Arbitrage is a risk free trading strategy. When two assets having similar cash flow and are priced differently, there exists an arbitrage and can be exploited to make profits.
Arbitrage is an important concept in valuing a derivative security. Arbitrage arises when similar securities are mispriced. The arbitrage exists until the gap gets filled by demand and supply where other arbitrageurs step in to exploit for profits, that’s how arbitrage opportunities cease to exist. Arbitrage for make money in the same market is impossible because prices instantly reflect value.
Law of one price:
When two securities of similar cash flows regardless of future happenings, they should trade at similar prices. If security A and B are of that kind, but are trading at different prices. Security A is over priced and security B is under priced. Short (sell) the security A and long (Buy) at B will initiate a profitable trade. Some day or other the security B rises to level A, Hence a profit. This is choosing two oppositely priced securities having relatable characteristics.
Arbitrage example: Imagine in an industry analysis, two companies are in indistinguishable terrain producing similar single products having less deviation in demand and producing similar cash flows. Apart from the management risk the two publicly traded securities can have interchangeable traits and they are priced differently. Naming them A and B, arbitrage exists and follows the law of one price rule.
Rent arbitrage: If the owner of the house is renting the property and staying for a lesser rent having similar facilities nearby is an ongoing arbitrage where the difference in rent is the trading profit. The trade is profitable until the tenant ia aware of the opportunity.
Risk free lending arbitrage:
If a less risky portfolio is sure to produce returns more than the risk free rate (Rf), there exists an arbitrage to benefit. Lending at the risk free rate and invest in the portfolio built to produce above Rf. This is making money out of thin air, the out performance of the portfolio is the arbitrage profit from the transaction (Only when the portfolio is certain to produce excess returns). If the portfolio fails to, off load in full and invest in risk free assets that produce the same return as the lending rate Rf to mitigate or eliminate losses.
Arbitrage funds are short lived because
Because whenever an opportunity shows up, traders try to benefit until the arbitrage ceases to exist. The major cause for lower shelf life is, arbitrageurs are increasing and the market is getting efficient day by day. Arbitrage is also a kind of market inefficiency and closing the gap is making the market more efficient.
Are arbitrage funds safe?
As far as the strategy is concerned, it is totally safe to implement and profit. But a fund is influenced by humans and high quality algorithms. An arbitrage fund to be safe or unsafe depends on the experts operating it and the fund house an investor chooses.
Can arbitrage returns be negative?
Arbitrage returns can explicitly be negative when leveraging. In risk free lending arbitrage, the portfolio may fall below the risk free return rate, which produces negative returns while repaying them with the interest. A normal arbitrage transaction may produce negative returns implicitly, when the trading costs are higher than the mispriced security transaction.