Joe Capone
Arbitrage, so... What is it?
Arbitrage is the practice of taking advantage of a price difference amidst two or more markets, striking a combination of matching deals that capitalize upon the imbalance and the profit made is the difference between the market prices. In simple terms, it means the possibility of risk free profit after transaction costs.For example, an arbitrage is said to be present when there is a chance to instantaneously purchase low and sell high. An arbitrage is risk free.
It may refer to profit being expected, though losses may occur, and in practice, there are always risk in arbitrage, some are minor which are fluctuation of prices decreasing profit margins and also some are major which are devaluation of a currency or derivative.
Consider this very simple example: Acme stock currently trades at $10 and a single stock futures contract due in six months is priced at $14. This future contract is a promise to sell and buy the stock at a predetermined price. So, by buying the stock and simultaneously selling the future contract, you can without taking any risk, gain a sum of $4 before transaction and also borrowing costs. In reality and practice, arbitrage is a little more complicated, but three trends in investing practices has opened up the possibility of all types of arbitrage strategies: the utilization of derivative instruments, trading software and different trading exchanges. For example, electronic communication networks and foreign exchanges make it to be possible to take advantage of exchange arbitrage. The arbitraging of prices among various exchanges.
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Only a few hedge funds are arbitrageurs that are pure, but when they are, recent studies often prove that they are a good source of low risk, reliably moderate returns. But, because observable price inefficiencies tend to be small, pure arbitrage usually requires large, usually leveraged investments and also high turnover. Furthermore, arbitrage is self defeating and perishable; if a strategy comes out to be too success, it gets copied and gradually it disappears. Most so called arbitrage strategies are better called as relative value.These strategies do try to capitalize on differences of price, but they are not risk free. For example, convertible arbitrage entails buying a corporate convertible bond, which can also be converted into common shares while simultaneously selling short the common stock of the same company or organization that issued the bond.
This strategy tries to exploit the relative prices of the convertible bond and also the stock; the arbitrageur of this strategy would think the bond is a little too cheap and stock is a little expensive. The whole idea is to make money from the bond's yield if the stock eventually goes up,but to also gain money from the short sale if the stock goes down.However, as the convertible bond and the stock can move independently, the arbitrageur can lose on both the stock and the bond, which means the position carries risk.
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