Arbitrage is a process of simultaneously buying and selling an asset and generating a profit due to imbalances in prices. The main objective of all the different types of arbitrage strategies is to exploit the inefficiencies in the market. If the markets were perfectly efficient, there would be no arbitrage opportunities.
Arbitrage has an advantage of providing you with almost risk free profit but the profit earned is very small. Hence only hedge funds and large institutional investors are capable of taking advantage of arbitrage opportunities. They trade with large amounts of money and can earn millions in profit even if the spread is small.
For any type of arbitrage opportunity to be present, at least one of the below conditions should be true.
- Same asset is traded in different markets at different prices.
- Two assets with the same cash flow are trading at different prices.
- There is a considerable difference between the expected future price and the current price of an asset.
When you buy an asset in a cheaper market, it increases the demand and the price of that asset. When you sell the same asset in an expensive market, it increases the supply and decreases the price of that asset. Doing this repeatedly will result in price convergence across the markets and eliminating different types of arbitrage opportunities.
There are few conditions which are required to take advantage of any arbitrage opportunity. Without these conditions, the positive arbitrage can turn into negative arbitrage resulting in a loss.
- Exchange trading fees and transaction costs must be low.
- Trading volume must be sufficient to mitigate the risk of price volatility.
- In case of spatial arbitrage, the asset being transferred should be fast.
Arbitrage free condition or no arbitrage condition occurs in a situation where all the similar assets are priced appropriately across different markets and there is no way to earn any reasonable profit without taking any additional risk.
Modern technological advancements have given rise to sophisticated computer trading systems and high frequency trading algorithms which make sure that any type of arbitrage opportunity is eliminated in a matter of few seconds.
Different Types Of Arbitrage Trading Strategies
There are various types of arbitrage strategies used by traders and investors in the world of finance to take the advantage of price discrepancies. Below is the list of most common and popular types of arbitrage.
- Cryptocurrency Arbitrage
- Triangular Arbitrage
- Covered Interest Arbitrage
- Uncovered Interest Arbitrage
- Merger Arbitrage Or Risk Arbitrage
- Statistical Arbitrage
- Index Arbitrage
- Betting Arbitrage Or Sports Arbitrage
- Currency Arbitrage
- Convertible Arbitrage
- Futures Arbitrage
- Capital Structure Arbitrage
- Cash Carry Arbitrage
- Fixed Income Arbitrage
- Relative Value Arbitrage
- Swap Arbitrage
- Options Arbitrage
- Gold Arbitrage
- Tax Arbitrage
- Negative Arbitrage
- Latency Arbitrage
- Rental Arbitrage
- Credit Card Arbitrage
- Regulatory Arbitrage
- Volatility Arbitrage
- Location Arbitrage Or Spatial Arbitrage
- Time Arbitrage
- Yield Curve Arbitrage Or Interest Rate Arbitrage
- On The Run And Off The Run Arbitrage
- Retail Arbitrage
- Crude Oil Arbitrage
- Multiple Arbitrage
- Information Arbitrage
- Riskless Arbitrage
- Political Arbitrage
- Institutional Arbitrage
- Beta Arbitrage
- Knowledge Arbitrage
- Static Arbitrage And Dynamic Arbitrage
- Quasi Arbitrage
Cryptocurrency arbitrage takes advantage of the price differences between two different cryptocurrency markets. For example, if a specific coin is trading lower on first exchange as compared to second exchange then you can buy the coin on first crypto exchange and sell it for a higher price on second crypto exchange and pocket the difference.
Bigger crypto exchanges with higher trading volumes effectively drive the price for the rest of the market, with smaller crypto exchanges adjusting the prices. However, there is a time lag present in following up with the prices set by bigger exchanges, which results in arbitrage opportunities in cryptocurrency markets.
In cryptocurrency triangular arbitrage, you can take advantage of price differences between three currencies. You can buy Bitcoin in USD, sell it on the EUR exchange and then convert those EUR back to USD.
