Types of Arbitrage Explained with Definition

Arbitrage is a way to make money from the difference in price between the same assets or goods by buying and later, selling them. It is an interesting field to study in economics and finance. Investors buy and sell the same asset in different places or at different times to make money from the price differences.This is how arbitrageurs try to make money off of the market’s flaws without taking on any extra risk. The article elaborates on the types of arbitrage with definition..

What Is Arbitrage?

scholars define arbitrage as a risk-free opportunity for profit-making that arises from market inefficiencies or temporary imbalances in supply and demand. Arbitrage entails the simultaneous process of buying and selling the same or similar asset in different markets or at different times to profit from tiny differences in the asset’s listed price. The goal of arbitrage is to generate a profit from the price difference between two markets (demand and supply differentiation) when the same good or service is being sold at different prices.One must make a sequence of deals that are timed so that the profit is equal to the difference between the selling prices of the unit on both markets.

Types of Arbitrage

Here the article discussed arbitrage types.

Pure Arbitrage

Financial market participants use a set of techniques collectively known as “arbitrage” to profit from price discrepancies. Market inefficiencies, regional variations, timing issues, or mis-priced assets are all potential explanations for observed price discrepancies. They are-Pure arbitrage is an investment strategy that aims to generate risk-free profits by exploiting price discrepancies across different markets. It involves buying
and selling the same asset or security simultaneously in separate markets to take advantage of the price difference. The objective is to eliminate any market risk and secure guaranteed profits by capitalizing on temporary market inefficiencies. Swift execution and precise timing are essential to capitalize on small price differentials.

Pros

• Fast and Efficient Execution.
• Risk-Free Profits.
• Market-Neutral Strategy.

Cons

• Limited Profit Margins.
• Capital Requirements.

Triangular Arbitrage

On the foreign exchange market, triangular arbitrage means taking advantage of an arbitrage opportunity caused by a price difference between three different currencies. A triangle arbitrage method is made up of three trades in which the starting currency is changed into two others and then back again.

Pros

• Quick Execution
• Profit Potentiality high.
• Flexibility and Independence in Business Operations.

Cons

• Intense Competition and exchange rate unpredictability.
• Fluctuating and Unpredictable Profit Margins.

Risk Arbitrage

Risk arbitrage, also known as event-driven arbitrage (sometimes merger), is an investment strategy employed in takeover situations. It allows investors to capitalize on the price differential between the target company’s stock trading price and the acquirer’s valuation of that stock. Risk arbitrage is an event-driven trading approach that aims to generate profits from discrepancies in
stock prices during merger and acquisition activities.

Pros

• Opportunity to Benefit from Market Inefficiencies and Mispricings.
• Utilization of Advanced Analytical Techniques and Models.
• Potential for Lower Volatility compared to Traditional Investments.

Cons

• Execution Risks and Timing Challenges.
• Regulatory and Compliance Risks.

Convertible Arbitrage

This arbitrage strategy is commonly used by hedge funds, aiming to maintain a neutral stance in the market. It entails concurrently buying convertible securities and selling short the common stock of the same issuer. The goal of the arbitrageur is to capitalize on market movements by establishing a suitable
hedge between long and short positions, to generate profits.

Pros

• Income Generation through Coupon Payments.
• Lower Volatility.
• Market-Neutral Strategy.

Cons

• Credit Risk in Convertible Securities.
• Interest Rate Sensitivity.

Dividend Arbitrage

This is an arbitrage strategy in options trading where traders purchase both put options and the equivalent amount of underlying stock before the ex-dividend date. By collecting the dividend and subsequently exercising the put options, traders aim to benefit from the price adjustment. This approach
allows them to capture the dividend payment while protecting against potential downside risk. It is important to assess factors such as transaction costs and market conditions to manage the associated risks effectively.

Pros

• Potential for Enhanced Portfolio Returns.
• Income Generation during Volatile Market Conditions.
• Utilization of Fundamental Analysis in Stock Selection.

Cons

• Options Expiration Risk.
• Exposure to Stock-Specific Risks.

Futures Arbitrage

Futures arbitrage involves profiting from price disparities between futures contracts and their underlying assets. Traders exploit these temporary differences by buying or selling futures contracts and imultaneously taking opposite positions in the underlying assets. They aim to make profits as the prices converge and the price discrepancy narrows.

