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Arbitrage: Basics

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Arbitrage divides into multiple strategies based on the target asset. All of these strategies divide into in risk and riskless arbitrage. The execution of the arbitrage strategies changes based on which type of arbitrage is being used.

Understanding the differences between the two types of arbitrage first requires understanding the situations which give rise to arbitrage opportunities. Arbitrage opportunities occur when the same or substitutable assets have pricing differences in two or more markets. The spread can widen if the barriers which created the difference in asset prices remain in place. Arbitrage seeks profit from these opportunities by purchasing the underpriced asset while selling (or short selling) the overpriced asset. If this activity is executed constantly, it increases the lower asset’s price and decreases the higher asset’s price. Price differences are usually small and converge at the same value quickly.

Riskless Arbitrage

The difference between risk free and risky arbitrage depends on the assets selected. In riskless arbitrage the same asset is used: managers purchase an asset in a single region or market, and quickly sell the exact same asset in another market or region at a higher price which was possibly secured in advance. There is such little risk the strategy is called riskless arbitrage. This generates an instant profit for the trader, but only works when the market is not efficiently pricing assets across market lines. If the market functions efficiently these opportunities do not emerge. Inefficiencies are usually caused by regulatory, legal, geo-political, or economic concerns or restrictions.

Risky Arbitrage

Risky arbitrage functions with a few differences that expose the strategy to potential loss. The assets bought and sold may be merely similar assets instead of the same asset, or a different investment instrument driven by the same underlying asset. The greater the difference in assets used the greater the amount of risk. Arbitrage relies on price differences between the same or highly correlated instruments. The similarity or correlation increases the chance assets will be narrowed towards each other in value. An alternative difference is time: the assets may not be purchased and sold at precisely the same moment. Greater differences in time between purchase and sale increase the chance the opportunity will be noticed by others. Other market players will exploit the opportunity, and their trades will narrow the price gap, or even eliminate it. Disruptive events have a higher chance of occurring during long periods of time, providing additional risk for those who wait. Arbitrage losses occur frequently when traders leave too much time between purchase and sale. If the price gap closes after purchase but before sale, or for short sales after sale but before purchase, the trader can suffer losses under the right circumstances. Costs will simply exceed profit potentially earned on the trade.

Concerns

The primary concern for arbitrage is not the overall price directions, though they may have influence if they’re driving prices together or farther apart. Arbitrage’s primary concern is the price relation of the two assets. The goal is earning as much profit as possible before the two prices converge at the same price. Before exploiting opportunities, funds must find them. As a result, most hedge funds using arbitrage strategies dedicate themselves to identifying and trading solely arbitrage opportunities.

Impact of Fees

Commissions and fees reduce the spread between the purchase and sale prices, decreasing potential arbitrage gains and increasing losses. Hedge funds can typically reduce costs by negotiating bulk rates from fees and expenses with banks or brokerages, using the amount of money they control as negotiating power.

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