What Does Arbitrage Mean?

Arbitrage leads to synchronized buying and selling of securities, currencies and commodities in alternative markets, as it provides an advantage to the investors trading the same asset in different markets. The airbridge method has no negative cash flow, as investors are appropriately hedged in different markets by continuously selling and buying the same financial instrument. The arbitrage opportunity is a risk-free profit that is generated by the investors after deducting the transaction cost. Therefore, arbitrage is responsible for converting the same or similar assets in different markets. Arbitrage trading can be conducted on stock, derivatives, commodities, currencies and bonds.

Concept involved in detail.

The specific concept of arbitrage is based on no loss attribute, where investors hedge the risk of loss and generate profits from the trade. Arbitrage is not a simple activity where investors can sell and buy stock in two markets, as it is adequate analysis and evaluation to determine the accurate link and correlation between the prices of the stock. Market risk is considered to be one of the major challenges that are faced by arbitrator while making relevant investment decisions as to the risk of price change directly increases the negative attributes of an arbitrage trade. There are specifically three different types of arbitrage, which includes convertible Bond arbitrage, Merger arbitrage, and regulatory arbitrage, which is conducted by the maximum of the investors in the capital market. However, there are other arbitrage instruments such as depository receipts, Telecom arbitrage, and Municipal Bond arbitrage that is used by investors from time to time to support their investment needs. However, arbitrage is only profitable when certain criteria or conditions are met. The relevant criteria for the occurrence of arbitrage in a particular trade are depicted as follows.

Identification of the asset value where the particular set is not traded at the same price in different markets
Identifying whether two assets do not eat with similar cash flow in the same market
Identifying whether an asset with a known price of future does not trade on a given day in the same market, which accommodates risk-free interest rate discounting

Without fulfilling the above criteria, an arbitrage opportunity is not developed, which investors can take advantage off. Arbitrage example, considering stock of Company X is trading at $18 on NYSE while it is trading on LSE at $21. According to a trade, an arbitrage opportunity has been identified, which supports all the relevant criteria. Hence, the investor will buy Company X shares in NYSE and sell them in LSE simultaneously for generating a no loss profit after deducting the relevant transaction cost. Thus, investors after taking the above trade will be able to gain from the arbitrage opportunity and nullify the risk of loss.

There are specific benefits and limitation of arbitrage that is conducted by investors for supporting their investment needs. If an investor wants to maximize the profit level from arbitrage then the overall trade needs to be conducted electronically within different markets. This allows the investors to adequately grasp the information that is required for completing all the relevant Transaction in different markets. Electronically traded system supports the investors with the detection and completion of the arbitrage trade as quickly as possible. Therefore, arbitrage, when done in an informative way with adequate stock market analysis, is able to provide higher profits to the investors.

There are certain limitations to de arbitrage trade, where certain restrictions are imposed on funds that are ordinarily used by rational traders on the arbitrage trade. The arbitrage trade can be conducted on a theoretical basis but in reality, the overall limitations and restrictions that are imposed by regulators and the capital market halts the progress of the traders. The national traders rely on the efficient market hypothesis and assume that whenever mispricing occurs in a publicly traded stock there is an opportunity of low-risk profit. However, the currents of low this profit are minimal in real case scenario as continuous market risk influences the valuation of the stock in the particular capital market environment. The above example indicates about a treat that was conducted in NYSE and LSE, where investments are conducted in two different capital market environments, which composes of different risk involved in Investments. Hence, the pricing of the particular stock deferred, which initiated the arbitrage opportunity. There is no assurance that the overall prices of the stock will decline to support the price levels in a different market. Hence, the arbitrage opportunity will feel and incur a loss for the trader. Therefore adequate market risk needs to be accommodated by the investor before making any kind of investment decision.