The inefficiencies in the market leads to arbitrage. Inefficiencies could be undervaluation or overvaluation of an asset, owing to a variety of reasons including cost of transactions or human preferences or lack of adequate information. If the market were efficient, there would be no scope for arbitrage. There are different types of arbitrage, though. Based on the risk involved, arbitrage could either be risk arbitrage or pure arbitrage. Pure arbitrage is free of any risks as it happens only when a trader knows that there is a difference in price. An example of such an arbitrage could be drawn from the forex market. When a forex trader buys or sells pairs of currencies on the basis of their exchange rate at that point in time, it’s a true or pure arbitrage. 

Risk arbitrage is based on the likelihood of an event in the future, and involves investors or traders weighing such a possibility. Risk arbitrage is also called merger arbitrage because there is the purchase of stocks during a merger and acquisition. An arbitrage opportunity is present when one comes up with an opportunity to buy something for a low price, and sell it at a much higher price.

To further study this topic, we are going to lay focus on different types of arbitrage.

Types Of Arbitrage

There are different classifications of arbitrage, and hence different types of arbitrage involved. One classification includes:

• Financial arbitrage: Financial arbitrage typically refers to forex arbitrage trading.
• Statistical arbitrage: This method of arbitrage involves extensive usage of data and statistics to tap into movement of price.
• Dividend arbitrage: This is an arbitrage type wherein a trader (in the options market) purchases stock and an equal number of put options before the next dividend date.  (ex-dividend). Dividend arbitrage is also called an options arbitrage strategy.
• Convertible arbitrage: This is one of the most popular types of arbitrage and is all about buying a security that’s convertible and short-selling the stock underlying it. A convertible security refers to a security that can be converted into another kind of security. For instance, it could refer to a bond that can be converted/exchanged into a company’s shares.
  

Arbitrage in the futures market

The futures market, wherein futures contracts are traded, also provides an opportunity for arbitrage. The arbitrage here is called cash and carry arbitrage.

• Cash and carry arbitrage – It is the  form of financial arbitrage wherein a trader buys the underlying asset in the cash/spot market and sells the future of that asset. Cash and carry arbitrage takes place when the price of the asset in the future is greater than its price in the cash market.
• Reverse cash and carry arbitrage – It is the flip of cash and carry. In this type of arbitrage, a trader buys an underlying asset and sells it. The asset is bought because it is underpriced and sold because it is overpriced.
• Arbitrage in case of the futures market – It occurs because of the very nature of a futures contract. Although an underlying asset and its future contract have the same pricing on the expiration date of the future, or close to the expiration, they are not priced in the same manner during the period leading up to the expiration. The difference in prices is what is made use of in an arbitrage.

With the help of all these types of arbitrage trading, a trader or investor has the opportunity to gain by way of pricing differences. Arbitrage trading, especially in the futures segment, is popular because of its low risk and inherent simplicity.

Arbitrage in Different Terms

In economics and finance, arbitrage trading is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.

In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets (relative value or convergence trades), as in merger arbitrage. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities, and currencies. People who engage in arbitrage are called arbitrageurs.

Conclusion

Thus, above have been laid down the various types of arbitrages and ways that an arbitrageur can make profits out of the price differences in the market. Arbitrage has the effect of causing prices of the same or very similar assets in different markets to converge. The simultaneous purchase and sale of a financial asset to obtain a small but risk free profit might exist for seconds or possibly minutes. Market makers, specialists, and hedge funds equipped with the means to discover these opportunities and the ability to capitalize on them leave few, if any, arbitrage opportunities for the average investor.

We hope the above article has been worthwhile and has been able to deliver some information on arbitrage trading.