Arbitrage

Research By: Saizal Agarwal

The practice of purchasing a security in one market and simultaneously selling it in another at a higher price is known as arbitrage. This allows investors to take advantage of the short-term difference in cost per share. An arbitrage trade is considered to be a relatively low-risk exercise.

Example: Stock Arbitrage between BSE and NSE

Imagine that a company, ABC Corporation, has its shares listed on both the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Let’s assume the following conditions exist: The stock is trading at ₹100 per share on the BSE. Simultaneously, due to a temporary exchange rate or market inefficiency, the same stock is trading at the equivalent of ₹102 per share on the NSE.

1. Buying on the BSE: The arbitrageur purchases 1,000 shares of ABC Corporation on the BSE at ₹100 per share. The total cost of this transaction is ₹100,000.
2. Selling on the NSE: At the same time, the arbitrageur sells 1,000 shares of ABC Corporation on the NSE at the equivalent of ₹102 per share. The total revenue from this transaction is ₹102,000.
3. Profit Calculation: The profit from this arbitrage transaction is the difference between the selling price on the NSE and the buying price on the BSE:

Profit = Revenue from NSE− Cost from BSE = ₹102,000−₹100,000= ₹2,000

This ₹2,000 profit is made without any exposure to market risk because the trades were executed simultaneously. The arbitrageur has successfully exploited the price discrepancy between the two markets.

It is a key mechanism that ensures the consistency of prices across different markets, and it offers traders a method to achieve risk-free profits. However, it is a strategy that requires precision, speed, and often sophisticated technology. In modern financial markets, where price discrepancies are quickly corrected, the role of arbitrageurs is crucial in maintaining market efficiency.

Types of Arbitrage:

Type of Arbitrage	Definition	How It Works	Example	Risk Level
Pure Arbitrage	Buying and selling the same asset in different markets to profit from price differences.	Simultaneously buy in one market at a lower price and sell in another market at a higher price.	Buy a stock at ₹50 on the BSE and sell it for ₹51 on the NSE, making ₹1 per share in profit.	Very Low
Merger Arbitrage	Exploiting price discrepancies in a target company’s stock before a merger or acquisition.	Buy the target company’s stock at a lower price before the merger and sell it after the merger at a higher price.	Buy shares of Company B at ₹95 before a merger announcement, and sell at ₹100 after the merger is confirmed.	Moderate (depends on merger outcome)
Convertible Arbitrage	Profiting from the mispricing between a company’s convertible bonds and its underlying stock.	Buy the convertible bond and short the underlying stock, or vice versa, to lock in a profit.	Buy ABC Corporation’s convertible bond at ₹1,000, short 50 shares of its stock at ₹19 per share, and profit from price changes in either the bond or stock.	Low to Moderate
Retail Arbitrage	Buying products at a lower price in physical stores and selling them online for a profit.	Purchase discounted items in-store and sell them on an online marketplace at a higher price.	Buy blenders on sale for ₹50 at Walmart and sell them on Amazon for ₹90, earning a profit after fees and shipping.	Low
Dividend Arbitrage	Taking advantage of dividend payments by buying stocks just before the ex-dividend date.	Buy stocks before the ex-dividend date, collect the dividend, and hedge with futures contracts.	Buy 1,000 shares of Infosys before the ex-dividend date to collect a ₹20,000 dividend while shorting futures to hedge against price drops.	Low to Moderate
Futures Arbitrage	Exploiting the price difference between the spot price and the futures price of an asset.	Buy the asset in the spot market and sell the futures contract, or vice versa, to lock in a profit.	Buy 100 shares of XYZ Ltd. at ₹1,000 in the spot market, sell the futures contract at ₹1,050, and profit from the difference after accounting for carry costs.	Low to Moderate

• Pure Arbitrage:

Pure arbitrage involves simultaneously buying and selling the same asset in different markets to profit from price differences. It is the most straightforward and traditional form of arbitrage.

• Merger Arbitrage:

This is a tactical endeavour. When arbitrageurs suspect an acquisition or merger, they purchase the target company’s stock. They sell the shares when the prices rise after the merger.

Real life example of merger arbitrage is the HDFC-HDFC Bank merger. Traders who understood the swap ratio and market dynamics could potentially profit by exploiting the price discrepancies between the two companies’ shares during the period leading up to the merger’s completion.

• Convertible Arbitrage:

Convertible arbitrage involves taking advantage of mispricing between a company’s convertible bonds and its underlying stock. Convertible bonds can be converted into a specific number of shares, and this strategy often involves buying the bond and shorting the stock.

• Retail Arbitrage:

A prevalent activity in e-commerce, retail arbitrage involves purchasing a product from a local merchant at a lower price and subsequently offering it for a higher price on an online marketplace. This approach leverages the convenience and accessibility of online platforms to capture price differentials.

• Dividend Arbitrage:

Dividend arbitrage traders purposefully purchase stocks just prior to the ex-dividend date, which is the final day on which a buyer is eligible to receive the dividend payment. Investors try to time their purchases to take advantage of the dividend payout, which increases their total return on investment.

Example: Infosys Limited (INFY) pays dividend to its shareholders regularly, ₹ 20 per share and ex-dividend date is 15^th Sep. On 14^th Sep (the day before ex- dividend date), the arbitrageur buys 1000 shares of Infosys at ₹ 1000 per share, totaling ₹ 1000000.

