, after aggressive research and use of statistical tools on two stocks A and B, investors find that there is a positive correlation between two stocks A and B. Positive correlation means when the price of stock A has increased, it has led to an increase in the stock price of B.
Today, statistical projection using past data has suggested that the stock price of A has increased and it is likely that it will increase in future as well. But there has been such price appreciation in Stock B.
Based on the positive correlation and other past evidence and results, investors invest in Stock B considering that it will follow the past trend. This is statistical arbitrage.