what is stock arbitrage

What is stock arbitrage?
Arbitrage is a strategy to take advantage of price differential of a product in different markets. An arbitrageur makes money by buying an asset at low price in a market and concomitantly, selling it in any other market at a relatively higher price. For instance, if one buys 100 shares of any company at Rs 10 each in spot market and sells at Rs 10.10 at futures, he makes Rs 10, assuming there is no transaction cost.

What are the basic conditions?
Arbitrage is possible only if the law of one price does not hold true, i.e. the price of the product, which is being used for arbitrage, has an unequal price in different markets. Arbitrageurs at times, use different products with similar cash flows for arbitrage. For an arbitrage opportunity, these products must be trading at different prices. Also, arbitrageurs grab the opportunity of price difference in spot and futures prices of an asset. In this case, the spot price of the asset should not be equal to its futures’ price net of carrying cost.

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What are different types of arbitrage?
There are several ways for executing arbitrage, such as merger arbitrage, convertible bond arbitrage and reverse arbitrage. Under merger arbitrage, one buys the shares of a target company and shorts the shares of the company, which is going to acquire. Arbitrageurs play with the spread between the prevailing market price of the target company and the expected offer price from acquiring company. Usually the future price of an asset is higher than its spot price. But sometimes, future price trades at a relatively lower price and to get advantage of this arbitrageurs sell shares in spot and buys in future market. This strategy is known as reverse arbitrage.

What is the risk involved?
Generally, the risk is lower in an arbitrage but certain developments can increase the quantum of loss substantially. For instance, if one takes position for a merger arbitrage and if the merger does not materialise, losses could be very high. Also, investors arbitrage by buying shares in one stock exchange and selling in another exchange to get advantage of price difference. But such price differences exist for very short periods and if the investor cannot make buy-sell order almost simultaneously, one may end up with considerable losses.