Trying to keep arbitrageurs out of financial markets is like trying to keep compulsive chain-smokers out of public toilets. Putting a sign saying “No smoking” or even a fire alarm or a guard round the clock is not enough. Compulsive smokers manage to slip into public toilets the moment there is an opportunity. Similarly, arbitrageurs also make inroads in the market to cash in on every minute opportunity of arbitrage. Our friend Johnny wonders how this whole business of arbitrage works. Let’s see what answers Jinny provides:
Johnny: Hi Jinny, I see you are in a great hurry today. Are you also looking for some opportunity?
Jinny: Opportunity? You can’t look for an opportunity in a hurry. You need to have patience to wait for the right thing to happen at the right moment. But anyway, what is this prelude all about?
Johnny: Well, Jinny, a couple of weeks ago, I read an article in Mint that talked about arbitrage opportunity in the financial market. I do not understand how this whole business of arbitrage actually works. Do you have any idea?
Jinny: Sure. Arbitrage is the favourite way of earning a risk-free profit. But arbitrage prefers those who can patiently wait and watch. Theoretically speaking, arbitrage takes place if the price of the same product or asset is different in two or more markets. You purchase the product or asset from one market at a lower price and simultaneously sell the same at a higher price in another market. In this manner, you earn a risk-free profit by indulging in what we call arbitrage. The people who indulge in arbitrage are called arbitrageurs. This kind of arbitrage can take place in any market in respect of any commodity or product; however, the financial markets are one of the most preferred places for arbitrageurs. This is so because all the financial markets today are interconnected through electronic means and you can simultaneously execute trades in different markets to take advantage of even a small price difference.
In financial markets, most of the financial instruments such as stocks, bonds, currencies or derivatives, or even variables such as interest rates, are subject to arbitrage.
You may hear about arbitrage of different kinds such as currency arbitrage, interest rates arbitrage, or even labour arbitrage, regulatory arbitrage, cash and carry arbitrage etc.
Johnny: It seems even a dumb person such as me can earn a money by simply doing arbitrage. What do you say?
Jinny: Well, looking for an arbitrage opportunity requires the eyesight of an eagle and the quickness of a leopard. Nowadays, arbitrageurs use sophisticated computer programs for locating every microscopic discrepancy in price. Once the opportunity is located, you quickly need to jump on it before others do.
Arbitrage opportunities in financial markets, or any other market, evaporate very quickly because they carry the seed of their own destruction. The moment arbitrageurs start to cash in on the differences in the price of two markets, the prices of both the markets start to converge. The price of the asset in the market where it is priced low starts rising due to the buying activity of the arbitrageurs. Similarly, the price of the asset in the market where it is priced high starts falling due to the selling activity of the arbitrageurs. Finally, the prices of both the markets converge at a price that is called the arbitrage equilibrium price.
So arbitrageurs play an important role in filling the gap between the demand and supply. How quickly this happens depends upon how efficient your markets are.
But, so far, I have told you about arbitrage that takes place if the same asset does not trade at the same price in different markets at the present time. However, arbitrage can also take place if there is divergence between the present price and the future price of any asset.
Johnny: How does that kind of exotic arbitrage work?
Jinny: There is nothing exotic about it. Suppose the future price of an asset is higher than its present price, you simply buy that asset now at a lower price and simultaneously sell the same in the futures market at a higher price. But this kind of arbitrage can work only if the purchase price of the asset at present, after adding the carrying cost, is less than the future price. Carrying cost includes cost of money in terms of interest and cost of preservation and storage, depending on the type of asset. This type of arbitrage, in technical terms, is known as “cash and carry arbitrage”.
There is an opposite version of this arbitrage also, which is known as “reverse cash and carry arbitrage”, in which you simply sell the asset at a higher price now and simultaneously purchase the same at a lower price from the futures market. In this manner, you can take advantage of the difference between the spot and future prices.
Johnny: Thank you Jinny, for giving me the opportunity to arbitrage my doubts with your wisdom.
What:Buying an asset or product at a lesser price in one market and simultaneously selling the same at a higher price in another market is called arbitrage.
How: Arbitrageurs use sophisticated computer analysis to detect even minute differences in prices of the same asset in different markets.
Why: Arbitrageurs are important because they fill the gap between the demand and supply, leading to arbitrage equilibrium price.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at email@example.com