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Arbitrage

Definition


An arbitrage happens when an asset is priced differently on 2 exchanges and a trader buys the cheaper one while shorting the pricier one.

Description


There are 3 main methods to execute an arbitrage trade.

First – Betting on Convergence

Buy asset A on exchange X and simultaneously short asset A on exchange Y.

In this trade, we assume that the price of asset A on exchange X and Y will converge eventually.

However, there is a risk that the price does not converge if there are external market constraints – such as an exchange halting fund withdrawals, or certain countries limit currency inflow/outflow.

This requires you to pay an interest cost to short asset A on exchange Y.

Second – Moving Assets

Buy asset A on exchange X, transfer asset A to exchange Y, sell it for a higher price.

The risk here relates to time. If the price difference disappears during the time it takes for the asset transfer to happen, the trader might not be able to sell the asset for a higher (profitable) price on exchange Y.

This requires you to pay a cost to transfer assets between exchanges.

Third – Moving Assets with Insurance

This is a hybrid of the above 2 methods.

Buy asset A on exchange X and simultaneously short asset A on exchange Y.

Next, transfer asset A to exchange Y, close your short trade with the transferred asset.

In this trade, you need to pay both the cost of shorting and asset transfer.

Risk-Free vs Low Risk

Ideally, an arbitrage trade is risk-free. In practice, the risks might be low but is not completely risk-free.

Here are some of the common risks:

  • Time risk
  • Exchange risk
  • Counterparty risk
  • Regulation risk
  • Country-related risk
  • Execution risk
  • Liquidity risk
  • Default risk

Arbitrage involving more than 2 assets

Arbitrage can occur when there are more than 2 assets. This is common in the Forex markets.

Currency arbitrage in 3 currency pairs occurs when their prices don’t match up.

For instance, if CurACurB = 2 and CurBCurC = 4, CurACurC should be 8.

Thus, if CurACurC is not 8, we can enter an arbitrage trade.

CurA represents Currency A.

CurACurB = 2 means that it takes 2 units of CurB to buy 1 unit of CurA.

Examples


  • In mid-2017, cryptocurrencies were priced 30% higher in Korea than in other countries. This is because there was a limitation by the Korean government on capital outflows.
  • Gold futures were priced different in COMEX (futures exchange in US) and TOCOM (futures exchange in Japan) in the early 2000s, even after taking into consideration of the currency exchange rate.
  • If CurACurB = 2, CurBCurC = 4, CurACurC is 16. We long CurACurB, CurBCurC and short CurACurC.

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