Arbitrageur

Arbitrageurs are market participants who exploit price differentials across various assets to secure riskless profits. They capitalise on temporary inefficiencies and play a vital role in ensuring fair value across markets. By understanding the concept of arbitrage and the associated strategies, you can identify better market opportunities, manage risks, and trade with greater confidence.

Who are arbitrageurs

In finance, arbitrageurs are sophisticated market participants who engage in the practice of arbitrage, which involves exploiting price differentials for the same asset:

• In different markets, or
• Across different instruments

The primary goal of arbitrageurs is to secure riskless profits by capitalising on price discrepancies. They prefer to buy and sell securities, commodities, or currencies at advantageous prices.

How do they operate

The essence of arbitrage lies in exploiting temporary imbalances in market prices, which arise due to factors such as:

• Information asymmetry: Not everyone has the same information about a stock or product.
• Transaction costs: It costs money to make trades, and those costs affect market prices.
• Delays in market reactions: It takes a while for markets to react to news or changes.

Arbitrageurs swiftly identify and react to these discrepancies in a bid to earn risk-free profit. Let us understand their working in simple steps:

Step I: Identification of opportunity

• Arbitrageurs continuously monitor financial markets to identify price differentials across various assets, such as stocks, bonds, currencies, or commodities.
• They pinpoint potential arbitrage opportunities by using:
  • Sophisticated analytical tools
  • Advanced market data, and
  • Modern trading platforms
    

Step II: Analysis and evaluation

• Once an arbitrage opportunity is identified, arbitrageurs assess the feasibility and profitability of the trade.
• This involves calculating potential profits after factoring in:
  • Transaction costs, and
  • Liquidity constraints
    

Step III: Execution of trades

• Post successful evaluation, arbitrageurs execute trades swiftly to exploit the price differential.
• They employ automated trading algorithms or execute manual trades, depending on the complexity and speed required.
  

Step IV: Risk management

• Arbitrageurs also employ risk management strategies to limit potential losses.
• This usually involves:
  • Implementing hedging techniques
  • Diversifying portfolios, or
  • Setting stop-loss orders
    

What are the different types of arbitrageurs

Arbitrageurs in financial markets can be divided into three major types:

How do arbitrageurs maintain market liquidity

Arbitrageurs actively participate in trading activities and provide constant liquidity. Let us see how they do it:

• Regularly executing trades
  • Arbitrageurs regularly buy and sell assets.
  • Through this active participation, they increase the overall trading volume of the market.
• Reducing spreads
  • Arbitrageurs exploit price discrepancies between bid and ask prices to make profits.
  • In doing so, they reduce the bid-ask spread, which is the difference between:
    • The highest price that a buyer is willing to pay and
    • The lowest price that a seller is willing to accept
  • A narrower spread enhances market liquidity as it leads to quicker transactions.
• Providing market depth
  • Arbitrageurs often place orders to buy or sell assets at various price levels.
  • This kind of placement adds depth to the market and allows investors to execute trades of varying sizes with greater ease.
• Responding to market imbalances
  • Arbitrageurs closely monitor market conditions and swiftly respond to imbalances in supply and demand.
  • When there is a shortage of buyers or sellers in the market, arbitrageurs step in to provide liquidity by either buying or selling assets as needed.
    

Why do arbitrage in financial markets

One of the primary objectives of arbitrageurs is to maximise profits by exploiting price differentials in financial markets. They usually do so by:

• Buying assets at lower prices in one market and
• Simultaneously selling them at higher prices in another market

Let us understand with a hypothetical example involving currency arbitrage:

• The exchange rate between the US dollar (USD) and the Indian Rupee (Rs.) is 1 USD = Rs. 80 in the forex market.
• However, in the futures market, the forward rate for the same currencies is 1 USD = Rs. 85
• An arbitrageur exploits this price discrepancy by:
  • Buying USD in the forex market and
  • Simultaneously selling USD forward in the futures market.
• By doing so, they lock in a profit of Rs. 5 per USD traded.
  

What are the different arbitrage strategies

Many arbitrageurs, particularly those in hedge funds, engage in three distinct types of arbitrage strategies. Let us study each of them:

Strategy I: Convertible arbitrage

• In this strategy, the price discrepancies are exploited between:
  • A convertible security (such as a convertible bond or preference share) and
  • Its underlying asset
• Arbitrageurs buy the convertible security and simultaneously short-sell the underlying asset to profit from differences in their prices.
• For example,
  • Let us assume that a convertible bond can be converted into shares of Company X at Rs. 85 per share when the current market price of Company X's shares is Rs. 95
  • In this case, arbitrageurs buy the convertible bond and short-sell Company X's shares.
  • By doing so, they profit from the price difference of Rs. 10 when the bond is converted into shares.
    

Strategy II: Merger arbitrage

• Arbitrageurs engage in merger arbitrage to hedge against deal-related risks.
• For example,
  • Company A announces its intention to acquire Company B at Rs. 100 per share.
  • Arbitrageurs buy shares of Company B at the current market price, which is Rs. 85 per share
  • They simultaneously short-sell an equivalent number of shares of Company A.
    
    
  • This strategy allows arbitrageurs to profit from the price differential between the:
    • The current market price of Company B's shares, i.e., Rs. 85 and
    • The expected acquisition price, i.e., Rs. 100
      

Strategy III: Statistical arbitrage

• Arbitrageurs also employ statistical arbitrage strategies to exploit:
  • Short-term mispricings or
  • Anomalies in financial markets
• For example
  • Let us assume that two highly correlated stocks temporarily deviate from their historical price relationship.
  • After finding this anomaly, arbitrageurs simultaneously:
    • Bought the undervalued stock and
    • Short-sold the overvalued stock.
  • They earned differential profit when prices reverted to their mean relationship.
    

Conclusion

Arbitrageurs are sophisticated market participants who exploit price differentials to generate riskless profits. They play a crucial role in promoting liquidity and price discovery. Depending on the situation and their expertise, arbitrageurs employ different types of arbitrage strategies, such as convertible arbitrage, merger arbitrage, and statistical arbitrage.

By understanding how arbitrageurs operate, you can develop a solid understanding of market dynamics and trading principles. Also, you can hone your analytical skills and be better prepared to capitalise on market inefficiencies.