What is Arbitrage? How Does It Work?

It’s a concept that confuses some and fascinates others, but what is arbitrage? And how exactly does it work? We’ll explore this and a whole lot more in this article.

What Is Arbitrage?

Firstly, what is arbitrage?

In its purest form, arbitrage refers to a guaranteed profit with zero risk and zero investment.

Risk free? Zero investment? Guaranteed profit?

That sounds like either a scam or something that simply cannot exist.

Remember, that’s arbitrage in its purest form. It’s what arbitrage is meant to be.

In reality, you can think of arbitrage as profiting from a transaction where there is some sort of a “price imbalance” for the same asset between two different markets for example.

In other words, the same asset is priced differently in two separate markets. Put differently, there’s been a violation of the Law of One Price, a crucial concept that we discuss in detail in this investing fundamentals article.

In such instances, you might be able to buy something in one market (for a lower price) and sell it in a different market (for a higher price).

If you make such a trade without any investment (for example, by borrowing money to fund the trade and repaying the money from your profit)…

Then you’d be pretty close to arbitrate in its purest form.

Speed of Trades

Naturally, if you do see such a possibility, it’s likely you’ll try and profit from it as soon as possible.

The problem? You won’t be the only one.

If such an opportunity arises, other investors will likely see it, too.

As more investors attempt to profit from the opportunity, arbitrage disappears.

To really profit from arbitrage trading and investing then, speed is key.

The paradox however, is that this very speed has mostly eliminated inefficiencies in financial markets. Note that the existence of arbitrage can be seen as a signal of market inefficiency.

Now, the concept of market efficiency is vast and would deserve an article in and of itself. That’s not our focus here, however.

Let’s further explore arbitrage and see how it works.

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How Does Arbitrage Work?

Arbitrage in its purest form is said to be risk-free. And it assumes both sides of the trade can be executed at the right time.

This can be illustrated by considering that most investments goals are achieved by buying low and selling high (unless you’re shorting a stock of course).

However, you might buy what you think is low, but the asset price could theoretically go either up or down.

Put differently, your estimate of the intrinsic value of a security may be incorrect.

It might lead you to believe a stock is undervalued when in fact it’s overvalued, for instance.

With arbitrage, the “buy low sell high” opportunity typically presents itself at the same time, hence the notion of a risk-free trade.

Arbitrage is extremely difficult to find within one country because of the speed and efficiency with prices reflect information.

However, stock prices compared between the UK stock market and a foreign stock exchange, say South Africa for example, may show slight differences.

Arbitrageurs can and do still capitalise on these opportunities. This type of arbitrage is called “spatial arbitrage” (aka geographic arbitrage) .

We’ll discuss the various types more in the next section.

What Types of Arbitrage Are There?

Now that you know what is arbitrage in its purest form, let’s consider the different types.

There are many types of arbitrage depending on the source of information.

For the purposes of simplifying the concept, let’s stick with three general types including:

• geographic arbitrage
• merger arbitrage, and
• statistical arbitrage

Geographic Arbitrage

This type of arbitrage includes several different subtypes, yet all of them have to do with benefiting from the geographic distance between two markets which list the same or similar assets.

This also tends to be one of the most common types of arbitrage used by many an arbitrage trader (or “arbitrageurs”).

In stocks, it’s still possible to find a particular company whose stock is performing worse in a different country.

However, this drop in value may take a bit of time to translate across oceans, so arbitrageurs – that is, those who profit from arbitrage – spend entire careers finding these opportunities.

Forex Arbitrage

In foreign currencies, or forex, there are several types of foreign exchange / forex arbitrage.

There is what’s known as triangular arbitrage. This involves three different currencies which are constantly compared so that small discrepancies can be found between them.

Interest Rate Differentials

There is also arbitrage involving interest rate differentials.

One is called just that – the interest rate differential trade – and another is called carry trades.

Both of these types of arbitrage involve using one currency at a low interest rate and investing in assets or currency of another asset. The idea’s to benefit from high interest rates in the other country.

Real Estate / Migration Arbitrage

A somewhat distinct geographic arbitrage can be seen in real estate markets across the globe.

Properties in California, New York, London, Tokyo for example are well known to be astronomical in price. However, the Covid-19 pandemic and other events caused people to move away from metropolitan cities’ high cost of living in droves.

The median home price in California at the time of writing was $813,980.

