Arbitrage is a prospect to buy a product at low price in one market place and immediately sell it in a different market for a higher price in order to book some profit. An arbitrage opportunity is present when a commodity I available at low price in one market and there are buyers who want to buy the same commodity at a higher price in a different market. People who are involved in arbitrage transaction are called arbitrageurs.
Let’s look at one example: One company is quoting at USD 125 on the New York Stock Exchange and on NASDAQ for USD 130. One can sell the stock from NASDAQ and buy from the New York Stock Exchange immediately to book USD 10 profit (ignoring transaction cost though).
Arbitrage is possible when;
Important Types of arbitrage:
Some important types of arbitrage are provided below
Convertible bond arbitrage: Convertible bond can be converted into a specified number of shares of the same company. The Convertible bond prices are mainly based upon the credit spread, the stock price, and the interest rate. Arbitrageurs can look for opportunities here and trade whenever there is a slight price difference.
Merger arbitrage: Merger arbitrage is also known as Risk arbitrage in which the stock of acquired company is purchased and at the same time, the stock of the acquirer company is short sold in the stock market to generate arbitrage profit. The positions are closed when the M&S news is announced the event is reflected in the share market.
Municipal or Government bond arbitrage: The Municipal or government bond arbitrage strategy is mainly followed by the Hedge fund managers. They look for arbitrage opportunities between short term and long term municipal or government bonds or swap interest rates between the respective municipal or government bonds.