Arbitrage is a trading or investment strategy that involves buying one financial asset while simultaneously shorting another one. It also involves buying or shorting two diverse securities with the goal of minimizing risks and maximizing profits.
Arbitrage is a big industry. In fact, hedge funds that focus on this strategy have more than $80 billion in assets under management (AUM), according to data compiled by BarclayHedge. The industry is substantially bigger than that since many traders and investors using the strategy are not tracked by the company.
Arbitrage can be applied in all financial instruments, including stocks, currencies, commodities, and indices. Let us look at some of the most popular types of arbitrage in trading.
Merger and acquisition (M&A) arbitrage
The number and volume of M&A deals are increasing around the world. In recent years, some of the most popular deals are LVMH’s acquisition of Tiffany, S&P Global acquisition of IHS Markit, and AMD’s buyout of Xilinx.
In most cases, shares of companies involved in deals tend to be relatively volatile. Typically, shares of the company making the acquisition tend to fall while that being acquired usually rises. Shares of other related firms in the industry also move upwards.
The reason behind this is very simple. Shares of the firm being acquired rise because of the guaranteed premium the buyer has to pay. Similarly, shares of the acquirer fall because it will have to spend money and dilute existing shareholders to fulfill the acquisition.
Therefore, when a deal is announced, a merger arbitrage trade can see you buy the acquirer while shorting the company being acquired. Also, you can buy shares that have the potential of being acquired in the future.
Interest rate arbitrage
This is a type of arbitrage that seeks to benefit from the overall interest rates of different countries. For example, at the time of writing, the main interest rate in Switzerland is -0.75% while that of the United States is at 0.25%.
Therefore, in an interest rate arbitrage situation, you can borrow money in a cheap interest rate environment and then invest it in a high-interest rate environment.
This type of arbitrage is also known as carry trade and is mostly done by highly-sophisticated traders. It is a popular form simply because of the minimal risks involved due to the culture of forward guidance by central banks.
After the Global Financial Crisis (GFC), central banks embraced forward guidance to prevent market shocks. In it, they provide guidance as to when they will increase or lower rates. For example, in 2020, the Federal Reserve hinted that it would leave rates unchanged for two to three more years.
Here’s an example of this. Assume that the US dollar has a deposit rate of 1% while the New Zealand dollar has a rate of 3.5%. Therefore, if you invest $100,000 in the US, you will only get a yield of $101,000. However, if you take the funds to Australia, you will get a yield of $103,500.
Statistical arbitrage refers to the process of using mathematical calculations to identify mispricing across different or similar asset classes. The most popular approach is the one where traders use correlations, mathematic study of relationships.
To conduct correlations well, you need to first download data of the assets you want to study. You should then enter the data in Excel and then run a correlation analysis. If the result is one or close, it means that the two assets are closely related. If it’s minus one or near, it means that the two assets have an opposite relationship. If it’s zero or close, it means that the two have a close relationship.
Fortunately, you can use several web platforms to find these correlations, as shown below.
Currency correlation table
If the two assets are closely correlated, you can buy one and short the other. In this case, your profit will be the spread between profit and loss.
Convertible bond arbitrage
There are many forms of bond arbitrage in the financial market. One of the most popular ones is known as a convertible bond. For starters, this is a bond type usually issued by a company. In it, the bondholder can convert the bonds into shares depending on the performance of the stock.
In a convertible bond arbitrage, the trader wants to benefit from the mispricing of the bond and the underlying stock. If the convertible bond is relatively cheap, the trader will buy it and short the underlying stock. Similarly, if the convertible is expensive, the trader will short the bond and buy the stock.
In this type of arbitrage, a profit will mostly come up when there is an improvement in credit, high volatility, the performance of interest rates, and in case of special events, like M&A.
Another popular type of arbitrage is known as index arbitrage. It is a simple process that involves buying one index and shorting another index. You can also combine one index and a tradable exchange-traded fund (ETF) that has similar assets.
For example, you can buy the Nasdaq 100 index and simultaneously short the Invesco QQQ ETF. In this case, if the Nasdaq 100 rises, you will generate a profit. At the same time, you will make a loss with the QQQ ETF, which is okay. As a result, your profit will be the difference between the profit and loss of the two.
Arbitrage is a popular trading and investing strategy that sounds complicated but is extremely easy to grasp. It is simply a process of identifying mispricing of different assets. As a result, there are many other types of arbitrage such as triangle, futures, fixed income, and even tax arbitrage, among others. As a trader, you can take time to learn and practice these various types and make money using them.