Arbitrage

ARBITRAGE MCOM(2)SEM III

CHAPTER 1

INTRODUCTION

NARSEE MONJEE COLLEGE OF ARTS AND COMMERCE Page 1


1.1 INTRODUCTION:

Arbitrage is the making of a gain through trading without committing any money and without

taking a risk of losing money. The term is also used more loosely to cover a range of activities,

such as statistical arbitrage, risk arbitrage, and uncovered interest arbitrage, that are not true

arbitrage (because they are risky).

Many of these strategies bear some similarities to true arbitrage, in that they are market neutral

attempts to identify and exploit (usually short lived) anomalies in pricing. The terminology used

usually adds a qualifier to make it clear that it is not real arbitrage. The discussion below is of

true arbitrage.

An arbitrage opportunity exists if it is possible to make a gain that is guaranteed to be at least

equal to the risk free rate of return, with a chance of making a greater gain. This is equivalent to

the definition of an arbitrage opportunity as the possibility of a riskless gain with a zero cost

portfolio, because a portfolio that is guaranteed to make a profit can be bought with borrowed

money.

Arbitrage should not be possible as, if an arbitrage opportunity exists, then market forces should

eliminate it. Taking a simple example, if it is possible to buy a security in one market and sell it

at a higher price in another market, then no-one would buy it at the more expensive price, and no

one would sell it at the cheaper price. The prices in the two markets would converge.

Arbitrage between markets is the simplest type of arbitrage. More complex strategies such as

arbitraging the price of a security against a portfolio that replicates its cash flows. These range

from the relatively simple, such as delta and gamma hedges, to extremely complex strategies

based on quantitative models.

Much of financial theory (and therefore most methods for valuing securities) are ultimately built

on the assumption that securities will trade at prices that make arbitrage impossible. In particular,



if there is no arbitrage then a risk neutral pricing measure exists and vice versa. Although this

result is not something that is used by most investors, it is of great importance in the theory of

financial economics.

Although arbitrage opportunities do exist in real markets, they are usually very small and quickly

eliminated; therefore the no arbitrage assumption is a reasonable one to build financial theory on.

When persistent arbitrage opportunities do exist it means that there is something badly wrong

with financial markets. For example, there is evidence that during the dotcom boom the value of

internet related tracker stocks and listed subsidiaries was not consistent with the market value of

parent companies: an arbitrage opportunity existed and persisted.

In economics and finance, arbitrage is the practice of taking advantage of a price difference

between two or more markets: striking a combination of matching deals that capitalize upon the

imbalance, the profit being the difference between the market prices. When used by academics,

an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal

state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-

free profit after transaction costs. For instance, an arbitrage is present when there is the

opportunity to instantaneously buy low and sell high.

In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical

arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are

always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins),

some major (such as devaluation of a currency or derivative). In academic use, an arbitrage

involves taking advantage of differences in price of a single asset or identical cash-flows; in

common use, it is also used to refer to differences between similar assets (relative value or

convergence trades), as in merger arbitrage.

People who engage in arbitrage are called arbitrageurs such as a bank or brokerage firm. The

term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives,

commodities and currencies.



1.2 OBJECTIVE OF STUDY:

To understand what is arbitrage

To know the concept of arbitrage trading

To know the conditions for arbitrage trading

To learn the types of arbitrage trading

To study the types of risks associated with arbitrage trading



CHAPTER 2

CONCEPTUAL DATA



2.1 WHAT IS ARBITRAGE TRADING?

Theoretically, there should not be any sustained opportunity for arbitrage trading because for

arbitrage opportunity to emerge, prices of same commodity need to differ in different markets at

the same time, which is not feasible according to the law of single price, which states that in a

competitive environment, assets with same risk and return profile should sell at the same price.

Hence, same asset cannot sell at different prices at different markets. Any difference would be a

temporary phenomenon and speculators would wipe out any difference by buying in cheaper

market and selling in costlier market. This temporary aberration is what presents arbitrage

opportunity and is exploited by traders.

