Arbitrage opportunity arises due to market inefficiency. It is an opposite situation of the efficient market hypothesis, which implies that all prices are discoverable, and a share price reflects all available information. But arbitrage in financial parlance refers to a practice of taking advantage of a price difference for the same underlier between two or more markets. In several economies, arbitraging is encouraged as it helps to discover any price difference between markets and eventually correct it.
Not many are aware that arbitrage trading isn’t illegal in India. Arbitraging opportunities arise when the price of security differs between two stock exchanges, such as NSE and BSE. But there are some restrictions; for example, you can’t use it as an intraday strategy.
What Does It Mean To Arbitrage?In economic and finance, arbitrage refers to a practice of taking advantage of a price difference between the market and successfully making a profit from the trade. Arbitragers buy an asset where the price is low and sell it in another market where the price is higher. In the process, they gain from the difference. Let’s try to understand it with an example.
Let’s say, XYZ bank trades in both Tokyo Stock Exchange and New York Stock Exchange. On a given day, stock of Company ABC is trading for Japanese ¥ 62.50 in Tokyo and USD 48 in New York stock exchange. Also, suppose the exchange rate between $/ ¥ is 1.37 or value of USD 1 is ¥ 1.37. Hence, $48 = ¥65.76. Here the price difference between the two exchanges creates an arbitrage opportunity encouraging trader to buy the stocks in Tokyo exchange and selling it at New York exchange for a profit of ¥ (65.76 – 62.50) or ¥3.26 per share.
Arbitrage trading is more common in the foreign exchange market, which is the largest market in terms of volume and frequency. But it can occur in any other market for any asset class.
Arbitraging in IndiaNot many of us are aware that arbitraging isn’t illegal in India. Traders can take advantages of a price difference between the major exchanges such as NSE and BSE. Arbitraging opportunities can arise,
- - When an asset isn’t trading at the same price in the exchanges
- - An asset with a known future price will trade at a future rate, creating an arbitrage opportunity