Overlook of the Arbitrage

Arbitrage is the buying and selling of an asset in order to take advantage of a price difference between the markets. It is a trade that benefits from exploiting price differences of identical or similar financial instruments in different markets or in different forms. Arbitrage exists because of market inefficiencies and therefore would not exist if all markets were perfectly efficient. Arbitrage occurs when a security is bought on one market and simultaneously sold on another market at a higher price, which is considered a risk-free profit for the trader. Arbitrage provides a mechanism to ensure that prices do not deviate
significantly from fair value for extended periods of time. With advances in technology, it has become extremely difficult to profit from pricing errors in the market. Many market participants have computerized trading systems that are set
up to monitor fluctuations in similar financial instruments. Ineffective pricing is usually dealt with quickly and the opportunity is often eliminated within seconds. Arbitrage is a necessary force in the financial market. For example : case of a share quoted at different prices on two financial markets A and B. In this situation, it is possible to arbitrage by buying the share at the
lowest price on market A and simultaneously selling it short at the highest price on market B. When the difference in price disappears, i.e. when the two prices return to their equilibrium level, the arbitrageur makes a profit. The idea behind arbitrage is the convergence, sooner or later, of securities prices towards their equilibrium level due to market efficiency.
Arbitrages set up by hedge funds can be divided into two categories:

• Safe arbitrages: grouping together operations whose success is not linked to market trends. For example: the price of a futures contract is expected to converge towards the price of the underlying when it is close to maturity.
• Risky trade-offs: entailing risks by assuming a directional evolution of the market for convergence to take place. For example, the purchase of a senior bond combined with the sale of a junior bond of the same issuer.

If markets do not allow for profitable arbitrage because prices are very similar, then we say markets are arbitrage-free or in equilibrium.


Written on 02/12/2020


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