In simplest terms, arbitrage is the process of making profit from the price differential of same

assets or instruments with same underlying assets in two or more markets. Now, because trade is

carried simultaneously at different markets, theoretically there is no risk. In its simplest form, it

works in this way; a trader spots the price difference of an asset in two markets, he buys the asset

in the market where price is lower and simultaneously sells the asset in the expensive market,

pocketing the difference. In plain vanilla form, same asset can have different prices in two

markets say, BSE and NSE. However, there are many other ways in which price differentials in

assets or indices can be exploited in cash or derivative markets. At any given point of time, there

are many scripts and ETFs in which price differentials exist which can be exploited. Similarly, at

any point of time, there are price discrepancies between spot and future prices which can be

arbitraged to gain risk free returns. And there are substantial profits to be made. It is possible to



make as much as four per cent on a monthly basis with careful exploitation of arbitrage

opportunities.

2.2 CONDITIONS FOR ARBITRAGE:

Arbitrage is possible when one of three conditions is met:

The same asset does not trade at the same price on all markets ("the law of one price").Two

assets with identical cash flows do not trade at the same price.

An asset with a known price in the future does not today trade at its future price discounted at

the risk-free interest rate (or, the asset has significant costs of storage; as such, for example,

this condition holds for grain but not for securities).

Arbitrage is not simply the act of buying a product in one market and selling it in another for

a higher price at some later time. The transactions must occur simultaneously to avoid

exposure to market risk, or the risk that prices may change on one market before both

transactions are complete. In practical terms, this is generally possible only with securities

and financial products that can be traded electronically, and even then, when each leg of the

trade is executed the prices in the market may have moved. Missing one of the legs of the

trade (and subsequently having to trade it soon after at a worse price) is called 'execution risk'

or more specifically 'leg risk'.

In the simplest example, any good sold in one market should sell for the same price in another.

Traders may, for example, find that the price of wheat is lower in agricultural regions than in

cities, purchase the good, and transport it to another region to sell at a higher price. This type of

price arbitrage is the most common, but this simple example ignores the cost of transport,



storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved.

Where securities are traded on more than one exchange, arbitrage occurs by simultaneously

buying in one and selling on the other.

2.3 TYPES OF ARBITRAGE:

1. Spatial Arbitrage:

Also known as Geographical arbitrage is the simplest form of arbitrage. In case of spatial

arbitrage, an arbitrageurs looks for pricing discrepancies across geographically separate markets.

For example, there may be a bond dealer in Virginia offering a bond at 100-12/23 and a dealer in

Washington is bidding 100-15/23 for the same bond. For whatever reason, the two dealers have

not spotted the aberration in the prices, but the arbitrageur does. The arbitrageurs immediately

buy the bond from the Virginia dealer and sell it to the Washington dealer.

2. Merger Arbitrage:

Also called risk arbitrage, merger arbitrage generally consists of buying/holding the stock of a

company that is the target of a takeover while shorting the stock of the acquiring company.

Usually the market price of the target company is less than the price offered by the acquiring

company. The spread between these two prices depends mainly on the probability and the timing

of the takeover being completed as well as the prevailing level of interest rates.

The bet in a merger arbitrage is that such a spread will eventually be zero, if and when the

takeover is completed. The risk is that the deal "breaks" and the spread massively widens.



3. Municipal Bond Arbitrage:

Also called municipal bond relative value arbitrage, municipal arbitrage, or just muni

arbitrageurs, this hedge fund strategy involves one of two approaches.

Generally, managers seek relative value opportunities by being both long and short municipal

bonds with a duration-neutral book. The relative value trades may be between different issuers,

different bonds issued by the same entity or capital structure trades referencing the same asset (in

the case of revenue bonds). Managers aim to capture the inefficiencies arising from the heavy

participation of non-economic investors (i.e., high income "buy and hold" investors seeking tax-

exempt income) as well as the "crossover buying" arising from corporations' or individuals'

changing income tax situations (i.e., insurers switching their muni for corporates after a large

loss as they can capture a higher after-tax yield by offsetting the taxable corporate income with

underwriting losses). There are additional inefficiencies arising from the highly fragmented

nature of the municipal bond market which has two million outstanding issues and 50,000 issuers

in contrast to the Treasury market which has 400 issues and a single issuer.

Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal

bonds with the duration risk hedged by shorting the appropriate ratio of taxable corporate bonds.

These corporate equivalents are typically interest rate swaps referencing Libor or SIFMA. The

arbitrage manifests itself in the form of a relatively cheap longer maturity municipal bond, which

is a municipal bond that yields significantly more than 65% of a corresponding taxable corporate

bond. The steeper slope of the municipalyield curve allows participants to collect more after-tax

income from the municipal bond portfolio than is spent on the interest rate swap; the carry is

greater than the hedge expense. Positive, tax-free carry from muni arbitrageurs can reach into the

double digits. The bet in this municipal bond arbitrage is that, over a longer period of time, two

similar instruments municipal bonds and interest rate swaps will correlate with each other; they

are both very high quality credits, have the same maturity and are denominated in U.S. dollars.

Credit risk and duration risk are largely eliminated in this strategy. However, basis risk arises

from use of an imperfect hedge, which results in significant, but range-bound principal volatility.

The end goal is to limit this principal volatility, eliminating its relevance over time as the high,



consistent, tax-free cash flow accumulates. Since the inefficiency is related to government tax

policy, and hence is structural in nature, it has not been arbitraged away.

Note, however, that many municipal bonds are callable, and that this imposes substantial

additional risks to the strategy.

4. Convertible Bond Arbitrage:

A convertible bond is a bond that an investor can return to the issuing company in exchange for a

predetermined number of shares in the company. A convertible bond can be thought of as a

corporate bond with a stock call option attached to it.

The price of a convertible bond is sensitive to three major factors:

• Interest rate: When rates move higher, the bond part of a convertible bond tends to move

lower, but the call option part of a convertible bond moves higher (and the aggregate tends to

move lower).

• Stock price: When the price of the stock the bond is convertible into moves higher, the price

of the bond tends to rise.

• Credit spread: If the creditworthiness of the issuer deteriorates (e.g. rating downgrade) and

its credit spread widens, the bond price tends to move lower, but, in many cases, the call

option part of the convertible bond moves higher (since credit spread correlates with

volatility).



Given the complexity of the calculations involved and the convoluted structure that a convertible

bond can have, an arbitrageur often relies on sophisticated quantitative models in order to

identify bonds that are trading cheap versus their theoretical value.

Convertible arbitrage consists of buying a convertible bond and hedging two of the three factors

in order to gain exposure to the third factor at a very attractive price.

For instance an arbitrageur would first buy a convertible bond, then sell fixed income securities

or interest rate futures (to hedge the interest rate exposure) and buy some credit protection (to

hedge the risk of credit deterioration). Eventually what he'd be left with is something similar to a

call option on the underlying stock, acquired at a very low price. He could then make money

either selling some of the more expensive options that are openly traded in the market or delta

hedging his exposure to the underlying shares.

5. Depository Receipts

A depositary receipt is a security that is offered as a "tracking stock" on another foreign market.

For instance a Chinese company wishing to raise more money may issue a depository receipt on

the New York Stock Exchange, as the amount of capital on the local exchanges is limited. These

securities, known as ADRs (American depositary receipt) or GDRs (global depository receipt)

depending on where they are issued are typically considered "foreign" and therefore trade at a

lower value when first released. Many ADR's are exchangeable into the original security (known

as fungibility) and actually have the same value. In this case there is a spread between the

perceived value and real value, which can be extracted. Other ADR's that are not exchangeable

often have much larger spreads. Since the ADR is trading at a value lower than what it is worth,

one can purchase the ADR and expect to make money as its value converges on the original.

However there is a chance that the original stock will fall in value too, so by shorting it one can

hedge that risk.

6. Dual-Listed Companies:



A dual-listed company (DLC) structure involves two companies incorporated in different

countries contractually agreeing to operate their businesses as if they were a single enterprise,

while retaining their separate legal identity and existing stock exchange listings. In integrated

and efficient financial markets, stock prices of the twin pair should move in lockstep. In practice,

DLC share prices exhibit large deviations from theoretical parity. Arbitrage positions in DLCs

can be set up by obtaining a long position in the relatively underpriced part of the DLC and a

short position in the relatively overpriced part. Such arbitrage strategies start paying off as soon

as the relative prices of the two DLC stocks converge toward theoretical parity. However, since

there is no identifiable date at which DLC prices will converge, arbitrage positions sometimes

have to be kept open for considerable periods of time. In the meantime, the price gap might

widen. In these situations, arbitrageurs may receive margin calls, after which they would most

likely be forced to liquidate part of the position at a highly unfavorable moment and suffer a loss.