Triangular arbitrage is a trading strategy which takes advantage of the price differences between three currencies in the forex market. It is also known as three-point arbitrage or cross currency arbitrage. The price discrepancies arise in situations where one market is undervalued and another is overvalued.
Triangular arbitrage trading strategy is executed by converting first currency into second, then second currency into third and finally converting the third currency back to first. All these transactions are done by trading algorithms in a matter of seconds.
Triangular arbitrage opportunities are very rare in real world as foreign exchange markets are highly sophisticated and competitive with large number of players. These transactions require large trading amounts as the price difference between currencies is limited to few cents.
Due to this, such opportunities can only be exploited by high frequency traders with low transaction costs. Using high speed algorithms these traders can easily find the mispricing and immediately execute the necessary trades.
Covered Interest Arbitrage
Covered interest arbitrage is one of the most common types of interest rate arbitrage which is designed to profit from the differences of interest rates between two countries. It involves the use of forward contract to limit the exposure of exchange rate risk.
Covered interest arbitrage would be possible only if the exchange rate risk and the cost of hedging is less than the return generated by investing in foreign currency. Hence low transaction costs are extremely important while exploiting such opportunities.
This strategy can be executed by exchanging domestic and foreign currency at current spot rate and then hedging the exchange rate risk by buying or selling the forward contract in foreign currency.
Uncovered Interest Arbitrage
Uncovered interest arbitrage also takes advantage of the interest rate discrepancies between two countries but it does not use any forward contract to eliminate or hedge the exposure to exchange rate risk.
For uncovered interest arbitrage to be profitable, the interest rates should remain favorable as the investor is exposed to exchange rate fluctuations. Any adverse movement in currency markets can wipe out all the gains and even result in negative returns.
For example, if the interest rate differential between two countries is 3% and the foreign currency appreciates by 5%, then the total return on this trade will be 8%. However, if the foreign currency depreciates by 5% then the total return will be -2%.
Merger Arbitrage Or Risk Arbitrage
Merger arbitrage, also known as risk arbitrage is a trading strategy that is executed during various corporate events like merger, acquisition or bankruptcy. Retail investors can take advantage of such events by investing in merger arbitrage ETF. It involves buying and selling the stocks of two merging companies.
There is always an element of uncertainty during mergers and acquisitions due to which the stock price of the target company is usually quoted below the acquisition price. The arbitrageur purchases the stock before the corporate event, expecting to sell it for a profit when the merger or acquisition completes.
Corporate mergers can either be classified into cash mergers or stock mergers. In a cash merger the acquiring company acquires the target company by paying cash whereas in stock merger the stock of target company is exchanged for the stock of acquiring company.
Statistical arbitrage, also known as stat arb is an algorithmic trading strategy used by many investment banks and hedge funds. It is not a high frequency trading strategy. It can be categorized as medium frequency where trading occurs over the course of a few hours to few days.
This type of arbitrage uses mean reversion to exploit the price movement across thousands of financial instruments by analyzing the price anomalies between these instruments. These algorithms are designed by using complex statistical methods and data mining.
Statistical arbitrage is an advanced version of pairs trading where the stocks are traded in pairs based on some similarities. When the first stock outperforms the second stock in the pair, the second stock is bought and the entire position is hedged by shorting first stock.
Index arbitrage is a trading strategy that exploits the price discrepancies between two or more market indexes by buying a lower price index and selling a higher price index with the expectation of making a profit.
Index arbitrage is theoretically possible between same indexes trading on two different exchanges or between two different indexes with similar components or between futures price and spot price of an index or between index components and different types of instruments that track the index like index mutual funds or exchange traded funds.
This type of arbitrage can be accomplished using algorithmic trading where the computers are instructed to monitor the difference between the spot price of a stock index and its futures contact. In case of mispricing, the algorithm will simultaneously place buy and sell orders for stocks and index futures, thus rebalancing the prices.
