Arbitrage and hedging: How do they differ?

Arbitrage and hedging are both risk mitigation techniques applied by traders – but they differ immensely in terms of techniques and features.

Arbitrage and hedging: How do they differ?

Arbitrage is the act of taking advantage of a price difference between two or more geographies. This practice is prevalent in trading; in fact, arbitrage is a popular trading technique. Hedging, on the other hand, is the act of reducing the risk of potential loss through an offsetting investment. In trading, a hedge fund is a commonly used protection against adverse price fluctuations.

It is possible to conduct purchase and sale transactions of financial instruments in multiple financial markets. There are often price variances in different markets, and a trader can buy a financial instrument from one market and sell it for a higher price in another. The trader can thus earn a risk-free profit because of the imbalance in the markets. 

It must be noted that arbitrage wouldn’t exist if all the markets in the world are perfectly aligned in terms of rates. Although there are powerful computers and highly efficient trading algorithms working towards it, price differences continue to exist. Most of the time, it is due to short-lived reasons like a delay in price adjustment that’s required to be made due to exchange rate fluctuation. 

Related: What are hedge funds?

Another factor that can cancel out the profit derived from an arbitrage fund is the transaction cost. If this is higher than the arbitrage profit, the investor will not benefit from such a transaction.

There are different theories and statistical approaches to understand and explain asset and portfolio returns. For example, the capital asset pricing model explores the relationship between systematic risk and the expected return from stocks. The arbitrage pricing theory considers the effect of macroeconomic variables on the return of assets and the sensitivity of the asset to it.

Here are some scenarios where arbitrage techniques can be used:

  • Risk arbitrage is applied in case of merger and acquisition deals where the trader aims to make a profit on the shares of the target company. This is because of an anticipated gap in the trading price of the target stock and the acquiring company’s valuation of the stock. This technique may also involve short-selling of the shares of the acquirer.
  • Convertible arbitrage is when you take a long position to buy convertible security and short-sell its underlying security, making a profit on the price difference.
  • Retail arbitrage is a very simple profit-making technique; all one needs to do is to buy products on one retail platform and sell it at a higher price on another.
  • Statistical arbitrage is the analytical technique of finding trading opportunities in financial instruments across markets through the use of statistical models and quantitative techniques.

Related: Important things to know before investing in the stock market

Hedging is used by individual traders and investors as well as asset management companies to reduce the possibility of losses. Hedge funds in India are active in the securities market in the form of hedge equities, and they are active in the commodities market as well.

Hedging is also used in negating interest rate risks, currency risks etc. Hedge funds use hedging strategies in deciding their asset allocation and their portfolio structure, which is generally the debt-equity proportion.

Some common hedging strategies are outlined below:

  • Money market hedge is used by a domestic company to reduce currency risks. It freezes the value of the foreign currency with respect to the party’s domestic currency and is generally done before an anticipated transaction. 
  • Forward contracts are made between two parties who agree to the purchase and sale of an asset on a specified date at an agreed price. Such contracts offset the rate fluctuation risk, whether it’s for commodities, equities, or currencies.
  • Futures contracts are arrangements similar to forward contracts and are standardised instruments. They are often traded through brokers, where parties agree to the quantity, date, credit process, and technical details. Unlike forward contracts, futures cannot be designed according to the customer’s specifications and are regulated by the market.

Related: What is algo trading? How foolproof is it?

Both arbitrage and hedging play an important role in investment strategy. They are helpful for traders in mitigating risk, although by means of very different techniques. Also check these 6 Practical strategies to help reduce investment risk.

 

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