Pros

• Utilization of Leverage for Amplified Returns.
• Market Neutrality.
• Availability of Liquid and Active Futures Markets.

Cons

• Counterparty Risk.
• Critical Clearinghouse Considerations.

Spatial Arbitrage

Spatial arbitrage refers to a trading strategy where traders leverage price differences of the same asset across different geographic locations. By purchasing the asset at a lower price in one market and selling it at a higher price in another market, traders aim to profit from the geographical disparity in prices.

Pros

• Flexibility in Market Selection.
• Utilizes Informational Advantages.
• Takes advantage of Geographical Price Disparities.

Cons

• Sensitive to Market Disruptions and Unexpected Events.
• Currency Exchange Rate Risks.

Statistical Arbitrage

Statistical arbitrage is a trading strategy that aims to profit from pricing discrepancies or patterns observed in financial markets by utilizing statistical analysis and quantitative models. Traders employing statistical arbitrage identify assets or securities that are mispriced relative to their historical relationships or statistical measures. The strategy involves simultaneously taking long and short positions in a pair or basket of assets that exhibit a historically correlated relationship.

Pros

• Short-Term Trading Opportunities
• Reduced Reliance on Market Direction
• Utilization of Advanced Technology and Data Analysis

Cons

• Liquidity Constraints
• Data Limitations and Quality

Arbitrage Vs Hedging

Aspect	Arbitrage	Hedging
Objective	Profit generation through price discrepancies	Risk management through price fluctuations
Nature	Speculative	Protective
Purpose	Exploit market inefficiencies	Reduce potential losses
Time Horizon	Short-term	Short-term or long-term
Risk Level	Relatively higher	Relatively lower
Market Condition	Requires market anomalies or mispricing	Doesn’t rely on market anomalies
Transaction Frequency	Frequent	Occasional or periodic
Investment Size	Large	Variable (based on risk exposure)
Key Players	Traders, market makers	Investors, businesses, fund managers
Strategy	Buy low, sell high to capitalize on price differences	Take positions to offset potential losses
Profit Source	Market inefficiencies, price differentials	Price movements or changes in underlying assets
Example	Buying an asset on one exchange and selling on another	Purchasing options to protect against stock price drop

Bottom Line

To summarize, different types of arbitrage aim to profit from price disparities between different markets, time frames, or assets. It exploits market inefficiencies by purchasing and selling assets concurrently. Investors seek low-risk profits by using their expertise and responding quickly. To take advantage of transitory chances, arbitrage involves regular monitoring, quick decision-making, and risk management. Arbitrage can be profitable, but it requires regular monitoring, discipline, and risk management to succeed in this dynamic and competitive investment technique.

References

• Dybvig, P. H., & Ross, S. A. (1989). Arbitrage. Finance, 57-71.https://link.springer.com/chapter/10.1007/978-1-349-20213-_4 Shleifer, A., & Vishny, R. W. (1997). The limits of arbitrage. The Journal of finance, 52(1), 35-55.
  https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540- 6261.1997.tb03807.x
• Varian, H. R. (1987). The arbitrage principle in financial economics. Journal of Economic Perspectives, 1(2), 55-72.https://pubs.aeaweb.org/doi/pdf/10.1257%2Fjep.1.2.55Sammut, J. (2017). Analysis of different types of arbitrage (Bachelor’s thesis, University of Malta).
• Bender, C. (2012). Simple arbitrage. https://projecteuclid.org/journals/annals-of-applied-
  probability/volume-22/issue-5/Simple-arbitrage/10.1214/11- AAP830.full
• Arbitrage (2023) Wikipedia. Available at: https://en.wikipedia.org/wiki/Arbitrage
• What is arbitrage? – 2023 (no date) Robinhood. Available at:https://learn.robinhood.com/articles/0SecVg50Rc90Oc0RjWkD4/what-is-arbitrage/
• What is arbitrage? 3 strategies to know (2021) Business Insights Blog.Available at: https://online.hbs.edu/blog/post/what-is-arbitrage
• _@groww (no date) What is arbitrage? – meaning, types and benefits,Groww. Available at: https://groww.in/p/what-is-arbitrage