Arbitrage in DLCs may be profitable, but is also very risky.

A good illustration of the risk of DLC arbitrage is the position in Royal Dutch Shell which had a

DLC structure until 2005 by the hedge fund Long-Term Capital Management(LTCM, see also

the discussion below). Lowenstein (2000) describes that LTCM established an arbitrage position

in Royal Dutch Shell in the summer of 1997, when Royal Dutch traded at an 8 to 10 percent

premium. In total $2.3 billion was invested, half of which long in Shell and the other half short in

Royal Dutch. In the autumn of 1998 large defaults on Russian debt created significant losses for

the hedge fund and LTCM had to unwind several positions. Lowenstein reports that the premium

of Royal Dutch had increased to about 22 percent and LTCM had to close the position and incur

a loss. According to Lowenstein, LTCM lost $286 million in equity pair’strading and more than

half of this loss is accounted for by the Royal Dutch Shell trade.

7. Private to Public Equities:

The market prices for privately held companies are typically viewed from a return on investment

perspective (such as 25%), whilst publicly held and or exchange listed companies trade on a

Price to earnings ratio (P/E) (such as a P/E of 10, which equates to a 10% ROI). Thus, if a

publicly traded company specializes in the acquisition of privately held companies, from a per-



share perspective there is a gain with every acquisition that falls within these guidelines. A hedge

fund that is an example of this type of arbitrage is Green ridge Capital, which acts as an angel

investor retaining equity in private companies which are in the process of becoming publicly

traded, buying in the private market and later selling in the public market. Private to public

equities arbitrage is a term which can arguably be applied to investment banking in general.

Private markets to public markets differences may also help explain the overnight windfall gains

enjoyed by principals of companies that just did an initial public offering (IPO).

2.4 TYPES OF ARBITRAGE TRADES:

Before the introduction of derivatives in India, the most prevalent arbitrage game used to be on

the difference of price of individual stocks in different markets. So, a price difference in price of

say HLL or Infosys on BSE and NSE would present opportunity for a trader to buy and sell the

shares in the cheaper and costlier markets respectively. Thus he can pocket the difference

without taking any risk. So, if HLL is trading at Rs 465 on NSE and at Rs 470 on BSE at the

same time, you can simply buy the stock on NSE and sell at BSE, thus making a profit of Rs 5 in

the trade. Similarly, many times, you can find substantial price difference in the ETF price on

exchange and the price at which the ETF can be bought from the fund house. There also you can

just buy the ETF at lower price point and sell at higher price point, making a risk free profit.

However, one should be a little cautious while executing this arbitrage. Reason being the prices

that you see on the trading screen is the last traded price, which is not at which your order would

go through; that is decided by the bid or ask prices on order book. Hence there is a definite



possibility that the trade may not fetch you the arbitrage gains at all. It is, therefore, important

that arbitrage trade should be tried only in liquid stocks, in which chances of trade going through

at given price are much higher than illiquid stocks.

After introduction of derivatives, arbitrage trading in many more types of assets and market

segments has become possible. The most prominent pair of arbitrage that has come up in

derivative era is the spot futures trade. This works in a very simple manner, on price differentials

between spot and futures market. In a typical trade, the trader would identify an asset whose

price in spot market is lower than price in the future market. Let us say price of stock is Rs. 100

in spot market and 110 in futures market. To exploit this difference, he would undertake

following sequence of actions. First he would go long on spot market, i.e. buy the stock at Rs.

100. Simultaneously he would sell the stock futures at Rs. 110. Moving forward, he has two

choices. If price differential narrows down a lot later on that day, or in next day or two, he can

reverse his positions and book profits. Or else, He can hold both the positions till the expiry of

the futures contract. Because at the expiration, the prices of futures and cash markets would

converge, he can then reverse the positions and make the profit.

