Pure Arbitrage and Risk Arbitrage

Arbitrage is a trading strategy that aims to capitalize on momentary price differences between the prices of assets on different exchanges. It involves buying and selling the same asset simultaneously in different markets to take advantage of slight price variations. This strategy leverages short-term price fluctuations in different markets or similar financial instruments.

For instance, consider a basic example of arbitrage: ABC LTD Company’s stock is priced at Rs. 100 on the Bombay Stock Exchange (Sensex) and simultaneously at Rs. 100.05 on a different exchange (National Stock Exchange – NSE). An investor can profit by buying 100 shares of ABC LTD. stock at Rs. 100 and simultaneously selling (or shorting) 100 shares of the stock at Rs. 100.05. The investor then gains a profit of Rs. 5 (100 * 0.05) from the difference. These trades are typically executed very quickly, allowing traders to conduct multiple transactions in a single day.

There are two basic types of arbitrage: pure arbitrage and risk arbitrage.

Pure Arbitrage

In pure arbitrage, the asset is bought and sold at the same time, eliminating downside risk. However, many pure arbitrage opportunities are not available to retail investors due to the prevalence of high-frequency trading and computerized systems designed to process data rapidly.

Risk Arbitrage

Risk arbitrage involves taking advantage of price differences with the risk that the condition causing the price difference may or may not occur. An example of risk arbitrage is seen in mergers and acquisitions. When one company acquires another, they typically pay a premium for the target company’s shares. An investor can set up a trade to capitalize on this price discrepancy. However, there is a risk that the merger may not happen, potentially leading to a decline in the stock’s price.

In conclusion, arbitrage is a trading strategy that seeks to profit from short-term price differences in various markets. Pure arbitrage eliminates downside risk, while risk arbitrage involves assuming the risk that a trade may not go as planned. It is essential for investors to carefully assess the opportunities and risks associated with arbitrage trading before engaging in such strategies.

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