Betting Arbitrage Or Sports Arbitrage
Betting arbitrage, also known as arbing or sports arbitrage is a technique where you can place multiple bets with different betting exchanges and can earn a profit regardless of the outcome. These bets are known as surebets or miraclebets.
Arbing opportunities arise due to differences in odds when the bookmakers cannot keep track of one another’s action or bookmakers make a mistake while calculating the odds resulting in wrong pricing. Usually these are binary bets with just two possible outcomes.
Betting arbitrage is very much different from traditional gambling. It is more of a mathematical process which ensures the profit. There are many sports betting calculators available online which can help you to identify the arbitrage situations by applying mathematical formulas.
Currency arbitrage, also known as two-point arbitrage is a trading strategy which takes advantage of the price differences between various currency spreads. Difference in spread is the difference between bid and ask price for the same currency pair at two different locations or foreign exchange markets.
Different brokers offer different rates for each currency pair. A forex trader can simultaneously buy and sell currency pairs at different brokers to take advantage of the price discrepancies. Alternatively a trader can also use three different currency pairs to create a triangular arbitrage.
Opportunities for this type of arbitrage are very rare and lasts only for a few seconds as currency markets are highly liquid with huge amount of trading volumes. Taking advantage of such opportunities requires sophisticated hardware and high frequency algorithms.
Convertible arbitrage is a trading strategy which requires taking a long position in convertible security and a short position in underlying common stock and thus taking advantage of the price differences between two securities.
A convertible security is one which can be converted into another form such as preferred stock or common stock. This type of arbitrage strategy is mostly used by hedge funds to capitalize on arbitrage opportunities.
Convertible bond arbitrage is one of the most common types of arbitrage under this category. This strategy benefits from the mispricing between convertible bond and its underlying stock. A convertible bond can be converted into underlying equity at a specific price in future.
Futures arbitrage is one of the most popular types of arbitrage without any directional risk. This strategy can be executed when the market is in contango or backwardation. It is also known as spot futures arbitrage.
This strategy capitalizes the difference between spot price and futures price of an underlying asset. A trader can take a long position in secondary market along with a simultaneous short position in futures market making a potential profit at maturity irrespective of the direction of movement.
There are two main types of futures arbitrage strategies – long the basis and short the basis. Being long the basis means being long the price difference between spot price and futures price. Opposite of this is short the basis where you are short the price difference between spot price and futures price.
This type of arbitrage is capable of giving a risk free profit but the profit margin is very small. For this it requires low commissions and large trading amount. But as this is a formula driven strategy, it requires no market analysis and can be executed via algorithmic trading.
Capital Structure Arbitrage
Capital structure arbitrage takes advantage of price discrepancies between different securities issued from the same company’s capital structure. This strategy is used by many directional and market neutral credit hedge funds.
Mispricing opportunities can arise between equity and debt or sub bonds and senior bonds or equity and credit default swaps or bank debt and bonds. These opportunities can be exploited by taking a long position in one security and a simultaneous short position in another security issued from the same company’s capital structure.
One of the most common examples of capital structure arbitrage is exploiting the differences between equity markets and credit default swaps. It takes into account the lead lag relationship between the prices of two markets.
Cash Carry Arbitrage
This type of arbitrage is a market neutral strategy which exploits the price differences between spot market and futures market in order to make a risk free profit. For this strategy to be profitable the futures price must be higher than the spot price.
Cash carry arbitrage strategy can be executed by taking a long position in underlying asset and a simultaneous short position in the futures contract of the same underlying asset. This strategy has a risk associated with the expenses involved in physically carrying the asset until maturity.
The opposite of this strategy is reverse cash carry arbitrage which can be executed by taking a short position in an asset and a long position in futures market for the same asset. This strategy will be profitable only if the futures price is less than the spot price.
Fixed Income Arbitrage
Fixed income arbitrage is mainly used by investment banks and hedge funds which aim to profit from the interest rate anomalies between different fixed income securities like municipal bonds, corporate bonds, government bonds, mortgage backed securities, interest rate swaps and credit default swaps.
