What is the Importance of Arbitrage?

In a robust capital market, you cannot underplay or underestimate the importance of arbitrage. After all, unless you have the arbitrageurs you don’t know what are mispricings happening in the market and such mispricing would never get reverted or rectified. That is the importance of arbitrage. These are done by informed traders who are institutions with deep pockets but a low appetite for risk. They use the mispricing in the market to make small profits on large capital allocation with low latency trading. Thus, arbitrage not only introduces pricing efficiency in the capital market but also makes the market efficient with the use of high-end sophisticated technology in trading arbitrage opportunities.

Importance of Arbitrage

To understand the importance of arbitrage, it is essential to understand the law of one price which governs the price discovery of inefficient markets. The law says that other factors remain constant, the law of one price should prevail for the same asset in different markets. For example, Reliance cannot quote at Rs.2100 on the NSE and Rs.1800 on the BSE since the underlying asset is the same. These gaps do come up but are immediately filled up by the arbitrageurs.

In well-functioning markets with low levels of transaction costs and controlled statutory costs payable, there is normally a relatively efficiently priced market. The free flow of information will ensure that the same asset cannot sell for more than one price. If the same asset, for example, trades at a higher price in one market and a lower price in another market then it gives rise to arbitrage opportunities. Here is what the arbitrageurs will do in this case.

They would sell the higher-priced asset and buy the lower-priced asset in the appropriate market and the demand and supply push will soon push the two prices to the same level. In doing so, these arbitrageurs earn a riskless profit which is called the arbitrage profit or arbitrage spread. Since this action continues to happen on a sustained basis across markets, this would naturally force the two prices to converge. This simultaneous transacting to take advantage of a price mismatch is known as arbitrage and the importance of arbitrage stems from the fact that it makes the pricing of assets efficient.

Let us now come back to the law of one price that we discussed before which lies at the core of arbitrage. What is this law of one price and how does it play a role in arbitrage opportunities? The law of one price and the lack of arbitrage opportunities are only upheld when market participants actively seek out such opportunities. The irony is that for the arbitrage opportunities to be eliminated, traders must closely follow and compare prices. It is not enough to just observe and compare prices. They must also jump in and act on such price movements to eliminate such pricing gaps or mispricing as they call it.

Although abnormal returns can be earned in various ways, arbitrage profits are examples of abnormal returns and violate the principle of market efficiency. Remember, the returns are not large, but they are abnormal because they arise from the violation of the law of one price which is at the core of efficient markets. We typically assume that arbitrage opportunities cannot exist for any great length of time and therefore it is not possible for anyone investor to consistently capture and capitalize and make profits on such arbitrage opportunities.

Thus, prices must conform to a model that assumes no arbitrage or the law of one price. To make the market free of arbitrage opportunities, the market players like arbitrageurs must be consistently indulging in arbitrage to even outprices. Nowadays, such arbitrage is done purely through algorithms and low latency trades rather than being done manually, as was the case in the past.

What is Arbitrage?

Arbitrage can be defined as the simultaneous purchase and sale of the same asset in different markets. The idea of an arbitrage trade is to profit from tiny differences in the asset's price. In a nutshell, arbitrage exploits short-lived variations in the price of identical or similar financial instruments across different markets, different maturities, different strokes, different related assets, etc. Not all arbitrage is risk-free, but it does contribute in a big way to making markets efficient. Arbitrage exists as a result of market inefficiencies and it both exploits those inefficiencies and resolves them.

In short, there are some key takeaways from arbitrage. Firstly, arbitrage is the simultaneous and synchronized purchase and sale of an asset in different markets to exploit differences in prices using technology-driven execution. Secondly, arbitrage trades are made in stocks, commodities, and currencies. In short, arbitrage is asset agnostic. Lastly, arbitrage takes advantage of the inefficiencies in markets and makes small profits on large volume trades.

Different Types of Arbitrage

Some of the popular types of arbitrage can be summarized as under:

  • Cash-futures arbitrage
  • Statistical arbitrage
  • Convertible arbitrage
  • Fixed-income arbitrage
  • Political arbitrage
  • News based arbitrage
  • Triangular arbitrage
  • Risk-based arbitrage
  • Macro arbitrage
  • Volatility arbitrage

Frequently Asked Questions Expand All

In order to take advantage of an arbitrage opportunity, you need to go beyond predicting trends. In other words, in order to make arbitrage trading decisions, you must be able to see and act on the interplay of market demand, capacity, product availability. It is very important to understand pricing and relationships to be a good arbitrageur.

Arbitrage is not only good but also essential as it makes the market more efficient, smoother and safer. It also adds to liquidity in cash and futures market.

Of course, arbitrage is ethical. It is just about capitalizing on pricing inefficiencies using algorithms and low latency trading. There is nothing unethical about it.