The world of finance can be complicated. There are many conflicting pieces of advice from people who insist their way is the only way to gain wealth. Add in an entire dictionary of terms such as: amortization, assets, asset allocation, arbitrage, balance sheets, and capital gains, and the entire process can seem unnavigable. This beginner friendly guide to understanding arbitrage can help make this process of earning that first million dollars more achievable.
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What is Arbitrage?
Arbitrage refers to the practice of exploiting price differences of the same asset or related financial instruments in different markets or platforms to make a profit with little or no risk. Now let’s break this down with an example.
You have a product that costs $100 and gives you $30 in profit. You get a loan with 10% interest to cover the costs of the product. This means that your costs are now $110, and you have $20 in profit. This assumes that you have a buyer and complete an instant transaction or a transaction within the term. A pitfall of this is taking the loan and then sitting on the product while accruing interest. A way to try and avoid this is by using preorders.
This is a basic example to help understand the principal. The goal of arbitrage is to take advantage of market inefficiencies that result in temporary mispricing. Investopedia does a great job of further explaining this.
Types of Arbitrage:
Spatial
This involves taking advantage of price differences for the same asset in different locations. For example, if a stock is trading at a lower price on one stock exchange compared to another, an arbitrageur (someone who is using arbitrage) could buy the stock on the cheaper exchange and sell it on the more expensive one.
Temporal
This focuses on exploiting price differences over time. This could involve taking advantage of price variations between different time periods, such as buying an asset at a lower price in the futures market and selling it at a higher spot price. Real estate is a good example of this. Lower interest rates versus higher interest rates and renegotiating terms to take advance of this.
Statistical
Another type involves using quantitative models and statistical analysis to identify mispriced assets. Traders employing statistical arbitrage may simultaneously buy and sell related securities based on statistical relationships, aiming to profit from the convergence of prices.
Risk (Merger)
This involves trading securities of companies involved in mergers and acquisitions. The arbitrageur takes a position in the target company’s stock, anticipating that the price will rise as a result of the merger.
Cryptocurrency
In the context of cryptocurrencies, arbitrage involves exploiting price differences between different cryptocurrency exchanges. Traders can buy a cryptocurrency on an exchange where the price is lower and sell it on an exchange where the price is higher.
Business Growth
In the context of business, it involves the price of capital to profit margin. Say you have an up and coming product, and you need capital to purchase said product. The cost of capital aka a loan is 5% and your profit margins are 15 percent. You can make a ROI of 10 percent if you sell the product in the certain time period. Often, the bigger your margin of movement of product the riskier you can Arbitrage. Some businesses have 50 percent profit margins and can take riskier loans of 20 or 30 percent. These are often from sites like Prosper, a peer-to-peer lending marketplace that doesn’t have the same strict loan practices of a bank or the slow process of the SBA.
So What Now?
It’s important to note that arbitrage opportunities are often short-lived, as market participants quickly respond to take advantage of any pricing discrepancies. Additionally, arbitrage opportunities may be limited by transaction costs, such as fees and slippage. Harvard Business School also dives into some strategies for utilizing arbitrage opportunities.
Arbitrage is a key concept in financial markets and plays a role in ensuring that prices across different markets remain efficient and closely aligned. However, successful arbitrage requires quick execution, advanced technology, and a deep understanding of the markets involved.