Fixed income arbitrage is a market neutral strategy and can be executed by taking opposite positions in two different fixed income securities. This type of arbitrage strategy requires that the securities are similar to each other and have sufficient liquidity.
Relative Value Arbitrage
Relative value arbitrage exploits price anomalies between related financial instruments like stocks and bonds. In this strategy a trader can buy a relatively underpriced security and simultaneously sell a relatively overpriced security thereby profiting from the difference in the relative value of two securities.
Relative value arbitrage is most commonly used by hedge funds which use leverage to amplify the returns. The popular trading strategy used to achieve this type of arbitrage is known as pairs trading which involves taking a long and a short position in two different assets which are highly correlated to each other.
Forex swap arbitrage refers to taking advantage of interest rate differential between two countries by simultaneously buying and selling currencies of those countries. When a trader buys or sells a currency pair, he is essentially borrowing first currency in order to lend second currency.
The opportunity for swap arbitrage arises when a trader can take forex position without paying swap rates. The trader can eliminate the market risk involved by taking a position with first broker that pays swap and taking an opposite position with second broker that does not credit or debit swap.
Options arbitrage can be initiated either between two options or between an option and the underlying asset. Synthetic options are very common in this type of arbitrage. When a trader feels that a call option is overpriced in relation to put option then he can sell a naked call and offset the same by buying a synthetic call.
Option traders also use conversions when options are overpriced in relation to underlying asset and reversals when options are underpriced in relation to underlying asset. Dividend arbitrage, box spread, calendar spread and butterfly spread are examples of strategies used for options arbitrage.
In this type of arbitrage traders can take advantage of the differences in gold prices at two different locations. Traders can buy gold at one location where the price is less and sell it at another location where the price is higher thereby pocketing the difference.
Arbitrage opportunity also rises when there is a difference between spot price and futures price of gold. A trader can take a long position by buying physical gold and an equivalent short position in gold futures market and settling both positions at maturity.
Tax arbitrage is a technique of making profits by taking advantage of the differences in tax rates, tax systems or tax treatments in same country. Different transactions are taxed in different ways which creates opportunities for individuals to restructure their transactions in order to pay the least amount of tax.
Tax arbitrage is also possible due to different tax systems or tax rates in different countries or jurisdictions. Businesses can take advantage of such differences by maximizing the deductions in a high tax region and minimizing the taxes in a low tax region.
Negative arbitrage is a lost opportunity due to higher borrowing cost and lower lending costs. Negative arbitrage occurs when a person gets lower returns on his investments but has to finance the debt at higher interest rates.
Latency arbitrage is mostly associated with high frequency trading and it refers to the fact that different people or firms get market data at different times. These time differences are known as latencies.
These differences can be as small as a nanosecond but they are crucial in the world of high speed trading. Latency arbitrage occurs when the high frequency trading algorithms earn profit by making trades split second before other traders.
Rental arbitrage is a strategy of leasing a property on a long-term basis and then renting it on a short-term basis on different rental websites or vacation rental platforms. The success of rental arbitrage is highly dependent on the difference between short-term and long-term rental prices in the property market.
Credit Card Arbitrage
Credit card arbitrage is a simple process of borrowing money from the credit card company at low interest rate and then investing the same money in high yield savings account resulting in a risk less profit.
Just like a bank, credit card holder can profit from the interest rate spread between money paid and money received provided he makes all the minimum payments and repays the full balance before expiry period.
Regulatory arbitrage is a process of taking advantage of loopholes in order to avoid unfavorable regulations. This type of arbitrage can be achieved by using financial engineering, restructuring transactions or geographical relocation to more favorable jurisdictions.
For example, a company can relocate its headquarters to a region which has favorable regulations and lower taxes in order to save the cost and increase the profits.
Volatility plays an important role in pricing of options. Volatility arbitrage can be achieved when there is a difference between implied volatility and realized volatility of an option. A trader can profit by buying an option when the volatility is low and selling it when the volatility is high.
