Arbitrage is one alternative investment strategy that, when properly leveraged, can be extremely profitable. It also has risks that must be considered. To include arbitrage effectively in your alternative investment strategy, you must first understand the nuances and risks involved.
The following is an overview of arbitrage, with a focus on three types you should be aware of: pure arbitrage, merger arbitrage, and convertible arbitrage.
What Is Crypto Arbitrage?
Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from small differences in the listed price of the asset.
Arbitrage describes the act of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit from the temporary difference in cost per share.
How Arbitrage Works
Arbitrage is typically used by large financial institutions due to the significant resources required to identify opportunities and execute trades. To find equivalent assets, they frequently use complex financial instruments such as derivative contracts, digital assets, and other types of instruments.
For example, if there is a high demand for Bitcoin in one country, Bitcoin prices will typically be higher than in other markets. This means that if you buy Bitcoin in cheaper markets and sell it in higher-priced markets, you will profit from Bitcoin arbitrage.
Types Of Crypto Arbitrage
1. Pure Arbitrage
Pure arbitrage refers to the investment strategy described above, in which an investor buys and sells a security in different markets at the same time to capitalize on a price difference. As a result, the terms “arbitrage” and “pure arbitrage” are frequently interchanged.
Many investments can be purchased and sold in a variety of markets. A large multinational corporation, for example, may list its stock on multiple exchanges, such as the New York Stock Exchange (NYSE) and the London Stock Exchange. Prices may temporarily fall out of sync when an asset is traded in multiple markets. When this price difference exists, pure arbitrage is possible.
Pure arbitrage is also possible in cases where foreign exchange rates cause minor pricing differences.
Finally, pure arbitrage is a strategy in which an investor takes advantage of market inefficiencies. As technology has advanced and trading has become more digitized, taking advantage of these scenarios has become more difficult, as pricing errors can now be quickly identified and resolved. This means that the opportunity for pure arbitrage has become increasingly rare.
2. Merger Arbitrage
Merger arbitrage is a type of arbitrage that occurs when two publicly traded companies merge. In general, a merger involves two parties: the acquiring company and its target. If the target company is a publicly-traded entity, the acquiring company must purchase the company’s outstanding shares.
In most cases, this is at a premium to the stock’s current trading price, resulting in a profit for shareholders. As the transaction becomes public, traders seeking to profit from it buy the target company’s stock, bringing it closer to the announced deal price.
The target company’s price almost never matches the deal price, but it frequently trades at a slight discount. This is due to the possibility that the transaction will fall through or fail. Deals can fail for a variety of reasons, including changing market conditions or refusal by regulatory bodies such as the Federal Trade Commission (FTC) or the Department of Justice (DOJ).
In its most basic form, merger arbitrage entails investors purchasing shares of the target company at a discount and profiting once the deal is completed. There are, however, other types of merger arbitrage. If an investor believes that a deal will fall through or fail, he or she may choose to short shares of the target company’s stock.
3. Convertible Arbitrage
Convertible arbitrage is a type of arbitrage involving convertible bonds, which are also known as convertible notes or convertible debt. A convertible bond is fundamentally the same as any other bond: it is a type of corporate debt that pays interest to the bondholder.
The primary distinction between a convertible bond and a traditional bond is that a convertible bond allows the bondholder to convert it into shares of the underlying company at a later date, often at a discounted rate. Companies issue convertible bonds in order to provide lower interest payments.
Convertible arbitrage investors seek to profit from the difference between the bond’s conversion price and the current price of the underlying company’s shares. This is typically accomplished by taking simultaneous long and short positions in the convertible note and underlying company shares.
The investor’s position and the ratio of buys and sells are determined by whether or not the bond is fairly priced.
When the bond is deemed cheap, they typically take a short position in the stock and a long position in the bond. If the investor believes the bond is overpriced or rich, they may take a long position in the stock and a short position in the bond.
Conclusion On Crypto Arbitrage
Arbitrage, in its various forms, can be an effective tool for investors seeking low-risk yields. Because yield is frequently low, high volumes are required to reap the benefits of arbitrage and generate a profit sufficient to cover transaction fees.
As a result, arbitrage is generally not a strategy available to individual investors. However, hedge funds and other institutional investors make extensive use of it.