Decoded: What is arbitrage, how does it work, and what are its limitations?

While talking about market participants, one usually refers to either long-term investors or intra-day traders, conveniently leaving out a third category – that of arbitrageurs.
 
Arbitrageurs are the traders who undertake risk-less trades across global markets through a method known as arbitrage.
 
Now, what is an arbitrage?
 
Simply put, arbitrage is a trading practice wherein one buys an asset from one market and sells it in another market to make a quick buck.
 
The practice exploits the assumptions of “efficient market” theory which suggests that a security or an asset, offering similar returns and having similar risks, should be valued at the same price across markets.
 
However, as we know, prices can vary across markets due to factors like different foreign exchange rates, supply constraints, or demand exuberance.
 
Thus, when price of a security is low in one market and high in another, arbitrageurs undertake trades to make “risk-less” profit.
 
If one ounce of gold trades at $1,700 in one market and at $1,780 in another, an arbitrageur can easily earn profit of $80.
 
Further, take a closer look around you and you would notice that arbitrage opportunity exists even at local levels.
 
For example, if a loaf of bread is sold at Rs 30 in Delhi and at Rs 35 in Noida, then someone interested in bakery business can easily earn a profit of Rs 5 per loaf by buying in Delhi and supplying it in Noida.
 
In the stock market, too, there is an opportunity for arbitrage in a scrip. However, such opportunities are usually rare.
 
At a certain time on a given day, assume the shares of a company are trading at Rs 3,274 apiece on the NSE and Rs 3,274.40 apiece on the BSE. Now if an arbitrageur were to buy 1,000 shares of the company on the NSE and sell on the BSE, he would make a profit of Rs 400.
 
With our basics in place, let’s now take a look at some of the conditions necessary to undertake arbitrage trades.
 
NECESSARY CONDITIONS FOR ARBITRAGE

• Asset price imbalance: Same asset is traded at different prices; or assets with similar cash flows are traded at different prices
• Simultaneous trade execution: The purchase and sale of identical or equivalent assets should be executed simultaneously to capture the price differences.

 
So, if the trade practice just involves buy-low-and-sell-high philosophy, why isn’t the strategy used widely?
 
The answer is that the opportunity is short-lived.
 
Arbitrage trades are extremely short-lived, where price deviation between assets can cease to exist within minutes.
 
This is because arbitrage itself provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods of time.
 
With advances in technology, it has become extremely difficult to profit from pricing errors in the market.
 
Computerised trading systems monitor fluctuations in similar financial instruments, and therefore, any inefficient pricing setups are usually acted upon quickly, thereby eliminating the opportunity within minutes.
 
In addition, equal assets with different prices generally show a small difference in price, smaller than the transaction costs of an arbitrage trade would be. This effectively negates the arbitrage opportunity.
 
Therefore, arbitrage is generally exploited by large financial institutions because it requires significant resources to identify the opportunities and execute the trades.

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