Overview of Arbitrageurs’ Strategies

Arbitrageurs are traders who exploit price discrepancies in financial instruments to make risk-free profits. They achieve this by simultaneously buying and selling related assets or derivative contracts in different markets to take advantage of price differences. Arbitrage opportunities arise when the same asset or contract is priced differently in two different markets or when combinations of assets and derivatives create a mispricing.

Simple Arbitrage Example

Let’s consider a simple arbitrage example with a stock trading on two different stock exchanges. Suppose Company ABC stock is trading at 50 USD per share on the NYSE (New York Stock Exchange) and 52 USD per share on the LSE (London Stock Exchange). An arbitrageur can buy Company ABC stock on the NYSE for 50 USD and simultaneously sell it on the LSE for 52 USD, pocketing a risk-free profit of 2 USD per share.

Risk-Free Nature of Arbitrage

Arbitrage strategies are inherently risk-free because they involve offsetting positions that result in no net exposure to the market’s fluctuations. The arbitrageur’s goal is to eliminate any price differences between assets or contracts quickly, as these opportunities tend to be short-lived.

Speed and Technology in Arbitrage

Arbitrage opportunities often last only for brief moments, and swift execution is critical. To capitalize on these opportunities, arbitrageurs rely on sophisticated trading algorithms and high-frequency trading (HFT) technology to execute trades at lightning speed.

Calculation of Arbitrage Payoff

The payoff from an arbitrage strategy is the net profit earned by the arbitrageur. The calculation involves the following steps:

Step 1: Identify the Arbitrage Opportunity
An arbitrageur must spot a price difference in related assets or derivative contracts. They may use market data feeds and advanced analytics to detect mispricings.

Step 2: Simultaneous Transactions
The arbitrageur simultaneously enters into offsetting positions to exploit the price difference. For example, if an asset is undervalued in one market and overvalued in another, the arbitrageur will buy the undervalued asset and sell the overvalued asset simultaneously.

Step 3: Calculate the Profit
The arbitrageur’s profit is the difference between the prices at which they bought and sold the assets or derivative contracts. The profit is realized with minimal or no market exposure.