Here it is important to understand the concept of cost of carry. The cost of carry defines the

relationship between the futures price and the spot price. To understand in non-mathematical

expression, It is the cost of "carrying" or holding a position from the date of entering into the

transaction up to the date of maturity. It measures the storage cost plus interest that is paid to

finance the asset less the income earned on the asset. So, the future price of an asset should be

taken as the sum of spot price of the asset and the cost of carry. Technically, you can make a

profit from your holdings if future price is higher than the sum of spot price and cost of carry.

So, in above example, if the cost of carry is Rs. 3, then the net profit from the arbitrage trade

would be Rs 7.

This is the plain vanilla spot future trade. If we were to take advantage of options on stocks and

futures, we can go long with deep in the money option on spot and simultaneously go short on



deep in the money options on Futures. This way we can take benefit of the widest of price range

discrepancy in cash and futures market.

Another very popular arbitrage play is between Nifty spot and Nifty futures. There are two types

of possibilities here. First, whenever Nifty futures trades at a premium to Nifty spot which is

higher than the cost of carry, there is an arbitrage possible. To play on this discrepancy, one can

buy Nifty spot, which means buying all stocks of Nifty in the same proportion. This can be done

by special software provided by NSE for buying all 50 Nifty stocks in the spot market in the

same ratio. At the same time, he can sell Nifty futures. As in case of stock arbitrage, positions

can be reversed in case of sudden reduction in price differential or at the expiry of contract.

Second and ore complex arbitrage method is to exploit the price differential between Nifty

futures and underlying stock futures, which is called Basis Arbitrage. In this situation, one can

create a short position in Nifty futures and simultaneously create long positions in Nifty's

underlying stock futures, taking advantage of the differential (basis) between the two.

Third popular arbitrage play is the reverse arbitrage. The strategy here is opposite of a regular

cash-futures stock arbitrage, where one buys shares and simultaneously sell stock futures. In

reverse arbitrage, one sells shares in spot market and buys stock futures in the beginning and

reverses the positions moving forward. This type of arbitrage works best in a falling market

when futures are at a discount to the cash market. Generally, mutual funds are big players in this

category of arbitrage trading.

From institutional perspective, arbitrage between ADRs (American Depository Receipts) or

GDRs (Global Depository Receipts) and local shares are also an interesting segment of arbitrage

play. Because there is two-way fungibility allowed between ADRs/GDRs and local listed shares,

many FIIs convert these to India listed shares whenever ADRs/ GDRs are in discount to local

price and sell converted shares in India at higher price, making a profit at no risk.

Operational Issues to Remember



Most important aspect of arbitrage trading is swiftness of execution of trade. To remove the

possibility of price fluctuation it is imperative that both legs of transaction are executed very fast.

From this perspective, arbitrage should be tried only in those assets which are highly liquid.

Secondly, interest rate fluctuations can make calculations go awry, as cost of carry is an

important link between prices in cash and future markets. Finally, trading circuit on individual

stocks and restriction on short selling for various market players create impediments in

exploitation of arbitrage opportunities.

Automated Arbitrage Trade

Very often it is not possible for individuals to track multiple markets simultaneously and also

execute trades in quick succession. To address this problem, automated trading software

packages have come into being. It started with spot trading but quickly upgraded to derivatives

and arbitrage trading. Thissoftware’s identify price discrepancies across markets on a real time

basis and also execute automated trades depending upon parameters passed by users. For

example, ODIN™ Program Trading software by Financial Technologies facilitates auto-

execution of the trades based on the defined parameters. It identifies arbitrage opportunities that

exist across the spot and futures markets and even spreads, which means price discrepancies

across futures of different trading contracts, across exchanges can be exploited.

Arbitrage Funds

If you are intimidated by the complexity of the arbitrage trading and strategies, you can still take

benefit of arbitrage opportunities by investing in arbitrage funds. These mutual funds are created

to exploit the arbitrage opportunity in market that may exist in any exchange in cash or

derivative segments. Because of the nature of inherent transactions, these funds are mostly low

risk investments. They generally generate returns in line with those of liquid and money market

funds. However, in a momentum market where prices are volatile, these funds can generate

higher returns than other near risk free funds. For example, over one year period ending March



28, 2013, top one dozen arbitrage funds generated returns in excess of nine per cent, with four

fund clocking over ten per cent. This compares decently with best of debt funds.