• Simultaneously, the arbitrageur shorts Infosys futures contracts equivalent to 1,000 shares at a price close to ₹1,000 per share, to hedge against the potential drop in the stock price.
• On 15th September, Infosys goes ex-dividend, and the stock price drops by ₹20 (the dividend amount), bringing the stock price down to ₹980.
• The arbitrageur is entitled to receive the ₹20 per share dividend, totaling ₹20,000.
• The stock price is now ₹980, so the value of the stock holding has decreased by ₹20,000 (1,000 shares × ₹20).
• However, the arbitrageur makes a profit from the short futures position, as the futures price would have also dropped by ₹20 per share.
• The loss in the stock price is offset by the gain in the futures contract, and the arbitrageur nets the ₹20,000 dividend as profit.

Profit Calculation:

• Dividend Income: ₹20,000 (1,000 shares × ₹20 dividend)
• Stock Price Loss: ₹20,000 (due to the ₹20 drop in stock price)
• Futures Profit: ₹20,000 (due to the drop in the futures contract price)

Thus, the arbitrageur’s profit is effectively the ₹20,000 dividend, as the positions in the stock and futures hedge each other out.

• Futures Arbitrage or Cash and Carry Arbitrage:

It involves taking advantage of the price difference between the spot price of an asset and its futures price. This strategy typically involves buying the asset in the spot market and simultaneously selling a futures contract on the same asset, then holding the asset until the futures contract expires. The profit is locked in through the difference between the cost of carrying the asset and the futures price.

This can include 2 scenarios:

• Now Buy 100 shares of XYZ Ltd. in the Spot Market at ₹1,000 per share, totaling ₹1,00,000.
• Sell a 3-month futures contract for 100 shares of XYZ Ltd. at ₹1,050 per share, locking in a sale price of ₹1,05,000.
• Assume you finance the purchase of the shares using a loan at an annualized risk-free rate of 6%. The cost of financing for 3 months is approximately ₹1,500 (calculated as ₹1,00,000 × 0.06 × 3/12).
• Now Hold the Shares Until the Contract Expires incurring the total carry cost of ₹3,000 (₹30 per share × 100 shares).The financing cost adds up to ₹1,500.
• Now Settle the Arbitrage:

• On the futures contract expiry date, you deliver the 100 shares of XYZ Ltd. against the futures contract and receive ₹1,05,000.
• Your total cost (including purchase, carry, and financing) is ₹1,00,000 + ₹3,000 (carry) + ₹1,500 (financing) = ₹1,04,500.
• You sell the shares for ₹1,05,000 as per the futures contract, realizing a profit of ₹500.

• Now Borrow Stock ABC from a broker and sell it immediately in the spot market at ₹1050.
• Invest the ₹1050 you received from selling the stock at the risk-free rate of 0.5% for one month. This investment will grow to ₹1055.25 at the end of the month.
• Simultaneously, buy a futures contract to purchase Stock ABC at ₹1000 with a one-month expiry.
• The futures contract expires, and you are obligated to buy Stock ABC at ₹1000.
• Use ₹1000 of the ₹1055.25 you earned from the investment to buy the stock via the futures contract.
• Return the borrowed stock to the broker and pay the cost of borrowing the stock, 1% of 1050= 10.50
• Proceeds from Investment: ₹1055.25, Cost of Buying Futures: ₹1000, Borrowing Costs: ₹10.50 and Net Profit: ₹1055.25 – ₹1000 – ₹10.50 = ₹44.75

In real scenario:

• India follows a T+1 settlement cycle, where trades are settled the next business day after the trade date. Only for some stocks the cycles is T+ 0 where the trades are settled on the same day.

• So for selling, the person can borrow or lend securities through Securities Lending & Borrowing (SLB) Mechanism and pay commission to the broker.

• Or use Index Arbitrage, where the trader buys the undervalued stocks and sells the overvalued future contracts, profiting from the convergence of prices. (3 future contracts are available at a time)

Benefits of Arbitrage strategy:

• Risk-Free Profit: Arbitrage offers low-risk, guaranteed profits by exploiting price differences across markets.
• Market Efficiency: It corrects price discrepancies, ensuring more accurate and fair market pricing.
• Liquidity Enhancement: Increases market liquidity and depth, making trading easier for others.
• Diversification: Provides a low-risk strategy that complements traditional investments.
• Reduced Volatility & Global Integration: Stabilizes prices by quickly narrowing price gaps, especially in volatile markets. Also it links international markets, promoting efficient global resource allocation.

Challenges and Considerations:

• Transaction Costs: Transaction costs, including brokerage fees and taxes, can erode arbitrage profits. Effective arbitrageurs must account for these costs to ensure that the profit from price discrepancies exceeds the expenses.

• Market Efficiency: As markets become more efficient, price discrepancies become less frequent and less pronounced. High-frequency trading and advanced algorithms can quickly correct price imbalances, reducing the opportunities for arbitrage.
• Regulatory Compliance: Arbitrage strategies must comply with financial regulations and market rules. Violations of regulations such as insider trading or market manipulation can result in legal penalties.
• Execution Risk: The timing and execution of trades are critical in arbitrage. Delays or errors in executing transactions can negate the expected profit from price discrepancies.

Conclusion:

Arbitrage remains a vital concept in financial markets, contributing significantly to market efficiency and liquidity. It ensures that asset prices remain aligned across different markets, integrating information and enhancing liquidity. However, successful execution of arbitrage strategies requires a deep understanding of market mechanisms, careful management of transaction and operational costs, and the ability to navigate regulatory and execution risks. Advanced technology and real-time market data are essential tools for identifying and capitalizing on arbitrage opportunities, making it a sophisticated and dynamic field within financial trading.

This practice not only benefits individual traders but also plays a critical role in enhancing overall market efficiency and liquidity.