What is Arbitrage and its Types? (Explained)

Arbitrage

In today’s time, in the world of alternative investments, many strategies can be used by anyone. Most of these strategies are those most often taken by long-term bond and stock investors. Which are completely different from the typical “buy and hold” strategy and are also more complex. Arbitrage is also one of the alternative investment strategies. If a sophisticated investor takes advantage of it, it can prove to be extraordinarily profitable for that investor. However, there are also several risks involved that you need to consider. If you are looking to effectively incorporate arbitrage into your alternative investment strategy, you first need to understand the nuances and risks involved. 

Here we will tell you about arbitrage as well as an overview of it, there are three types which we have also mentioned below. You should know about them: convertible arbitrage, pure arbitrage, and merger arbitrage. So, if you are planning to trade Bitcoin, you may use a reliable trading platform like Bitcoin Profit

What is Arbitrage?

Here, if we talk about arbitrage, it has the potential to take advantage of price differences in similar assets in different markets. When the asset in one market is sold for a higher price than the other, it can lead to higher returns for the investor. If they buy it in a cheap market and sell it in an expensive market. Arbitrage has not been seen to have any long-term effects so far. This is because prices tend to stabilize quickly.

TYPES OF ARBITRAGES

1. Convertible arbitrage

It exists as an arbitrage related to convertible bonds, also known as convertible debt or notes. Here, if we talk about convertible bonds, it also acts like any other bond: it comes out as a corporate debt by which interest payment is made to the bondholder. A primary difference exists between a convertible bond and a traditional bond, i.e. if a convertible bond is exercised by a bondholder, they are provided long-term as an option to convert into shares of the underlying company, Which usually includes a discounted rate. On the other hand, if we talk about convertible bonds, it is usually issued by companies. They do this because it allows them to offer lower interest payments.

2. Pure arbitrage

Here if we talk about pure arbitrage, it refers to the above investment strategy, in which an investor can simultaneously take advantage of the price difference in which he can buy and sell a security in different markets. If seen, there are many markets where one can buy and sell investments. In the markets, whenever trading for an asset is initiated, its potential prices are usually temporarily out of sync. Pure arbitrage automatically becomes possible when such a price differential is exposed. Pure arbitrage has recently emerged as a strategy where inefficiencies within the market can be easily taken advantage of by investors.

3. Merger arbitrage

Here if we talk about Merger Arbitrage, then it is a kind of Arbitrage. If seen, these arbitrages are related to entities that are about to merge, such as publicly traded businesses. In general, there are two parties to a merger: the one being the acquiring company and the other being its target. If either of the target companies is a publicly traded entity, the acquiring company may be required to purchase the outstanding share of the said company. In most cases, it is seen to be at a premium to the stock at the time of the announcement, which helps in providing higher returns to the shareholders. An investor who, in its most basic form, participates in merger arbitrage, typically uses its discounted price to purchase shares of its target company, then once the deal is done, that investor can earn a large profit.

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.