Have you ever tried buying something at a lower price and then selling the same thing at a higher price ? If you have, then unknowingly you have done what we call- Arbitrage.
Arbitrage is nothing but buying a security from one market and selling it in another where the price is much higher (in terms of trading arbitrage). There are many kinds of arbitrage like Trading arbitrage, Risk arbitrage, Sports arbitrage, Municipal bonds arbitrage, etc. People perceive arbitrage to be similar to gambling. But the major difference between the two is that gambling involves a lot of risk while arbitrage is risk-free.
We’re going to talk about three types of arbitrage ,which are often used.
First one is ‘Trading Arbitrage’. So, I’ve already defined the topic. Suppose, you have the similar security priced Rs. 40 at BSE and Rs. 45 at NSE. Now, if you’re holding the security at BSE, then you can sell it at Rs. 45 at NSE and earn a profit!
You can see a few examples of Arbitrage Opportunities .
Next one is, ‘ Risk Arbitrage’. I’ve been saying that Arbitrage is not gambling as it does not involve any kind of risk. But you can say that this is an exception because as the name suggests, it does involve risk.
Risk Arbitrage can be understood in case of companies where we witness two kinds: Mergers & Acquisitions arbitrage and Liquidation arbitrage.
Let’s understand these with the help of examples.
Suppose, there are two companies Company X and Company Y. Company Y plans to takeover Company X which will lead to the rise in worth of the shares from Rs 100 to Rs. 120. Suppose the early trading leads the price to rise upto Rs. 115, we still have an incentive of Rs. 5 for which we can undertake risk. But where’s the risk ?
I said, Company Y PLANS to takeover Company X, it didn’t happen yet. There are equal chances of the vice versa happening as well, and that’s where the risk comes into the picture.
For ‘ Liquidation arbitrage’ , similar thing holds true. You don’t know if the company will liquidate and therefore risk exists.
Lastly we have ‘ Sports arbitrage’. This again can be well understood by an example. Suppose two teams are playing, Kolkata Knight Riders & Mumbai Indians (Following IPL Auctions, can’t help it :P). And there are two match predictors who predict the winning of either teams.
Suppose ABC says that Kolkata Knight Riders would win and he’ll pay Rs. 1000 if the opposite happens. While, XYZ says that Mumbai Indians will win and he’ll pay the same amount which we’ll bet if vice versa occurs.
Now, suppose you bet on both the teams, Rs. 500 each.
Now, if Kolkata Knight Riders wins, you’ll lose your 500 with ABC but get 500 from XYZ with your initial amount.
But, if Mumbai Indians wins, you’ll lose 500 to XYZ. And, you’ll get Rs. 1000 from ABC in addition to your initial amount.
You don’t lose anything in each case. Either you’re at a no profit, no loss situation or you’re making profits.
(This is a made-up situation, everything varies with different situations)
Arbitrage is not easy. You need to have a pretty good knowledge of the concerned sector.
Hope it helped. Contact me in case of queries 🙂
Written by Tanya Jain