In foreign investments, the strategy identified by the name arbitrage helps the investor to clasp the profit by simultaneously selling and buying an identical asset, currency, commodity or security across two distinct markets. This strategy helps the investor to gain benefit on the varying prices for the same said security across the two different fields represented on each portion of the trade.
- The arbitrage takes place when an asset is purchased from one market and concurrently sold at a higher price in another financial market.
- The difference (temporary) in the amount of the same security in two different financial markets leads the investor to lock in profit.
- Investor often tries to utilise the arbitrage opportunity by purchasing a share in the foreign exchange where the stock cost has not been set for the varying exchange rate.
- There is a comparatively low risk associated with the arbitrage trade practice.
- This term is principally used for trades in financial instruments, including stocks, commodities, currencies and bonds. The people engaging in this process are called arbitrageurs.
What Is Arbitrage?
It is defined as the process of simultaneously purchasing an asset from one market and selling it in another market at a higher cost. It enables the trader to lock in gain from a temporary difference in the price per stock. In the share market, an investor makes use of arbitrage opportunities by buying a share on a foreign exchange where the stock price (equity) has not still set for the rates of exchange; it is in a static condition of flux.
Therefore, the cost of share on foreign trade is undervalued as compared to its value in the domestic or local exchange, enabling the investor to reap profits from this differential. This whole process appears to be a little bit tricky and complicated to inexperienced investors. However, it is a relatively easy and straightforward way and hence considered comparatively less risky.
Example of Arbitrage
For better knowledge, consider the following example: TD or TD Bank trades on both the NYSE (New York Stock Exchange) and TSX (Toronto Stock Exchange). Let us assume that on a given trade day the share trades for $63.50CAD on the Toronto exchange and $47.00USD on the New York exchange. Further assume that the exchange rate of USD/CAD is $1.37 (means $1.37CAD = $1USD) hence, $47USD is equal to $64.39CAD. Under such conditions, an investor can buy TD stocks for $63.500CAD in TSX and can concurrently sell the same share for $47.00USD at NYSE this is the equivalent of $64.39CAD. Finally, the lock-in profit of the trader for this transaction is $0.89, which is nothing just the difference between $64.39 and $63.50.
Conditions For Arbitrage
It can only be applied if the following conditions are met:
- Always remember the law of a single price which states that the same security does not trade at the exact cost on all markets.
- Two securities having the same cash flows do not exchange or trade at a similar price.
- The security is never traded at its future price or discounted at the risk-free rate of interest (or have storage value) even if its future price is known. This situation is only applicable to things like a grain but not for assets or securities.
If no profitable arbitrage is not allowed on the financial market costs, then these costs are said to create an arbitrage-free market or an arbitrage equilibrium. An arbitrage-free exchange and equilibrium is a primary condition for a usual economic equilibrium. The term no arbitrage is used in quantitative finance for measuring a neutral risk cost for derivatives.
Considering the Transaction Costs
When considering the arbitrage opportunities, one should beware of transaction cost along with it. The reason for this is if the prices are prohibitively high, they will tend to nullify the profits from the trades. We are again considering the scenario mentioned earlier if the fee (trading) per stock surpass more than $0.89, the aggregate return on arbitrage will neutralise those profits.
Amount variances across the financial markets are usually small in size, so strategies of arbitrage are practical only for traders having substantial securities to invest in a particular trade.
The Bottom Line –
If all the financial markets were excellently efficient and, the foreign exchange halted to exist, there would be no arbitrage opportunities left. But in reality, the market is rarely perfect, which gives investors many opportunities to gain benefits on pricing disparities.