Arbitrage Persuasive Essay

By exploiting price differences, people can make hundreds upon thousands of dollars. Arbitrage is the process of taking advantage of price imbalances between two or more markets. Arbitrageurs are the people whose role it is to strike a combination of similar deals across markets to capitalize upon any perceived imbalance. Often, this can offer a guaranteed profit, with no risk which is a very good thing. However, frequently participants fail to account for all of the risks which itself explains why arbitrage is not always risk free and can be such a dangerous thing.
What can make Arbitrage such a risky trade? Is the dream of arbitrage too good to be true? First, we need to distinguish between arbitrage that is free money and arbitrage that is a dangerous gamble. Before we can find this out, we must go into detail about what arbitrage actually is, beyond the basic definition of mispricing between markets.
Arbitrage “in the
real world” can be categorized into three categories: Pure, Near or Speculative. In Pure Arbitrage, you risk absolutely nothing, and can earn more than the risk-free rate of return which is defined as the interest rate on short term U.S. Treasury Bills. This is quite rare, as market efficiencies tend to keep two identical assets from being priced differently. Market efficiencies result from professional market participants (mainly computer algorithms) who through pure arbitrage remove these opportunities virtually instantaneously. Next up is near arbitrage, where assets with nearly identical characteristics trade at different prices and values that can’t be accounted for purely by those small differences. And finally, we have speculative arbitrage, which may not even be arbitrage at all. This is when investors take advantage of what they believe to be opportunity among similar (not identical) assets. Speculators will buy the cheaper asset and sell the more expensive one, thereby earning what they believe to be a low-risk or no-risk return. It is that belief among speculators, which strays from the true essence of arbitrage that may lead some to believe that arbitrage is a dream that may be too good to be true.
One way to lock in a riskless profit is to take advantage of the fact that trading can occur in the same stock, across multiple markets.
Although not likely, it is conceivable that you could buy a stock in one market, and instantaneously sell it at another market for a higher price. To continue to make this a riskless transaction, not only must you do this at the exact same time, but one must eliminate all if any exchange rates by converting the foreign currency into the domestic currency instantly. This is an example of a Dual Listed Stock, dual meaning two. For example, at one point in time, a particular stock could be listed at $60.02 at one exchange but offered at $60.00 at another. In theory, one could then purchase the cheaper contract at the price and sell it at the other. Due to this, a risk free profit could be made of two cents ($0.02 USD). With this, there are also Depository Receipts, which are quite different and possibly riskier than Dual Listed Stocks. Not only this, but they can become more costly and time consuming as
well.
Like many different types of arbitrage, Closed-end funds, stocks in which only have a fixed amount of shares in circulation, can trade at prices lower than their net asset value (the value of the components). With this, the price can differ than the net asset value, and the potential for arbitrage exists.
Suppose that I was selling a particular item for $10, and that somebody else was selling the last few copies of said item for $30. A consumer could then buy that item from me for $10, and sell it to somebody else to make a profit of $20. This is a quite simple version of arbitrage, as there are a multitude of reasons why this could end up not becoming a long term profit. For instance, I could run out of the item, I could raise the price on my remaining stock due to an increased demand, or the supply of my competitor could increase, which would result in a price reduction. This is what makes arbitrage such a fascinating topic, and there is still more yet to come.
Now, let’s get into detail about some of the more complex forms and ways of arbitrage by using currency futures. These contracts allow investors to reduce the risks and the price movement of foreign exchange. Let’s say that there are two countries, Germany and England, in which have two different one-year interest rates. Pretend that Germany’s one-year interest rate is 1% and that of England is 2%. Lastly, let’s assume that the spot exchange rate is $1.10 per euro.

Futures Price$ (1.02)
_______________ = _______ $ 1.20 (1.01)

Futures Price=$1.1109

Let’s round this up to $1.12. Now, we can borrow this $1.10 in the England domestic markets at 2%