What is the Difference Between Arbitrage and Hedging

Last Updated: 1 Oct 2025

The financial market offers various strategies for traders and investors to grow profits and manage risk. Among these, arbitrage and hedging are two of the most widely used. While both of them require strategic trading decisions, they serve different purposes. Here we’ll discuss the distinction between the two to understand which is the ideal option for you.

What is Arbitrage?

Arbitrage is a trading technique that exploits the price discrepancy on the same instrument in diverse markets or forms. Basically, a trader buys an asset at a low price in one market and at the same time sells it at a higher price in another and makes a risk-free profit. It is a strategy of speed and accuracy and is regularly employed in equities, commodities and currency markets to take advantage of minor differences in the price.

What is Hedging?

Hedging is a risk management process that is designed to mitigate the possible losses in investments as a result of market changes. Hedging is geared towards safeguarding the value of an established position. Derivatives such as futures, options, or swaps are commonly used by traders to counter the possibility of losses associated with a price change. Hedging strategies are aimed not at earning money but at creating stability and decreasing the risk of being exposed to the fluctuations of the market.

Arbitrage vs Hedging

While both Arbitrage and Hedging work on financial markets, one focuses on earning profits and the other on protecting investments from losses. The table below breaks down the difference between hedging and arbitrage to help you select which option suits your investment preference.

Aspect	Arbitrage	Hedging
Purpose	Profit from price differences	Reduce risk of loss
Risk Level	Generally low risk if executed correctly	Lowers risk but does not eliminate it
Strategy Type	Gets benefits from inefficiencies in the market	Protect existing positions
Tools Used	Buying and selling assets simultaneously	Futures, options, swaps, insurance
Profit Potential	Direct, often small but guaranteed	Indirect, through risk reduction
Typical Users	Traders and speculators	Investors, businesses, and portfolio managers
Market Dependency	Price discrepancies across markets	Market volatility or uncertainty

Examples of Arbitrage vs Hedging

Here are a few examples of hedge arbitrage trading options:

Arbitrage

Suppose a stock is trading at ₹1,000 and one exchange and 1,020 on another. In such situations, a trader can buy the stock at ₹1,000 in the first exchange and sell it at ₹1,020 in the second, which lets them earn ₹20 as profit.

Hedging

Let’s say an exporter is expecting payment in a foreign currency in three months, and might use a currency forward contract to lock in the current values. If the currency value weakens, the forward contract compensates for the loss and protects the exporter’s revenue from market fluctuation.

When to Use Arbitrage vs When to Use Hedging

Arbitrage: Arbitrage is recommended when you find the same asset priced differently in two or more markets. It allows you to purchase stocks at a lower price and sell at a higher price quickly. It works best in markets that are very active. Using arbitrage can also help you earn short-term profits with minimal risk if the opportunities are carefully identified.

Hedging: Hedging is recommended in situations where you would like to safeguard your investments against potential losses. It helps when your positions will change because of the price fluctuations, currency fluctuations, or market volatility. With the help of hedging instruments, like futures, options or swaps, you can eliminate risk and retain the worth of investments.

Conclusion

Arbitrage and hedging play crucial but distinct functions in investment and trading strategies. Arbitrage emphasises the making of profits on price variations, but hedging leads to safeguarding your investment in the event of losses. By understanding the use of each strategy and its intended meaning, you can control risk accordingly.

Frequently Asked Questions

1. Is it possible to use arbitrage and hedging in my strategy?

Both methods can be effectively used together. However, arbitrage will allow you to make money in the short term when the market is inefficient, whereas hedging will allow you to minimise risk. Combining them can result in stability of returns and protection.

2. How frequently should I revise my hedging strategy?

When there is a significant change or a shift in the portfolio of your hedging approach, you should revisit your hedging approach. The frequent updates will keep your strategy consistent with the existing risks and investment objectives.

3. Is arbitrage truly risk-free?

Arbitrage is often considered low-risk, but it is not completely risk-free. The outcome can still be influenced by factors such as timing issues, transaction costs and unexpected market movements.

4. How does tax affect arbitrage and hedging?

There can be differing tax treatment, like arbitrage gains can be taxed as capital gains or business income, depending on the classification of trades. Hedging may have an effect on the timing and amount of taxable investment gains or losses.