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Why Do Arbitrage Opportunities Exist?

Arbitrage

Arbitrage is as old as the profession of trading. Even in a bartering economy, arbitrage existed. People saved up seeds or traded for extra wood and stored them up to barter for more during winter months.

It is in human nature to seek profit and exploit opportunities. From clipping coupons to mergers and acquisitions, we all seek a better deal. But, in a strict market sense, according to Investopedia, “Arbitrage exists as a result of market inefficiencies.”

The technology enhancement in the stock market is making arbitrage opportunities less and less common. With the computer systems in today’s exchanges able to update prices of stocks and commodities in milliseconds, the utilization of trading bots is becoming more common. However, with humans incapable of performing calculations and exploiting arbitrage opportunities, bots taking over the repetitive task leaves deep insights into the trading regiment on the sidelines.

Yes, the day-trader profession still exists with a glint in the eye of a dreamer to score big, but more and more firms are opting for computers to perform algorithmic electronic trading at impossible speeds and a fraction of the cost of hiring traders.

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These instructions can be related to price, timing, volume, or a mathematical model. For instance, you write an algorithm that tells the computer to buy 1000 Tesla stocks whenever the price goes above $200 and sell if the stock price increases by 10% above the purchase price. For more reading on arbitrage and algorithmic trading, check out the links.

Algorithmic trading provides details like price, timing, volume, or all the data brewed down into a mathematical model. Something akin to providing an algorithm that orders a computer to buy 1000 Tesla stocks above $200 and dump it when the stock price increases by 10% above the purchase price. 

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Consequently, traders have begun looking for opportunities elsewhere. Aside from cryptocurrency markets, many other venues are being utilized to exploit arbitrage opportunities. For example, Forex markets, sports bookmaking, and other speculative money-making opportunities exist for arbitrage opportunities.

Let us admit that arbitrage is central to financial economics. The mechanics of trade and how our financial markets operate make arbitrage a given in studying the financial world. However, the role of arbitrageurs, who exploit arbitrage opportunities in financial markets, is undeniable as we know that the existence of one price law rules the concept of arbitrage. 

According to the one price law, identical securities are expected to have price uniformity regardless of how they exist, especially in an efficient market. But, the reality in the financial market is that invasion of the one price law exists because of market inefficiency. When the market is devoid of transparency, it causes arbitrage opportunities to exist.  

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It is important to note, though, that the existence of arbitrage opportunities is inherently risky due to the assumption of transaction cost at a risk-free rate. That is to say that it assumes no transaction costs. In reality, however, arbitrage opportunities sans transaction costs are few and far between. 

Another assumption typically made here is that in arbitrage trading, the risk taken is minimal and that losses can always be covered to get out of the situation with minimal losses. However, many speculative arbitrageurs in forex trading have found it hard to find that the risk involved in currencies is significant. Unlike your shares and bonds, you can’t always cover the losses if they start losing value. There might be no one to buy them to save your bet at the right moment. So there is exponential risk involved.

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As far as Forex Arbitrage is concerned, the combination of technological advancements and unstable foreign exchange policies in many third-world countries’ financial markets has fueled the exploitation of arbitrage opportunities. As a result, it has become increasingly popular and excessively lucrative.

However, in the market for foreign exchange, exchange rates, particularly for foreign countries, may be inconsistent due to systematic factors or existing unhealthy market practices like attempted infiltration of a parallel market deepening the risk to both markets and participants.

Other Arbitrage opportunities

Market conditions create several other arbitrage opportunities.  Let’s take a look at a few examples of these arbitrage opportunities.

Capturing a Bubble

A bubble is either sudden international news or local events that cause a flurry of short-term trades causes imperfect prices across time zones and markets, thus creating a bubble. This price advantage will probably be corrected in the next several minutes, but in the meantime presents a unique arbitrage opportunity.

Often traders in one time zone can purchase futures in one geographical location and sell them on an exchange in a different geographic location. Doing so will capture the price difference driven by short-term trading and the bubble created, which also assists in bringing the price of a security or commodity back down, preventing a short-term flurry of trades from becoming a long-term bubble.

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Currency Exchanges

At times, the central banks of influential political actors act in response to external factors pricing foreign currencies at different prices, creating an arbitrage opportunity. For example, if the French central bank prices the Dollar/Euro at 1.50/0.66, the Chinese central bank, due to political pressure, prices the dollar at a lower price of 1/0.62. Although external factors have influenced the pricing, this is an example of an inefficient market.

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An arbitrageur potentially could take advantage of this by utilizing the dollars to convert them into Euros with the French central bank, then converting those Euros into dollars at the Chinese bank. In turn, the $1.50 turned into one euro could potentially be turned back into dollars at a rate of $1.60. This phenomenon will not end until the Chinese bank either changed its price, suspended trading, or simply ran out of dollars.

Substantial Similarity

Arbitrage opportunity could also occur when you trade assets that are substantially identical, even if technically they are not the same.

In conclusion, arbitrage opportunities exist because someone somewhere violates the on-price law and thus creates an imperfect pricing situation to be exploited.

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