In a nutshell, arbitrage trading is a well-developed but complex trading strategy which presents

opportunity to earn risk free return in cash and derivative segments for smartinvestors. However,

it must be undertaken with extreme caution because inherent complexities and uncertain factors

could make potential profits disappear in no time.

2.5 TYPES OF RISKS ATTACHED TO ARBITRAGE TRADE:

Arbitrage transactions in modern securities markets involve fairly low day-to-day risks,

but can face extremely high risk in rare situations, particularly financial crises, and can

lead to bankruptcy. Formally, arbitrage transactions have negative skew prices can get a

small amount closer (but often no closer than 0), while they can get very far apart.



The day-to-day risks are generally small because the transactions involve small

differences in price, so an execution failure will generally cause a small loss (unless the

trade is very big or the price moves rapidly). The rare case risks are extremely high

because these small price differences are converted to large profits via leverage

(borrowed money), and in the rare event of a large price move, this may yield a large

loss.

The main day-to-day risk is that part of the transaction fails – execution risk. The main

rare risks are counterparty risk and liquidity risk – that a counterparty to a large

transaction or many transactions fails to pay, or that one is required to post margin and

does not have the money to do so. In the academic literature, the idea that seemingly very

low risk arbitrage trades might not be fully exploited because of these risk factors and

other considerations is often referred to as limits to arbitrage.

Execution risk

Generally it is impossible to close two or three transactions at the same instant;

therefore, there is the possibility that when one part of the deal is closed, a quick

shift in prices makes it impossible to close the other at a profitable price.

However, this is not necessarily the case. Many exchanges and inter-dealer

brokers allow multi legged trades (e.g. basis block trades on LIFFE).

Competition in the marketplace can also create risks during arbitrage transactions.

As an example, if one was trying to profit from a price discrepancy between IBM

on the NYSE and IBM on the London Stock Exchange, they may purchase a large

number of shares on the NYSE and find that they cannot simultaneously sell on

the LSE. This leaves the arbitrageur in an un-hedged risk position.



In the 1980s, risk arbitrage was common. In this form of speculation, one trades a

security that is clearly undervalued or overvalued, when it is seen that the wrong

valuation is about to be corrected by events. The standard example is the stock of

a company, undervalued in the stock market, which is about to be the object of a

takeover bid; the price of the takeover will more truly reflect the value of the

company, giving a large profit to those who bought at the current price—if the

merger goes through as predicted. Traditionally, arbitrage transactions in the

securities markets involve high speed, high volume and low risk. At some

moment a price difference exists, and the problem is to execute two or three

balancing transactions while the difference persists (that is, before the other

arbitrageurs act). When the transaction involves a delay of weeks or months, as

above, it may entail considerable risk if borrowed money is used to magnify the

reward through leverage. One way of reducing the risk is through the illegal use

of inside information, and in fact risk arbitrage with regard to leveraged buyouts

was associated with some of the famous financial scandals of the 1980s such as

those involving Michael Milken and Ivan Boesky.

Mismatch

Another risk occurs if the items being bought and sold are not identical and the

arbitrage is conducted under the assumption that the prices of the items are

correlated or predictable; this is more narrowly referred to as a convergence trade.

In the extreme case this is merger arbitrage, described below. In comparison to

the classical quick arbitrage transaction, such an operation can produce disastrous

losses.

Counterparty risk

As arbitrages generally involve future movements of cash, they are subject to

counterparty risk: if counterparty fails to fulfill their side of a transaction. This is

a serious problem if one has either a single trade or many related trades with a

single counterparty, whose failure thus poses a threat, or in the event of a financial



crisis when many counterparties fail. This hazard is serious because of the large

quantities one must trade in order to make a profit on small price differences.

For example, if one purchases many risky bonds, then hedges them with CDSes,

profiting from the difference between the bond spread and the CDS premium, in a

financial crisis the bonds may default and the CDS writer/seller may itself fail,

due to the stress of the crisis, causing the arbitrageur to face steep losses.

