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The Arbitrage Risk And How To Lower It

Aug 17, 2007
Arbitrage is defined as a process of buying and selling various products, assets or shares in order to earn profit which generate because of the differences in the prices of such assets or shares in other markets, brokers etc. It is generally said that Arbitrage is risk less however in the real world risk does exist. But still Arbitrage can be really profitable if you can find opportunities to earn profit before they disappear.

According to the finance theory an arbitrage can be defined as a transaction through which you can earn profit without any risk. Just suppose if an asset is being traded at 45.03 US dollars in one exchange and at 45 US dollars in another exchange than you can purchase the asset from one exchange and sell it in the another exchange to make a profit of 0.02 dollars.
A market is termed as a No Arbitrage market if the prices offer no arbitrage opportunities. There is another way in which the term arbitrage can be used. In this usage arbitrage is generally a speculative transaction. Such arbitrage includes:

1. Statistical Arbitrage
2. Merger Arbitrage
3. Fixed Income Arbitrage
4. Convertible Arbitrage

These two types of arbitrages can be termed as true arbitrage and a Speculative arbitrage. Generally true arbitrage is rare in practice and it always includes some risk either due to liquidity, timing when transactions get offset, etc. in case these true arbitrages become complicated the risks multiply. There are three types of arbitrages that consist of risk:

1. Merger and Acquisition: it involves purchasing stock from company being acquired and selling them to the acquiring company,
2. Liquidation Arbitrage: it involves taking an advantage of differences between the company's current value and its future expected value.
3. Pairs trading: involves taking advantage of the differences between two companies within the same industry and continuously correlated with each other. When values of both the companies diverge to a high level one can take an offset position as there are great chances that both of them will be similarly valued in the near future.

Although arbitrage process appear to be risk free on the paper but world offers very few opportunities to make profit without any risk. Although these three types of arbitrages are not risk less there are various other strategies where the risk is less or zero. Anyway always try to risk a less as possible and be clear about every risk that might be invloved.
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