Introduction
Arbitration is the scenario of buying something at a lower price in one place and selling it with profit in another price. It is a very common and tactical practice of taking advantage of price differences for the same assets in different markets to make profits with minimum risk.
For instance, you see a vendor selling a product ‘X’ at $ 10 and then you realize that you have seen an advertisement of the same product ‘X’ online which was priced at $ 15. So, you decide to take advantage of this price difference. You purchase the product ‘X’ from the vendor at $ 10 and market it and sell it online for $ 15, earning the profit of $5 (considering no additional cost incurred). This is arbitrage.
John C. Hull defines arbitrage as the practice of taking advantage of a price difference between two or more markets to make a riskless profit. Hull has focused on the risk-free nature of arbitrage.
It takes advantage of brief fluctuations in the cost of identical or comparable financial products on several markets or in various formats. Any time a stock, commodity, or piece of money can be bought at one price on one market and concurrently sold at a greater price on another, arbitrage can be employed. The circumstance offers the trader the chance to benefit without taking any risks.
Arbitrage offers a way to make sure that prices don’t diverge significantly from fair value over an extended period of time. Technology improvements have made it very challenging to profit from price mistakes in the market. A lot of traders use automated trading programs configured to track changes in similar financial instruments. Any ineffective price structures are often addressed immediately, frequently within a few seconds, and the opportunity is lost.
Elements of Consideration in an Arbitrage
Arbitration is a tricky approach. It requires certain elements for a transaction to be called an arbitrage. Some of such characteristics of arbitrage are:
Price Differential
Price difference is a fundamental factor in arbitrage. Arbitrage happens only when there is price difference for the same products, asset or security in different markets. Arbitrageurs take the benefits of this price difference to earn profit. Price differences arise due to market inefficiencies due to information asymmetry, transaction costs, liquidity imbalances, regulatory disparities or temporary supply demand imbalances.
Risk-Free or Low Risk Profit
Professional traders, market makers, institutional investors and other arbitrageurs participate in arbitration for profit making due to the price difference. This is the ultimate objective of arbitrage. As there is nothing complex involved in arbitration, the profit generation is risk free or low risk. Arbitrageurs capitalize the price difference due to market inefficiencies and engage in simultaneous buying and selling transactions for profit.
Market Efficiency
Arbitration arises due to market inefficiencies like the imbalance in demand and supply. But arbitration eventually helps in balancing the demand and supply by equalizing the princess across the different markets or platforms. Arbitration quickly leads to price adjustments i.e. convergence of prices and reducing the opportunity for further arbitrage.
Quick Execution
Arbitration is a careful short time shot. Market takes no time to detect the loophole and act on the correction measures. Fleeting pricing discrepancies lead to arbitration opportunities and arbitration requires quick and efficient execution to earn the profit. Arbitrageurs use modern trading techniques, algorithms and trading strategies to detect the price difference and capitalize arbitration opportunities.
Simultaneous Transaction
Arbitrage occurs when there are regular and simultaneous transactions. There is buying and selling of assets simultaneously in order to enjoy the marginal profit. Simultaneously transaction is necessary because the market takes no time to correct its inefficiencies. To take the benefit of the pricing discrepancy, buying and selling activities typically occur within a short timeframe.
Capital and Liquidity Requirement
The liquidity position of arbitrageurs is important for determining the profit. Arbitration needs quick response and execution. So, it is important to require significant capital and access to sufficient liquidity. Buying of assets requires capital and the level of capital determines the share of profit from the arbitration. Therefore, availability and access to reliable capital is essential in arbitration.
References
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