Term of the Day - 18 March 2024

Today’s Term is “Arbitrage”.

Arbitrage is a trading strategy in finance that exploits price differences of identical or similar assets across different markets or exchanges to generate profits with little to no risk. The essence of arbitrage lies in capitalizing on temporary discrepancies in asset prices, buying the asset at a lower price in one market and simultaneously selling it at a higher price in another market, thereby profiting from the price differential.

Key characteristics of arbitrage include:

1. Efficiency of Markets: Arbitrage relies on the assumption that markets are efficient and that prices adjust quickly to new information. Any deviation from the theoretical fair value of an asset creates an arbitrage opportunity.

2. Types of Arbitrage: Common types of arbitrage include:

   • Spatial Arbitrage: Exploiting price differences between geographically distant markets (e.g., buying a commodity in one country where it's cheaper and selling it in another where it's more expensive).

   • Temporal Arbitrage: Exploiting price differences over time (e.g., taking advantage of price variations between spot and futures markets).

   • Statistical Arbitrage: Exploiting price divergences based on statistical models (e.g., using quantitative trading strategies to capitalize on mispricings).

   • Merger Arbitrage: Capitalizing on price discrepancies between a target company's stock and the offer price in a merger.

   • Convertible Arbitrage: Simultaneously buying convertible securities and short selling the underlying stock.

   • Index Arbitrage: Profiting from pricing disparities between index futures contracts and the underlying securities.

   • Cross-Border Arbitrage: Exploiting price differences between related financial assets traded in different countries.

   3. Risks and Costs: Arbitrage opportunities may be short-lived, and executing arbitrage trades requires prompt action and low transaction costs. There may also be risks such as execution risk, market risk, and regulatory risk.

Arbitrage plays a crucial role in maintaining market efficiency by ensuring that prices across different markets remain closely aligned. However, arbitrage opportunities tend to diminish over time as markets become more efficient and competition increases.