What is international arbitrage?
International arbitrage is the act of buying and selling the same quantity of an asset in two different markets simultaneously. International arbitrage works on the principle of price differential created due to the inefficiencies of the market. International arbitrage entails a trader buying a security from a market at a lower price and selling a similar quantity of security in another market at a higher price to earn a riskless gain. If both the markets are in the same country, it would be called a simple arbitrage trade, but as per international arbitrage definition, both the markets should be in different countries. International arbitrage opportunities are not very common as price differentials reach an equilibrium as soon as they are spotted. If there is a price equilibrium in the market, there will be no space for international arbitrage. The most common types of international arbitrage trades are the buying and selling of International Depository Receipts (IDR), currencies and the same stock registered in two different countries.
Example of international arbitrage
Let us try to understand what is international arbitrage? Suppose the shares of company XYZ are listed on both the National Stock Exchange and the New York Stock Exchange. The shares of XYZ are trading at Rs 500 on the NSE. However, on the NYSE, the shares are trading at $10.5 per share. Let us assume the US$/INR exchange rate is Rs 50, which means 1US$ = Rs 50. At the prevailing exchange rate, the price of the shares on NYSE in INR will be equal to Rs 525. In such circumstances, an investor can simultaneously buy shares of XYZ on NSE and sell on NYSE to earn a profit of Rs 25 per share. However, in real life, the difference is very small and one has to ensure that a favourable exchange rate holds for some time. While opting for international arbitrage, one should take the transaction cost into consideration. High transaction costs can neutralise the gains from arbitrage.
Types of international arbitrage
There are several types of international arbitrage. The three major types of international arbitrage are covered interest arbitrage, two-point arbitrage and triangular arbitrage.
Covered interest arbitrage: When a trader uses a forward contract to hedge against the exchange rate risk while investing in a higher-yielding currency, it is known as covered interest arbitrage. In a covered interest arbitrage, the word ‘cover’ means to hedge against fluctuations in the exchange rate and ‘interest arbitrage’ means to take advantage of an interest rate differential. Covered interest arbitrage is complex trading manoeuvres and requires sophisticated setups.
Two-point arbitrage: A two-point arbitrage is a simple trading technique where a trader buys a security in one market and sells it at a higher price in a geographically different market. According to the dominant economic theory, the exchange rate of a currency should be the same all across the world. But due to certain factors like difference in time zones and lag in the exchange rate, a price differential gets created. To take advantage of the situation, a trader can buy the currency in the market where it is priced lower and sell in a market where the currency is priced higher. A gain can be made only if the exchange rate is higher than the transaction cost.
Triangular arbitrage: A triangular arbitrage or three-point arbitrage is an advanced version of the two-point arbitrage. It involved three currencies or securities instead of two. A triangular arbitrage opportunity arises when there is a mismatch in the exchange rate of three different currencies. In a three-point international arbitrage, the trader sells currency ‘A’ and buys currency ‘B’. Then he/she sells currency ‘B’ and buys currency ‘C’. In the last leg of the arbitrage, he/she sells currency ‘C’ and buys currency ‘A’.
There are different types of arbitrages, from cash and carry to reverse cash and carry and statistical arbitrage. Also called stat arb, it is a term that defines a set of trading strategies where mathematical modelling is used to determine price differences between securities. The strategy makes use of the concept of short-term mean reversion. Statistical arbitrage is also bracketed under a set of algo trading strategies, where trades are executed on the basis of the algorithm that is preset.
If statistical arbitrage is employed, then price movement across several securities is tapped into after an analysis of price differences and patterns between these instruments.
Statistical arbitrage is used by hedge funds and investment banks as well as an effective strategy.
What is short-term mean reversion and its relevance in statistical arbitrage?
This is a technique wherein buying occurs after prices have dropped below their average and leaving once they get back to normal levels. In a short-term mean reversion technique, these positions are held only for some days or weeks. This is the opposite of value investing where it is held on to for years. The principle where the price differences are expected to see a reversion to the mean over the short term is at the core of this technique. The time leading up to this reversion is exploited for making gains.
The short-term nature of this model is employed in statistical arbitrage strategies, where hundreds of securities can be invested in for a highly shortened period of time, from a few minutes to some days.
Types of statistical arbitrage strategies
There are many strategies that are bracketed under statistical arbitrage trading. Some of them are:
- Market neutral arbitrage: This strategy is about going long on an asset that’s undervalued and taking a short position on an asset that’s overvalued at the same time. The long position is expected to go up in value while the short continues to drop, and the increase and decrease are at the same levels.
- Cross asset arbitrage: This model taps into the price difference between an asset and its underlying.
- Cross market arbitrage: This model exploits the difference between the same asset across markets.
- ETF arbitrage: This is also a cross-asset arbitrage technique wherein the differences between an ETF’s value and the assets underlying are spotted. This is employed to ensure that an ETF’s price is in line with the price of the assets underlying.
What is pairs trading and how is it different from statistical arbitrage?
Pairs trading is often used as a synonym for statistical arbitrage. However, statistical arbitrage is more complex than pairs trading. The latter is a simpler strategy and is one of the statistical arbitrage strategies. Pairs trading is a market-neutral strategy wherein stocks are bunched into pairs. It means two socks with similar price movements are found, and when the correlation comes down, a long position and a short position are taken on the two. The gap between the two is tapped into, till such a time that the two go back to their original or normalised level.
Typically, traders look to pair stocks that belong to the same industry or sector because they tend to have a strong correlation.
Statistical arbitrage trading does not involve pairs and instead considers several hundreds of stocks, making up a portfolio.
Not without risks
Statistical arbitrage plays a key role in ascertaining everyday liquidity and stability in the market. Also, traders benefit from such a strategy. However, it helps to remember that sometimes it also comes with a risk. One of them is that the mean reversion may not occur in some cases and prices may vary hugely from the normal level, as shown historically. The markets are constantly changing and evolving and sometimes don’t behave as it has in the past. This risk needs to be borne in mind while using statistical arbitrage strategies.
Statistical arbitrage is a strategy that uses extensive data and mathematical/algorithmic modelling to take advantage of price differences among securities. It relies on short-term mean reversion, wherein the price differences up to the point of reversion to mean levels are taken advantage of.