If a family sold that house and moved to Texas, for instance, they would be able to buy the same size house for nearly half that.

They could buy a much larger and nicer house, or they could buy an outdated house and upgrade it.

Either way, the somewhat risk-free nature of the move creates a geographic arbitrage.

Merger Arbitrage

Merger arbitrage involves somewhat betting whether a company is planning to buy out or merge with another company.

You can’t make this sort of trade if you have explicit insider information (because that’s illegal).

But the idea’s to have a sort of “educated guess” about a merger that could happen in future.

The market price of the “target company” is typically lower than the price that the acquiring company would pay.

The arbitrage opportunity can be found by buying the stock of the targeted company and selling or even selling short the stock of the buying company.

If the expectation proves to be correct, the arbitrageur will profit on both sides.

To explain why this works, let’s consider the implications of a merger from both the target company’s perspective as well as that of the buying company.

Target vs Acquirer Stock Price Reactions

Companies get purchased and merged with because they have something – either a product, a skillset, or a process – that can be merged into the processes of another company to add value to the purchasing company.

It’s important to note that the stock price is only a perceived value from the market. It may not accurately convey the “true” value of a company.

In other words, the current market price of a stock is not necessarily equal to its intrinsic price.

When a merger or acquisition takes place, the market is suddenly made aware of exactly what the target company is worth, and the stock price is almost always below that value.

This is why target companies’ stock price tend to rise after the announcement.

Alternatively, when another company buys a competitor, this must generally involve large cash injections,

The acquiring company might sell bonds, take out loans, or deplete its cash reserves. All of which could decrease the buying company’s stability and increase its debt burden.

Generally, this is seen as a negative for the stock price, so it goes down (which is why shorting the acquiring company can make sense).

Statistical Arbitrage

Statistical arbitrage fundamentally relies on the Law of One Price which says that any 2 assets that are identical in all aspects must trade at the same price.

If 2 identical assets don’t trade at the same price (i.e., if there’s a price difference), then an arbitrage opportunity exists.

Statistical arbitrageurs identify similar stocks by typically relying on statistical metrics as their proxy of choice to compare and determine similarity between stocks.

For example, statistical arbitrageurs may evaluate the correlation of stocks to identify strongly correlated pairs of stocks.

The idea’s that, once these pairs are identified, one could compare the performance of the two stocks and go long in the one that’s underperforming the other.

In practice, the amount of computational power needed to weed out statistical arbitrage can be somewhat ludicrous.

It usually takes a team of data scientists to put together a profitable strategy.

That being said, the open source nature of Python and the Python community, R community, etc mean it is becoming increasingly possible for one person to do what would’ve previously required a whole team.

Are There Any Risks With Arbitrage?

Every type of investing involves some risk. Despite arbitrage being described as “risk-free” in its purest form, the reality is usually somewhat different.

As we’ve alluded to before, there is execution risk. This means that, in order for your arbitrage trade to be profitable, the profit is only realised if both ends of the trade are executed according to plan.

Moreover, even if you manage to successfully execute both sides of the trade…

You may still need to convert funds back into your local currency (if you’re attempting interest rate differentials or some form of foreign exchange / forex arbitrage, for example).

If you’re not able to execute the exit trade on either or both sides of the trade, then it could end up making you a significant loss.

And if a short is part of your trade, then your losses can, at least theoretically, rise to infinity.

Can Arbitrage Be Used As an Investment Strategy?

Arbitrage can, in theory, occur every day in one of the various forms. Not only can it occur every day, but it can occur several times or several hundred times per day.

However, retail traders should not focus on arbitrage as a sole strategy for investing because the goal is long-term investing.

The reason is that it would take full-time analysis, and perhaps more, to find these arbitrage opportunities and make a meaningful amount of money.

Final Thoughts

While arbitrage may be a game mostly for the institutional traders and investors, there are still opportunities that can show up for even retail investors.

After all, even institutional investors can’t watch all markets all the time.

There are many different types of arbitrage. But by understanding the global financial system better, you can perhaps find profitable arbitrage opportunities to add a bit of an advantage to your investment portfolio.

Hopefully, all of this now makes sense. If you’d like to take control of your finances and learn how to rigorously manage your investment portfolio, do check out the course below.

You might also want to explore our Data Driven Investing course. The link takes you to the Python version, but there is an Excel version of the course available if you don’t know how to code.

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