Location Arbitrage Or Spatial Arbitrage
Location arbitrage, also known as spatial arbitrage or inter market arbitrage is mostly associated with cryptocurrency trading or forex trading. A trader can profit from location arbitrage strategy by buying a currency on one exchange at lower rate and selling it on another exchange at higher rate and pocketing the difference.
Time arbitrage occurs when there is a difference between the short-term price of a stock and its long-term price forecast. Most of the investors have a short-term horizon which creates a mispricing for the assets in the long-term. This creates an opportunity for time arbitrage for an investor with long-term horizon.
Yield Curve Arbitrage Or Interest Rate Arbitrage
Yield curve arbitrage, also known as interest rate arbitrage is a form of fixed income arbitrage trading strategy. In this type of arbitrage a trader exploits the relative mispricing along the yield curve due to difference in demand for selected maturities.
Bond prices and interest rates move in opposite directions. Changes in interest rates can have significant impact on bond prices. If the bond prices do not change quickly enough to reflect changing interest rates then we can have an opportunity for interest rate arbitrage.
On The Run And Off The Run Arbitrage
US treasury is the biggest issuer of debt securities. Newly issued securities are known as on the run whereas the securities which are already issued and outstanding are known as off the run. Traders can take advantage of the convergence of spreads as there is a difference in the yields of new and old securities.
Retail arbitrage is a very simple concept. You can buy products from your local retail store at a certain price and sell the same products on an online marketplace for higher price. The difference between buying and selling price is your profit.
Crude Oil Arbitrage
Crude oil arbitrage is a very popular trading strategy in the energy sector to profit from the price discrepancies in Brent and WTI. This strategy involves buying or selling Brent and simultaneously taking an opposite position in WTI.
Private capital markets are not very transparent and can provide you with arbitrage opportunities. Multiple arbitrage is a strategy of increasing the value by buying and selling the same company without making any operational improvements.
In other words, you are arbitraging the multiple at which the company is traded. Multiple arbitrage strategy is very complicated and is used by strategic buyers and private equity firms to take advantage of the differences in asset valuations.
Information arbitrage is a technique of using more information, better understood information and better used information to identify the trends and opportunities and capitalizing on them. In other words, information arbitrage can be used to make accurate predictions about the future requirements of customers.
Riskless arbitrage is an act of buying and selling an asset immediately and generating the profit from price difference. Riskless arbitrage does not require any investment and does not have a rate of return as the asset is sold immediately.
Political arbitrage is a strategy of trading securities or assets by taking advantage of knowledge about future political activity. Political arbitrage is mostly specific to a country or a region. For example, government elections in any country can give rise to political arbitrage opportunities specific to that country.
The idea of institutional arbitrage is to deliberately do something that you think the institutional investors or majority of market participants are unlikely to do. For example, maintaining a long-term horizon or maintaining a concentrated portfolio or maintaining an appropriate level of cash in your portfolio.
Beta is a measure of how systemic risk is calculated for a stock. Beta arbitrage is a trading strategy where you take a long or short position in low beta stocks and an equivalent opposite position in high beta stocks. This helps in earning a positive premium and neutralizing the systematic equity risk.
Knowledge arbitrage is another way of carrying forward innovation. It is a strategy of applying what works great in one industry to another industry. In other words, borrowing good concepts from an unrelated industry and applying it to your own industry.
Static Arbitrage And Dynamic Arbitrage
Static arbitrage is a strategy which does not require any rebalancing of portfolio. A portfolio once established can realize the full potential of arbitrage opportunity without any rebalancing. Dynamic arbitrage is a strategy which requires continuous rebalancing of portfolio to realize the full potential of arbitrage opportunity.
Quasi arbitrage is a type of an implicit finance arbitrage where one asset or position is replaced with another asset or position which has similar risk but a higher rate of return. For example, the two assets can be futures and the underlying.