How do traders come across arbitrage opportunities?

Arbitrage refers to the simultaneous acts of buying and selling similar assets in different markets by taking advantage of the price differences. When a trader uses arbitrage, the process involves buying a cheaper asset in a given market and selling it at a higher price in a different market. In this act of arbitrage, the trader makes a profit without any net cash flow. Theoretically, people think arbitrage does not require capital and it does not involve any risk. However, in reality arbitrage deals involve capital as well as risk.

How do traders come across arbitrage opportunities?

What is known as the efficient markets hypothesis in the economic theory advises that the financial markets (representing all the investors and active participants) process all the available information in terms of asset values efficiently and quickly. This will minimize the chances for price action discrepancies across different markets.

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However, in reality we see that the markets are never 100% efficient at all times on account of the prevalence of asymmetrical information between the sellers and buyers within a given market. This fact can be understood from a situation where the seller’s asking price for a given asset happens to be lower than the buyer’s bidding price. Such a situation is termed as ‘negative spread’. This kind of situation is one of the top reasons why the opportunities for arbitrage occur.

Currency arbitrage

Currency arbitrage happens when the traders exploit the price differences seen in the money markets in order to make a profit. For example, interest rate arbitrage is one of the highly sought after ways to trade on arbitrage in the currency market. In this process, a trader sells a particular currency from a country where the interest rates are lower and buys the currency of a country that gives higher interest rates. The trading profit ensues from the difference between the two interest rates. The name of this method is ‘carry trade’.

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Cash and carry is another type of currency arbitrage. In this process, the trader takes positions on the same asset simultaneously in the spot market and futures market. As part of this strategy, a trader buys a currency and then short the same currency in futures market. In this scenario, the trader benefits from the different spreads provided by different brokers for a given currency pair.

Statistical arbitrage

Statistical arbitrage is developed from a group of quantitative algorithmic investment strategies. This method aims at exploiting the relative price movements of a large number of financial instruments across a wide range of markets through technical analysis. The prime objective of statistical arbitrage is to generate a higher than usual profits on trades for the benefit of larger investors. Statistical arbitrage does not accommodate high frequency trading. It can only be used for medium frequency trading. The trading periods in this case might vary from a few hours to several days. In a statistical arbitrage, a trader opens a long term as well as short term position simultaneously for taking advantage of the inefficient pricing of the assets that are related to each other.
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