Risk-free profits, often called arbitrage opportunities, can arise in various markets when mispricings occur. Here are some common scenarios across different financial instruments and strategies:
Contents
1. Arbitrage in Stock Markets
a. Market Mispricing
- Scenario: A stock trades at different prices on two exchanges.
- Action:
- Buy the stock at the lower price on one exchange.
- Simultaneously sell it at the higher price on the other exchange.
- Example: If Stock XYZ is $50 on NYSE and $51 on NASDAQ:
- Buy at $50, sell at $51 for a risk-free $1/share.
2. Risk-Free Profits in Currency Markets (Forex Arbitrage)
a. Triangular Arbitrage
- Scenario: Discrepancy in exchange rates between three currencies.
- Action:
- Convert Currency A to Currency B.
- Convert Currency B to Currency C.
- Finally, convert Currency C back to Currency A.
- Example:
- EUR/USD = 1.2, USD/GBP = 0.75, EUR/GBP = 0.9.
- Arbitrage profit exists if 1.2⋅0.75≠0.91.2 \cdot 0.75 \neq 0.91.2⋅0.75=0.9.
3. Fixed-Income Arbitrage
a. Interest Rate Arbitrage
- Scenario: Difference between domestic and foreign interest rates doesn’t align with currency forward rates (Covered Interest Rate Parity).
- Action:
- Borrow in the low-interest-rate currency.
- Convert to a high-interest-rate currency.
- Invest in the high-interest-rate currency’s assets.
- Lock in the forward exchange rate to avoid currency risk.
- Outcome: Risk-free profit from the interest rate differential.
4. Index Arbitrage
Scenario: Futures prices for an index are inconsistent with the underlying stock basket price.
- Action:
- Buy the basket of stocks making up the index.
- Sell index futures (or vice versa, depending on mispricing).
- Outcome: The spread narrows, and you lock in a profit.
5. Convertible Arbitrage
Scenario: A convertible bond’s price is misaligned with its underlying stock.
- Action:
- Buy the underpriced convertible bond.
- Short the corresponding amount of the underlying stock.
- Outcome: Profit from mispricing when the bond converges with the stock’s value.
6. Dividend Arbitrage
Scenario: A stock is about to pay a dividend, but options on that stock don’t reflect the dividend payment.
- Action:
- Buy the stock before the ex-dividend date.
- Hedge with a synthetic short position using options.
- Outcome: Profit from the dividend while hedging stock price risk.
7. Statistical Arbitrage (Pairs Trading)
- Action:
- Short the overperforming stock.
- Buy the underperforming stock.
- Outcome: When prices converge, unwind positions for a profit.
8. Merger Arbitrage
Scenario: A merger or acquisition announcement creates a price difference between the target’s stock and the offer price.
- Action:
- Buy the target company’s stock.
- Hedge by shorting the acquirer’s stock (if the acquisition involves stock).
- Outcome: Profit when the deal closes at the stated terms.
9. ETF Arbitrage
Scenario: An exchange-traded fund (ETF) deviates from its net asset value (NAV).
- Action:
- Buy the underpriced ETF.
- Sell the basket of underlying assets (or vice versa).
- Outcome: Profit as the ETF price converges with its NAV.
10. Volatility Arbitrage
Scenario: Implied volatility in options misprices relative to realized volatility.
- Action:
- Buy options if implied volatility is too low.
- Hedge using the underlying stock.
- Outcome: Profit when realized volatility aligns with expectations.
Limitations of Arbitrage
- Transaction Costs: Brokerage fees, taxes, and spreads can erode profits.
- Execution Risk: Delays in trades may lead to losses.
- Market Efficiency: In highly efficient markets, arbitrage opportunities are fleeting.
- Capital Requirements: Some strategies require significant initial capital.
