Intermediaries are vital for a well-functioning financial system and allow their clients to solve the problems they face more efficiently than they could by themselves.
We find several types:
- Brokers, Exchanges, and Alternative trading systems
- Dealers and Securitizers
- Depository Institutions
- Insurance Companies
- Arbitrageurs, and
- Clearinghouses and Custodians
In the world of finance, “arbitrage” is a trading strategy designed to profit from small differences in the prices of similar or identical assets.
What Is Arbitrage?
In its purest form, arbitrage refers to buying an asset on one market and reselling it on another at a higher price. By doing so, arbitrageurs act as financial intermediaries, providing liquidity to participants on the market where the asset is purchased, and transferring the asset to the market where it will be sold.
Suppose that the stock of Apple is trading at $100 on the New York Stock Exchange (NYSE).
At the same time, the London Stock Exchange (LSE) is offering the same stock for $105. An investor can buy the stock on the NYSE and immediately sell it on the LSE, earning a profit of 5 dollars per share.
The trader could continue to exploit this arbitrage until the dealers on the NYSE run out of inventory of Apple’s stock, or until the two exchanges adjust their prices to wipe out the opportunity.
As you may have figured, if markets are efficient, pure arbitrage opportunities rarely exist. That’s because market makers frequently use computerized systems that automatically notice and take advantage of such price differences. By doing so, arbitrageurs have fewer opportunities to profit.
Common Arbitrage Trading Strategies
Commonly, arbitrageurs try to exploit pricing differences for similar instruments. Take the values of the call options and those of the underlying shares. They are highly correlated, right?
When the stock price increases, so does the option value. That’s why if we sell the call option, and simultaneously buy the underlying stock, the long stock position hedges the short, and the strategy is not risky anymore.
If the two instruments are not properly priced, arbitrageurs can exploit the pricing discrepancy by buying the underpriced instrument as well as selling the overpriced, thus, realizing a profit. Such a trading strategy is called replication.
Consider the following scenario:
Microsoft stock trades on the NYSE. Alternatively, its corresponding call option contract trades on the Chicago exchange. If the option were to suddenly become cheaper than the stock, an arbitrageur could simultaneously short (or sell) the more expensive of the two instruments while buying the other to profit from the difference.
Sounds like a piece of cake, doesn’t it? Well, not really… Arbitrageurs are typically very experienced investors who use complex models for securities valuation and risk management.
Here’s the general rule of arbitrage, “Buy the undervalued instrument and sell the overpriced one.” This is a key takeaway for you to remember!
You may now want to find out more about the sixth financial intermediary ― Clearinghouses and Custodians.