Examples of Arbitrage
Examples of Arbitrage. How to make money with arbitrage. All about pairs trading, index arbitrage, risk arbitrage, tax arbitrage, regulatory arbitrage.
Arbitrage Betting Opportunities
As Billingsley suggests, arbitrage can be executed in two main ways. Through the construction of a new riskless position or portfolio designed to exploit a mispriced asset or portfolio of assets, or through the riskless modification of an existing asset or portfolio that requires no additional funds to exploit some mispricing.
In efficient financial markets, arbitrage-free prices are expected to be the norm. That is, the Law of One Price will hold and the prices of the assets will rest at this equilibrium price.
Types of Arbitrage
Pairs Trading involves identifying two stocks with prices that are historically highly correlated to each other. Arbitrage example: If the relative price spread between the two stocks widens, the arbitrageur will buy the stock with the lower price and sell the stock with the higher price.
Index Arbitrage involves establishing a long position in a stock index futures contract and a short position in the replicating cash market portfolio (or vice versa) when the futures price differs significantly from its theoretical value.
Also known as merger arbitrage, risk arbitrage is the simultaneous buying of an acquisition target’s stock and the selling of the acquirer’s stock. This strategy is commonly used by hedge funds. More on Hedge Fund Strategies.
Tax arbitrage is the process which shifts income from one investment tax catgory to another in order to take advantage of different tax rates across income categories.
Yet another example of arbitrage, regulatory arbitrage is the tendency of firms to move toward the least-restrictive regulations. A regulated institution will thus seek to take advantage of the difference between its real economic risk and its regulated position. Arbitrage example: if a bank is required by regulation to hold 10% capital against the risk of default but the actual risk of default is lower, it would be profitable to securitize the loan.