Liquidity risk

Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a

short position. If the assets used are not identical (so a price divergence makes the

trade temporarily lose money), or the margin treatment is not identical, and the

trader is accordingly required to post margin (faces a margin call), the trader may

run out of capital (if they run out of cash and cannot borrow more) and be forced

to sell these assets at a loss even though the trades may be expected to ultimately

make money. In effect, arbitrage traders synthesize a put option on their ability to

finance themselves.

Prices may diverge during a financial crisis, often termed a "flight to quality";

these are precisely the times when it is hardest for leveraged investors to raise

capital (due to overall capital constraints), and thus they will lack capital precisely

when they need it most.

2.6 HOW TO PLAY THE ARBITRAGE GAME:

Arbitrage, in layman’s terms, involves simultaneously buying and selling the same asset across

two different markets, profiting from the price difference. Many times, arbitrage is considered to

be risk-free as the two simultaneous acts automatically hedge the price risk of the asset going up

or down in value. Let’s take an example. Suppose Reliance Industries’ shares are trading at



rs860 on the BSE and at rs862 on the NSE. One could simply purchase the shares at rs860 from

the BSE and sell the same quantity at rs862 on the NSE.

In most equity markets, the trader can immediately claim a profit of rs2; however, since cross-

clearing has not been approved in India, the trader would need to sell the BSE shares and

purchase back the NSE shares within the same day to capture the rs2 profit.

Due to arbitrage, the prices tend to convergeandthe price of Reliance shares may overlap on both

the exchanges. At that point, the trader can execute his reversal trades. For example, assume

Reliance Industries is priced at rs865 later in the same day.

o Cash-Futures Arbitrage

The trader would sell his shares at rs865 on the BSE and purchase shares at the same price on

the NSE. He has now earned rs2 in profit per share. Another common arbitrage strategy is the

Cash-Futures arbitrage. Suppose Reliance Industries equity is trading at rs860 on the NSE, and

the near month Futures contract is trading at rs870 on the NSE. The trader can buy the

underlying and sell the Futures contract.

Since Futures contracts are traded in lots, the trader should execute the same number of shares.

Since Reliance Industries has a lot size of 250, the trader could purchase 250 shares of Reliance

Industries at rs860 and sell one lot of Reliance Futures at rs870.

Now, the trader has two options. As the price difference between the Futures price and the

Equities price is rs10, he needs to wait for the price difference to be lower than rs10 to earn a

profit. If this is not possible, he can hold the positions overnight and execute the reverse trades

on a future date.

The risk here is that the Securities Transaction Tax for delivery shares (holding shares overnight)

is significantly higher than that on sale of shares within the same day (known as intraday). So,

it’s best to wait for the price difference to be below rs10 within the same day.

o Patience pays



Suppose, later in the day, Reliance shares are trading at rs864 and Reliance Futures, at rs872.

He sells his 250 shares and buys one lot of Reliance Futures. He has now earned rs2 in profit.

There are many profitable arbitrage traders who use automated algorithms that constantly scan

the markets for price discrepancies. If you’re looking to play the arbitrage game, be patient and

seek out opportunities where the price discrepancy is large. Over time, you can look to increase

your position sizes.

2.7 ARBITRAGE AND SPECULATION:

• Arbitrage

Arbitrage involves the simultaneous buying and selling of an asset in order to profit from

small differences in price. Often, arbitrageurs buy stock on one market (for example, a



financial market in the United States like the NYSE) while simultaneously selling the

same stock on a different market (such as the London Stock Exchange). In the United

States, the stock would be traded in US dollars, while in London; the stock would be

traded in pounds.

As each market for the same stock moves, market inefficiencies, pricing mismatches and

even dollar/pound exchange rates can affect the prices temporarily. Arbitrage is not

limited to identical instruments; arbitrageurs can also take advantage of predictable

relationships between similar financial instruments, such as gold futures and the

underlying price of physical gold.

Since arbitrage involves the simultaneous buying and selling of an asset, it is essentially a

type of hedge and involves limited risk, when executed properly. Arbitrageurs typically

enter large positions since they are attempting to profit from very small differences in

price.

