Arbitrage

For example, in a village, 1 kg of apples costs 5 dollars. Tom buys 10 kg for $50. He arrives in the city and finds out that apples here cost $9 per 1 kg, sells his 10 kg, and makes a profit of $40.

Of course, this example of arbitrage is conditional, since the apples still had to be brought to the city, and the price could change; besides, Tom could end up earning nothing at all if the apples spoiled on the way.

But this example demonstrates the very essence of arbitrage — the income was received due to the difference in the price of the same asset.

Unlike the vegetable and fruit market, the stock market is characterized by a change in the situation in a split second. Here, the purchase and sale of the same asset takes place simultaneously.

Trading takes place using both borrowed and the investor’s own funds; in the first case, the investor’s risks are higher.

Inter-Exchange Arbitrage

The same assets can be listed on several exchanges in different countries. At the same time, the asset price may be different on different exchanges. Thanks to such inter-exchange arbitrage, an investor can earn money, for example, by buying the asset cheaper on a foreign exchange and selling it more expensively on a local stock exchange.

Spot Futures Arbitration

Spot futures arbitrage (or cash-and-carry arbitrage) is a strategy in which an investor acquires an asset, for example, shares, and, at the same moment, sells futures for the same shares with a maturity of several months.

The purpose of this type of arbitrage is to exploit the inefficiency of the futures market. For futures, you need to wait several months, and because of this, the cost of carrying the position — including the interest rate factor — is taken into account in the yield, which, of course, will be higher.

Hence the difference in the price of the underlying asset and futures.

For example, an investor purchased shares for $1,000 per share. On a four-month futures contract, they were sold for $1,050 apiece. The risk-free return was $50 per share. This return is unlikely to be very large.

For example, a broker may want to raise the margin requirement on a futures contract, and the investor will need to deposit money immediately. If the investor does not do this, the broker will forcibly close the position (sell futures), and the broker can raise the margin by 100%. Using this type of arbitrage, investors need to analyze the potential profitability. If its level is comparable to the income from a bank deposit or bonds, then it is better to abandon such a deal.

Interest Rate Arbitrage

Interest rate arbitrage works as follows: an investor borrows money in one country at 7%, and in another country invests it at 12%. Earnings come from the difference in rates.

Interest rate arbitrage is popular among large institutional investors who operate in several different countries. It is worth considering that this scheme works well only if the exchange rates are stable.

For example, investor Tom took out a loan in US dollars at 6% per year. In Russia, he sold the currency at the rate of 80 rubles for 1 dollar and purchased short-term federal loan bonds, whose yield is 18% per year. When the year ended, the investor closed the position to repay the loan. But, unfortunately, the ruble exchange rate has become 110 rubles per dollar. The investor sold the bonds and suffered losses.

Currency Arbitrage

Here, the investor earns due to the difference in the exchange rate of the same currency. The spread often appears because in some markets there may be an imbalance of supply and demand for a particular asset.

For example, on some exchanges, the British pound / US dollar is traded at a rate of 1.2. On another exchange, this instrument is bought and sold for 1.25. An investor can get a guaranteed income of 0.05 per pound by buying pounds sterling on the first exchange, where the rate is lower, and selling them on the second exchange, where the rate is higher.

Unfortunately, in the age of information technology, such a spread is very rare, as markets quickly synchronize their work, and the exchange rates of pairs quickly align. Also, the investor does not always have access to the exchange where the spread appears. There will be great risks in such trading, as investors need to invest a lot of money to make a significant profit. To make money on currency arbitrage, investors need to open a brokerage account with a broker.

Arbitrage on Interrelated Assets

The essence of this strategy lies in the fact that assets of the same type move in the same direction. If the price of one instrument increases, the price of the second one should also increase. Unfortunately, the strategy has a significant disadvantage — most of these assets (bonds of the same credit quality, shares of commodity companies, etc.) are traded simultaneously on the same markets. How can an investor make money on the dynamics of preferred shares when they duplicate the dynamics of ordinary shares at the same time?

Conclusion

Arbitrage can be useful for helping a trader make money, but there are also a number of difficulties:

• You need to have access to different exchanges in different countries.
• You need to be able to get a loan at a low interest rate in another country.
• You need to be able to react promptly to market changes, as a result, to devote a lot of time to this.

In summary, arbitrage is most likely not suitable for an ordinary investor, who finds it more profitable and easier to earn on simpler instruments, such as stocks and bonds.