Last Updated: Sep 27, 2022 Value Broking 7 Mins 1.3K

This article is about understanding arbitrage, the reason behind the process of arbitrage, the different types of arbitrage,

What are the Types of Arbitrage?

It can be risk arbitrage or pure arbitrage, depending on the risk. Pure arbitrage is risk-free because it only occurs when a trader is aware of a price difference. Different types of arbitrage are involved since there are various classifications of arbitrage. The following are some examples of the categories:

  • Financial arbitrage: Forex arbitrage trading is the most common type of financial arbitrage.
  • Statistical arbitrage: This type of arbitrage entails a large amount of data and statistics to tap into price movement.
  • Dividend arbitrage: A marketer buys a stock and an equal amount of put options around another dividend time. Options arbitrage is another name for dividend arbitrage.
  • Convertible arbitrage: It is among the most common types of arbitrage, and it entails purchasing a convertible instrument and short-selling the underlying stock. A convertible security is one that should be transformed into another. For example, it may be a bond that can be exchanged for stock in a corporation.

Some More Types

  • Arbitrage of Risk: Commonly referred to as Merger arbitrage, it is a trading method used to profit from business events such as mergers, acquisitions, and bankruptcies. Individual investors may benefit from this kind of development by investing in a merger arbitrage Investment. It entails the purchase and sale of stock in two merging companies.
  • Negative Arbitrage: It’s a missed opportunity since borrowing rates are greater and lending costs are lower. This happens when a person earns lesser returns on their investments yet must finance his debt at a greater interest rate.
  • Interest rate arbitrage: Arbitrage of Interest Rates, or yield curve arbitrage, is a type of fixed income arbitrage trading method. A trader uses relative mispricing along the yield curve due to variances in demand for specific maturities in this arbitrage type.
  • Interest rates and bond prices move in contrary patterns: Interest rate fluctuations can have a significant effect on stock prices. We may have a chance for interest rate arbitrage if stock prices do not change overnight to reflect fluctuating interest rates.
  • Political arbitrage: Arbitration in politics is a trading strategy that makes use of information about future political behavior to trade securities or assets. Political arbitrage is usually limited to a single country or region. Government elections, for example, in any country can result in political arbitrage opportunities unique to that country.
  • On-the-Run And Off-the-Run Arbitrage: The world’s largest debt-securities issuer- “The US Treasury.” On the run, securities are those that have just been issued and are still in circulation, whereas the run securities are those that have previously been published and are still in circulation. Traders can benefit from the narrowing of spreads since the returns of new and old assets diverge.
  • Arbitrage of Beta: Beta is a metric for calculating a stock’s systemic risk. The term “beta arbitrage” refers to a trading technique in which one can take a short or long position in low beta equities and an equal but opposite position in high beta companies. This aids in generating a positive premium while also mitigating systemic equity risk.
  • Institutional Arbitrage: The principle behind institutional arbitrage is to do something that one can believe the bulk of institutional investors or market players are unlikely to do. Maintaining a long-term view, a concentrated portfolio or an adequate balance of money in your portfolio are just a few examples.
  • Retail Arbitrage: The principle of retail arbitrage is fairly basic. You can acquire things at a specific price from a local retailer and then sell them for a premium cost on an internet marketplace. Your profit is the difference between the purchase and sale prices.
  • Crude Oil Arbitrage: Crude oil arbitrage is a common trading method in the energy sector that takes advantage of price differentials between Brent and WTI. This technique entails purchasing or selling Crude oil and simultaneously taking the opposite viewpoint on WTI.

What is Arbitrage?

Arbitrage is a process of taking advantage of differences in price levels in different markets. It is a concept in financial economics. It refers to an investment strategy in which an investor seeks to profit from the mispricing of financial instruments by obtaining the difference between two or more prices. If the difference is a large enough sum of money, it can be worthwhile to undertake the transaction. However, It is a strategy that gives an advantage to a company in exchange for a small risk. If an arbitrage opportunity arises, a company can capitalize on it and buy low and sell high. A company can even make a profit from its own products by selling them at a higher price than they cost to produce. Some people think of this activity as fraud, but it is perfectly legal. There are “n” numbers of arbitrage types based on different aspects.

Arbitrage occurs as a result of market inefficiencies. Inefficiencies can occur when an item is undervalued or overvalued for various reasons, such as transaction costs, human preferences, or a lack of relevant information. It would be impossible if the market were efficient. Therefore, there are several types of arbitrage.

Advantages of Arbitrage Trading:

Risk-free Profits: Arbitrage trading aims to exploit price discrepancies across different markets, leading to risk-free profits.

Market Efficiency: Arbitrage trading helps promote market efficiency by reducing price discrepancies and bringing prices closer to their fair value.

Diversification: Arbitrage trading allows investors to diversify their portfolios by participating in multiple markets and taking advantage of various opportunities.

Low Volatility: Arbitrage strategies often involve short-term trades, resulting in lower exposure to market volatility than long-term investments.

Quick Execution: Arbitrage trades are typically executed swiftly to capitalize on fleeting price differences, allowing for quick profits.

Risks of Arbitrage Trading:

Execution Risks: Delayed execution or inability to execute trades at the desired price can lead to missed opportunities and potential losses.

Market Liquidity: Insufficient liquidity in certain markets can make entering or exiting trades quickly challenging, impacting arbitrage strategies.

Transaction Costs: Transaction costs, such as brokerage fees and exchange charges, can eat into potential profits and affect the overall profitability of arbitrage trading.

Regulatory and Compliance Risks: Different markets may have varying regulatory requirements, and failure to comply with these regulations can result in penalties or legal issues.

Technology Risks: Dependence on technology for real-time data, order execution, and trade monitoring introduces the risk of technical glitches or system failures that can disrupt arbitrage strategies.

Conclusion

It happens due to market inefficiencies and entails taking advantage of price differences between being an asset in one sector and the same or a substitute in another industry. The arbitrage types in the future market: Cash and carry arbitrage and reverse cash and carry arbitrage are two of the most popular types of arbitrage. These comprise a product and its inclusive, and traders can profit from the difference in performance ahead of the termination date by placing short or long bets based on the price. There are various types of arbitrage investing, and if one wants to achieve the most of them, one will need to grasp how each system works and the asset structure in question. The type of Arbitrage is a class of investment strategies where the expected return on the asset is the same as the market portfolio’s expected return but with less risk.