• Speculation

Speculation, on the other hand, is a type financial strategy that involves a significant amount of

risk. Financial speculation can involve the trading of instruments such as bonds, commodities,

currencies and derivatives. Speculators attempt to profit from rising and falling prices. A trader,

for example, may open a long (buy) position in a stock index futures contract with the

expectation of profiting from rising prices. If the value of the index rises, the trader may close

the trade for a profit. Conversely, if the value of the index falls, the trade might be closed for a

loss.

Speculators may also attempt to profit from a falling market by shorting(selling short, or simply

"selling") the instrument. If prices drop, the position will be profitable. If prices rise, however,

the trade may be closed at a loss.



2.8 ARBITRAGE PROCESS:



Arbitrage refers to the ability of investors to trade in complementary securities (buying and

selling stocks, commodities or ETFs) in two different markets at the same time. The purpose of

using arbitrage is to take advantage of market inefficiencies where one stock might be trading for

rs500 on the NSE while it could be trading at rs450 on the BSE. Investors who engage in

arbitrage are known as Arbitragers. Arbitrage basically takes advantage of the price differences

between two comparable commodities or securities trading simultaneously on two different

secondary markets or stock exchanges. An arbitrage investor (arbitrager) buys a security on the

exchange with the lower price and sells it right away on the exchange that offers a higher price,

for a profit or capital gain. The formula for arbitrage is:

P = (Yb– Xa) x Q

Where:



P = Arbitrage profit

Yb = price of higher priced security on the higher trading exchange – We’ll call it the exchange B.

Xa = Price of lower priced security on the lower trading exchange – We’ll call it the exchange A.

Q = Quantity

Example 1

Say for instance L&T is trading for RS 80 per share on the NSE while it is trading for rs95 per

share on the BSE.An arbitrage investor buys 2000 shares of the stock on the NSE for rs80/share

and sells it simultaneously on the BSE forrs95/share, thus making a decent profit of rs15/share.

The arbitrage profit will therefore be:

P = (Yb– Xa) x Q

P = (95 –80) x 2000 shares

P = 15 x 2000 shares

P = rs30,000

The arbitrage profit is rs30,000. This transaction and similar transactions to this one will increase

the value of the stock on the BSE as arbitragers will be buying and driving up demand in an

attempt to lock in profit. However, the price of the security on the NSE will go lower because

arbitragers will be dumping the stocks in that exchange in order to make their profits; for

instance even if the arbitrager sells the shares at rs93/share on the NSE instead of the rs95

current trading price, he will still make a very good gain on his sale; this will therefore drive

prices of that security on the NSE downwards.





CHAPTER 3

CONCLUSION

3.1 CONCLUSION:



Arbitrage has many forms and encompasses many strategies; however, they all seek to take

advantage of increased chances of success. Many of the risk-free forms of pure arbitrage are

typically unavailable to retail traders, although several types of risk arbitrage do offer significant

profit opportunities to all arbitrageurs.

In the private sector, true arbitrage is completely hedged. In other words, both sides of the

transaction are guaranteed at the time the position is taken so there is no risk of loss. Arbitrage

differs from traditional investing in that profits are made by the trade itself, not from the

appreciation of a security. In fact, holding securities long enough for them to change in value is

generally considered a risk by the arbitrageur.

Riskless, or near riskless, profit opportunities without the need for actual work are so attractive

to arbitrageurs that they continue to search and exploit them using whatever means necessary. In

so doing, it appears that they also contribute to the smooth functioning of the market.



CHAPTER 4

ANNEXURE



4.1 Books

Financial Market and Services - Gordan&Natrajan

Financial Management - PRASANNA CHANDRA

4.2 Magazines

Business Today

Business world

Business India

4.3 Webilography

http://www.investopedia.com/terms/a/arbitrage.asp

http://shabbir.in/arbitrage-trading/

http://www.indianinfoline.com

http://www.nseindia.com


Arbitrage

Documents

arbitrage opportunity

risk arbitrage

true arbitrage

arbitrage assumption

real arbitrage

statistical arbitrage

arbitrage arbitragemcom2sem

arbitrage impossible