In financial markets, investors compete with each other to exploit arbitrage opportunities that often quickly disappear once they are discovered. But, what exactly is an arbitrage opportunity and how do you exploit it?Learning objectives:
- Define the concept of an arbitrage opportunity.
- Understand how investors follow the “buy low, sell high” strategy to exploit arbitrage opportunities.
A practical example of an arbitrage opportunity
Arbitrage opportunities stem from asset mispricings. To give an example, suppose that you live in the US and will be going to the UK for a holiday soon. Also, suppose that the current price of gold per gram is $55 in the US and £30 in the UK. Moreover, the exchange between the US dollar and pound sterling is such that $1 is worth £0.5 at the moment. Given this exchange rate, the price of gold in the UK is £30 / (£0.5 / $1) = $60 per gram. This is $5 more expensive than in the US.
How can we develop a trading strategy that exploits the discrepancy in the price of gold across the US and UK? The strategy should be to buy low and sell high. That is, we buy gold where it is trading cheap (US) and sell it where it is trading rich (UK).
To implement this strategy, imagine that you borrow $55,000 from a bank and use the money to buy 1,000 grams (or a kilogram) of gold in the US. Then, after you arrive in the UK for your holiday, you sell the gold there for £30,000. Finally, you convert £30,000 into $60,000 at the current exchange rate and pay $55,000 back to the bank on your return to the US. This yields an arbitrage profit of $60,000 — $55,000 = $5,000. Notice that you did not use any of your money in the process, but made a profit of $5,000!
The reality is more complicated…
Clearly, the example above is stylized. In reality, you might have to pay customs duty when transporting gold from one country to another, you would pay some interest to the bank for the loan you took out, you would be exposed to exchange rate risk while carrying out your transactions, and the mispricing in gold across the two markets may partially (or completely) disappear before you complete your steps. Because of these issues, your arbitrage profit could end up being much less than $5,000. You might even lose money. Nonetheless, the general principle is sound: Temporary mispricings in financial markets may generate arbitrage opportunities, and you can exploit them by following a buy low, sell high strategy.
What is next?
This post is part of the series on trading basics. In our next post, we will discuss how an order book can be used to facilitate trading between buyers and sellers. We explained the concept of short selling in the previous post.
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