Arbitrage is a strategy which traders and fund managers use to take advantage of price imbalances in different markets. In this article we discuss what this strategy involves and different types of arbitrage strategies.
What is the definition of arbitrage?
The simple explanation of arbitrage is buying an asset where the price is lower and selling the asset where the price is higher in a different market. Traders who want to exploit price discrepancies between two markets can use this strategy. This strategy disagrees with the market efficient theory which states that the share market reflects all the information available and the actual price of the security is an accurate reflection of its intrinsic value. This allows the trader to take advantage of the price imbalance between the two markets as one market has not factored in all the publicly available information.
Examples of arbitrage:
1.Traders can use the arbitrage strategy on dual listed companies by buying and selling simultaneously and profiting from the price differences. For example, if an investor owns stocks in company called Red and this is listed on the Nasdaq exchange for $50 USD and this stock is also listed on the Australian stock exchange (ASX) and trades at $75 AUD which is equivalent to $51.00 USD using AUD/USD exchange rate of 0.68. The trader can therefore profit from buying on the Nasdaq exchange and selling it on the Australian stock exchange.
2.A company which is about to have a takeover and it is offering investors $20 per share once acquisition occurs but the stock is currently trading at $15 on the stock market. An investor could buy it on the stock market for the lesser purchase price and then receive $20 per stock once takeover happens.
3.Convertible arbitrage – Traders can take a long position in a convertible bond and at the same time take a short position in the underlying security. If the price of the underlying security falls then the trader will profit from the short position. If the price of the underlying security increases then the trader can convert into the stock and sell the stock on the market. These convertible bonds can usually be converted to the stock at a discount to the stock’s market value.
4.Interest rate arbitrage – Investors can sell currency from a country with a low interest rate and buy a currency with a higher interest rate. For example, the investor exchanges their AUD dollars to USD dollars at the spot exchange rate. They then invest these funds in the US at an interest rate of 1.75% and at the end of the year, converts these USD dollars back to AUD. This strategy takes advantage of the interest price differentials between the two countries.
Lauren Hua is a private client adviser at Fairmont Equities.
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