Arbitrage – Process of Buying/Selling Complementary Securities
Arbitrage refers to the ability of investors to trade in complementary securities (buying and selling stocks, commodities or ETFs) in two different markets at the same time. The purpose of using arbitrage is to take advantage of market inefficiencies where one stock might be trading for $500 on the NYSE while it could be trading at $450 on the London stock exchange. Investors who engage in arbitrage are known as Arbitragers. Arbitrage basically takes advantage of the price differences between two comparable commodities or securities trading simultaneously on two different secondary markets or stock exchanges. An arbitrage investor (arbitrager) buys a security on the exchange with the lower price and sells it right away on the exchange that offers a higher price, for a profit or capital gain. The formula for arbitrage is:
Say for instance Binti Kiziwi Corp (ticker symbol BKC) is trading for $80 per share on the New York stock exchange (NYSE) while it is trading for $95 per share on the Toronto stock exchange (TSX). An arbitrage investor buys 2000 shares of the stock on the New York stock exchange for $80/share and sells it simultaneously on the Toronto stock exchange for $95/share, thus making a decent profit of $15/share.
The arbitrage profit will therefore be:
The arbitrage profit is $30,000. This transaction and similar transactions to this one will increase the value of the stock on the New York stock exchange as arbitragers will be buying and driving up demand in an attempt to lock in profit. However, the price of the security on the Toronto stock exchange will go lower because arbitragers will be dumping the stocks in that exchange in order to make their profits; for instance even if the arbitrager sells the shares at $93/share on the TSX instead of the $95 current trading price, he will still make a very good gain on his sale; this will therefore drive prices of that security on the TSX downwards.
Arbitrage for Currencies
Arbitrage can also be done on foreign exchange currencies
markets. The formula for calculating arbitrage profit on trading currencies
Assume Binti Kiziwi Corp. borrows $1,000,000 from a bank in New York for 90 days at 8% borrowing rate and converts it to Canadian dollars at an exchange rate of 1.10, thus totalling $1,100,000 Canadian. The Canadian dollars are then invested at 10% interest for 90 days. What will be the arbitrage profit?
Arbitrate is used by investors when they are seeking to
exploit the price differences between two complementary securities trading
on 2 different markets or exchanges in order to turn over some profits.
These kinds of price differentials exist for small periods of time, thus
arbitragers usually have to be very quick in order to make profits. Arbitrage
is also used by international financial managers who use interest-rate
differences for various currencies to take advantage of cheaper purchasing
costs of foreign products. Arbitragers also use forward contracts to take
advantage of such price differentials.